The UK's Q4 2023 banking crisis.

[sancho panza]

I've held off starting a thread like this for years due to the work involved and the fact that the crisis didn't seem to be imminent.No point discussing a banking collapse when the ponzi has years to run.

However, this week certain things have fallen into place and it's time.

The plates have been kept spinning for years in the UK banking system due to Zirp/QE/HTB and a host of other factors(not least a compliant political elite). The day they end Help to Buy seems an apt time to start the banking crisis thread.

The thesis is simple,the UK banking system is overleveraged, poorly capitalised and facing losses in residential and commerical property that will require either equity raising for some of the systemic banks or mergers/bankruptcy(dare we even suggest it?) for the small BS's that have mispriced risk.

Those losses are going to start coming as we begin to see marginal BTL players go under. Initially,it's the most leveraged and then we'll work down the ladder until the bottom.These are the losses that will likely deal blows to the smaller BS's that are overexposed to the BTL sector.

As ever,the worst leverageappears to be in the peripheries.

All opinions and views welcomed,particularly from those who can shed light on bank accounting mechanisms.

Going to start with a repost of Kevin Dowd & Dean Buckner's enlightening paper on UK banks post covid,which lays out the context for the coming crisis and then over the next few months start trawling through the accounts of some of the financial houses to see who's the most exposed.

I have timestamped a prediction for when I think the losses will become apparent but there is an element of guesswork here due to us being unable to second guess not only consumers who've caused runs on supposedly solvent US banks but also central banks who aren't always rational players themselves

Time will tell.

Edited March 31, 2023 by sancho panza

[sancho panza]

Highlights are mine

 

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3851948

A paper by  a former PRA valuation specialist and  a professor Econ at Durham Uni.Data current as of May 29th 2020

http://eumaeus.org/wordp/wp-content/uploads/2020/05/Can UK banks pass the COVID-19 stress test 6 May 2020.pdf

Can UK Banks Pass the COVID-19 Stress Test?

By Dean Buckner and Kevin Dowd* This version: May 29th 2020 Results currently based on data up to May 29th 2020.

 

                                                                                                                             Abstract

 

As the UK economy enters the COVID-19 downturn, the Bank of England (BoE) continues to maintain that the UK banks are strongly capitalised. Yet there is considerable evidence that they are anything but.

The core metrics of the Big Five UK banks have deteriorated sharply since the New Year, and even more since the end of 2006, i.e., the eve of the Global Financial Crisis. Their market capitalisation is now £140.6 billion, down 61% since December 2006; their average price-to-book ratio is 39.2%, down from 255% at end 2006; their average capital ratio, defined as market capitalisation divided by total assets, is 2.3%, down from 11.2% at the end of 2006; their corresponding leverage levels are 43.3, up from 8.9 (end 2006). By these metrics, UK banks have much lower capital ratios and their leverage is nearly 5 times what it was going into the previous crisis.

These metrics indicate a sickly banking system. If the banks were in good financial shape, their PtB ratios would be well above 100% and their capital ratios well above current levels. Traditional rules of thumb also suggest that leverage levels should be no greater than 10 or 15 to be considered safe.

In addition, UK banks have hidden problems relating to their off-balance-sheet positions, their gameable ‘Fair Value’ Level 3 (or ‘mark to model’) and loan book valuations, and their problematic implementation of IFRS 9, all of which have further adverse consequences for their capital adequacy. The BoE’s ‘Great Capital Rebuild’ narrative about a strongly recapitalised UK banking system is little more than an elaborate, and occasionally shambolic, window dressing exercise. The BoE focused most of its efforts on making the banking system appear strong by boosting banks’ regulatory capital ratios instead of ensuring that the banking system became strong through a sufficiently large increase in actual capital meaningfully measured. The result is that the UK banking system enters the downturn in a worryingly fragile state and avoidably so. Another massive bank bailout now appears inevitable.

 

“On Monday 17 March 2008 I was at the annual conference of the Royal Economic Society listening to a lecture on financial stability by Hyun Shin … Bear Stearns had been bailed out the very day before. … it barely crossed my mind that events were in train that, but for huge government rescues, would collapse the western banking system. In fact the thought did flit across my mind, only to be dismissed, naively, as incredible.

I tell this story to illustrate that the real shock of 2008 was not the shock – of subprime, the drops in property prices, &c – but the system’s lack of resilience to the shock. Put another way, the “it” that few saw coming was not the sharp movement of asset prices, but the fragility of the system. It is a basic proposition of financial economics, and no ground for criticism of economists, that you can’t see sharp asset price movements coming. Failure to anticipate systemic fragility in the face of such shocks is an altogether different matter.

Inadequate equity capital was the basis for that fragility. Of course there were liquidity problems too, but they were often down to (justified) perceptions of capital inadequacy, as Northern Rock itself showed. And there were problems of management conduct and incentives and corporate culture too, but their consequences for the economy are far more severe when capital falls short. Banks’ capital adequacy is a cornerstone of our economic system.” Sir John Vickers (2019, our emphasis) 1

   Section 1. The Big (Divs) Freeze

By late March, it was clear that the UK economy was going into a major COVID19 downturn. Even , UK banks were still intending to go ahead with their plans to pay some £7.5 billion in dividends to their shareholders. The first payment, by Barclays, was due on Friday, April 3rd.

News of the banks’ intentions triggered a public outcry. Kevin Hollinrake MP, the chair of the all-party parliamentary group on fair business banking, was appalled: “They live in a different world, don’t they? Why on earth would you pay a dividend right now? It’s shocking they could even contemplate this.” Taxpayers had already rescued the banks once, he said, and it would be outrageous if they had to be supported a second time.

As late as Friday March 27th, the BoE was said to be “relatively unfazed” about the dividend payments going ahead, although in private the BoE had been telling the banks ever so gently that it was “concerned about the optics.”

Come the next Monday, March 30th, and the bankers were holding out. To quote a subsequent article in the Financial Times:

'some of the banks argued their balance sheets were strong enough to make the payouts. They pointed out that they had passed the BoE’s stress tests last year, which measured whether the lenders were able to withstand an economic shock on a similar scale to the coronavirus fallout.'

Faced with an offer they could hardly refuse, the bankers backed down. Mr. Woods had certainly raised a few eyebrows.

So why the change of heart by the central bank? The BoE’s decision to play the heavy

'hardly smacks of a considered change of direction; more a handbrake U-turn that left black rubber marks all over the road. No, it is not whether the central bank should have acted: few seriously dispute that the country’s lenders should be conserving their capital given the economic shock Britain is experiencing. Rather, it’s the opposite. Why did it take so long? (Ford, 2020)

 Mr. Ford points out that the official explanation is coronavirus and the pressures that that puts on the banks. He continues

'But the virus did not become news only last Tuesday [March 31st]. What is puzzling is the failure to gate earlier all capital distributions. It’s hard to believe the central bank trusted bank bosses to show restraint, especially when the likes of Barclays’ Jes Staley had big bonuses riding on the payouts.

More likely, the central bank believed its own story that the lenders were super well-capitalised. That has certainly been the mood music from Threadneedle Street, with the now departed governor Mark Carney boasting recently that their balance sheets were now so strengthened that, unlike 2008, the banks could be “part of the solution”.

The next day, the prices of the Big Five UK banks’ shares plunged: 12% for Barclays, 9.5% for HSBC, 11.7% for Lloyds, 5.2% for RBS and 7.3% for Standard Chartered.

There is deeper puzzle, however. If it believed that UK banks are super strong, why didn’t the BoE just let the dividend payments go ahead? The proposed payments were barely 2.1% of the Big Five banks’ book value capital, which, by hypothesis, was super adequate. Allowing the payments to go ahead would have sent the perfect signal of strength to the market, especially at a time of so much uncertainty. The BoE blocking those payments then looks like a panicky overreaction that unnecessarily spooked the markets, because it gave the impression that the BoE was having second thoughts about how strong it thought the banks really were. How else to explain the market reaction the next day?

So the question is, how strong is the UK banking system? Or, more precisely, does the UK banking system have the financial resilience it needs to withstand a major shock and still emerge in good shape?

This article seeks to answer these questions. Our answer is, inevitably, involved, and is laid out in the follow steps. Section Two outlines our main argument. Section Three looks at banks’ current share prices and market capitalisations, and how these have changed since the New Year and since before the Global Financial Crisis (GFC). Sections Four and Five examine banks’ price-to-book (PtB) and market value capital to asset ratios. Section Six discusses how the UK banking system is now bifurcated into two sub-systems – HSBC and the other banks – and discusses HSBC’s exposure to Hong Kong. Section Seven examines off-balance sheet (OBS) and other hidden risk and valuation problems facing the banks. Section Eight examines the uselessness of the regulatory capital framework, section Nine examines the BoE’s claims that the UK banking system is now superstrong and section Ten discusses the BoE’s track record in the GFC. Section Eleven discusses the underlying political economy of bank capital and section Twelve concludes.

 

[sancho panza]

Section 2. Outline of Argument

 

To summarise the main argument, as the UK enters the downturn, the BoE continues to maintain that UK banks are strongly capitalised. However, reliable evidence indicates otherwise. The core metrics for the Big Five UK banks have deteriorated sharply since the New Year, and even more since the end of 2006, i.e., the eve of the Global Financial Crisis (GFC). Their market capitalisations, their price-to-book ratios and their ratios of market capitalisation to total assets have fallen sharply since the New Year and even more since before the GFC. Their corresponding leverage levels have correspondingly increased. For example, banks’ average price-to-book ratios are now 39.2%, down from 255% at the end 2006, and their average leverage, defined as total assets divided by market capitalisation, has soared to 43.3, up from 8.9 at the end of 2006. Few would disagree that banks were already over-leveraged going into the GFC and yet UK banks are more than four times more leveraged now than they were then.

These metrics indicate a sickly banking system. If the banks were in good financial shape, their PtB ratios would be well above 100% and their capital ratios well above current levels. Traditional rules of thumb also suggest that leverage levels should be no greater than 10 or 15 to be considered safe.

In addition, UK banks have hidden problems relating to their off-balance-sheet positions, their gameable ‘Fair Value’ Level 3 (or ‘mark to model’) and loan book valuations, and their problematic implementation of IFRS 9, all of which have further adverse consequences for their capital adequacy.

The BoE’s ‘Great Capital Rebuild’ narrative about a strongly recapitalised UK banking system is an elaborate window dressing exercise. The BoE focused most of its efforts on making the banking system appear strong by boosting banks’ regulatory capital ratios instead of ensuring that the banking system became strong through a sufficiently large increase in actual capital meaningfully measured. The result is that the UK banking system enters the COVID-19 downturn in a woefully fragile state and avoidably so.

Another massive bank bailout now appears inevitable.

The assurances of the central bank about the supposed strength of the banking system must also be weighed against its unimpressive track record from the GFC: the BoE completely failed to see the crisis coming, despite market signals that something was amiss; then, when the crisis did come, the BoE persistently misdiagnosed the true nature of the crisis as being a liquidity crisis (which is not a big deal) rather than the capital or solvency crisis that it was (which is a big deal), despite the fact that markets had been signalling capital problems since 2007. The scale of the losses overwhelmed the UK banking system and blew the UK’s fragile regulatory capital framework out of the water.

Fast forward to the present, markets are again signalling major problems and the Bank of England is again insisting, against the evidence, that all is well. As Deputy Governor Sam Woods reiterated to the Treasury Committee on Wednesday April 15th, “We go into this with a well capitalised banking sector.” 9

We end with some speculations about the underlying political economy of bank capital, i.e., the game that is really going on. In a laissez faire world, bankers who took excessive risk could reasonably expect to bear the consequences of those risks, so they would restrain their risk-taking out of their own selfinterest.

Enter central banks and regulators, who set up lender of last resort facilities, deposit insurance and such like, and associated expectations of bailout. The bankers respond to these incentives by increasing their leverage and taking more risks to boost their returns on equity, which are the basis of bank CEOs’ remuneration. High leverage seeks to maximize the value of the (often implicit) central bank or government guarantees by letting banks borrow at rates subsidised by society at large, thereby privatising profits on the upside and socialising losses on the downside. The bankers’ Social Contract is highly destructive, however. The regulators attempt to rein it in by capital adequacy regulation, the aim of which is to constrain leverage, but the bankers are able to defeat them each time by ‘capturing’ the regulatory system which they then manipulate to their own advantage. Thus, the regulator’s dismal performance, while shocking, is only to be expected.

At some point, there will need to be radical reform to reverse the ever more destructive banksterisation of the economy and re-establish a Social Contract in which the bankers serve the public and not the other way round. To go back to the Vickers quote with which we started, “Banks’ capital adequacy is a cornerstone of our economic system.” A healthy economy – a healthy society, even – depends on banks’ capital adequacy being restored and then protected against those who would knock it down.

 

 

Section 3 Bank Share Prices and Market Cap

Let’s start with some evidence. Consider the following chart, which gives the changes in the prices of the Big Five banks’ share prices since the New Year.

Between the end of 2006and the close of business on Friday,May29th2020, the banks’ share pricesfell by between 54.8% in the case of the best performer, HSBC, and 98.1% in the case of the worst performer, RBS.

The big five banks’ latest market capitalisation (‘market cap’)is £140.6billion. This number is to be compared to the banks’ total assets, £6,093.3billion,which is 43.3times their market cap. To see how much their market caphas changed, the next table shows the corresponding market cap numbers as of December 31st2006

Banks’ market cap was £360.9 billion at the end of December 2006. Banks’ current market cap has fallen by 61% since 2006.Not much sign here of the Great Capital Rebuild.

 

Edited March 31, 2023 by sancho panza

[sancho panza]

   Section 4 Price-to-Book Ratio

Another metric is the price-to-book (PtB) ratio, the ratio of a bank’s market cap to its reported or book capital.9

Theoretical considerations about price-to-book

A healthy bank would have a PtB ratio well in excess of 100%.

Why is that?

Imagine that webuild a factory costing £100. We finance it through some mix of debt and equity, say,£90 in debt and £10 in equity. Shareholders are assumed to operate under unlimited liability, i.e., we are back in early Victorian England. I report the book value of my equity as £10. Shareholders anticipate that ourfactory business will be profitable, so they are presuming a positive franchise value, i.e., that future profits will be positive. Therefore, they value the firm at more than book, say, £15reflecting a franchise value of £5. So the price to book ratiois £15/£10 = 150%. The law is then changed to allow shareholders the protection of limited liability, i.e., they can now walk away from any losses exceeding the share capital they have subscribed. Limited liability is valuable to shareholders, and they value the implicit limited liability put option as, say, £3. The market value of their shares therefore rises to £18 and the PtB rises to £18/£10 or 180%. The lesson is that we would expect a healthy business to have a PtB in excess of £100 because of (a) franchise value and (b) the value of the limited liability put. Substitute ‘bank’ for ‘factory’ and the same applies.

Now suppose that the skies darken and the market anticipates that future profits will be zero, so the whole of the franchise value has been wiped out. Revaluing the franchise value at £0, the market value of the firm’s equity falls from £18 to £13 and the firm’s PtB becomes £13/£10 or 130%.

But wait.

Since the market now takes a more pessimistic view of the firm’s profit prospects, the value of the put option rises from £3 to, say, £4. So the market value of the firm’s equity goes up again, from £13 to £14 and the PtB ratio becomes £14/£10 or 140%.

The question then is what would it take to get the PtB under 100%? Presumably either a perception by the market that the firm is carrying hidden losses or a perception by the market that the NPV of its future cash flows is well below zero. Either way, a PtB less than 100% is a bad sign.

The implication is a strong one: a healthy bank should have a PtB ratio comfortably over 100%. Conversely, if a bank has a PtB ratio under 100%, then there is something wrong

Price to book ratios for UK banks

How do the Big Five banks’ PtBs look? The answer is not so good.

By PtB ratios, the best performer is HSBC at 48.8%, the average is 39.2% and the lowest is Standard Chartered at 28.7%. To point out the obvious: these ratios are well below 100%. Ergo, the market must believe that there is something wrong with the banks.

We are reminded of Merton Miller’s comments about a 50% PtB: “That’s just the market’s way of saying: look at these guys; you give them a dollar and they’ll manage to turn it [or perhaps he meant, burn it] into fifty cents (p. 199).”12

It would appear that UK banks can’t even manage that.

The next table shows the corresponding PtB ratios as of end-2006 and end 2019

The average PtB ratio was 255% at the end of 2006.

By this criterion, UK banks are in considerably worse shape than they were going into the GFC.

As a cross check, according to a BoE spreadsheet, the average price to book ratio for UK banks fell from 211% at the end of 2006 to 85% by November 2015. Unfortunately, that series ends in November 2015 and appears to have since disappeared from the BoE’s website. (Good job we kept a copy. For those who wish to see it, we provide a link to it here, see sheet ‘9. Bank equity measures,’ cell B194.) The Bank’s numbers are a little different to ours, but the story is much the same.1

 

 

 

Section 5  Capital Ratios and Leverage

Theoretical considerations

A bank’s capital strength is traditionally evaluated in terms of its capital ratio, the ratio of its capital to its assets, and by its leverage, which is inverse of the capital ratio i.e. the ratio of assets to capital.

We will work on the presumption that the numerator in the capital ratio, capital, should be measured as market cap, and that the denominator, assets, should be measured as total assets.

In defence of the use of market cap as a capital measure, we would point out that if you want to sell an asset, you have to sell at market value and the book value doesn’t matter; if you want to buy an asset, then you would be a fool to pay book value if market value were lower, and you would have to pay market value if market exceeds book. Similarly, if a bank wants to sell its shares, it gets the market value (or less, if it sells via a rights issue) and again the book value is irrelevant.      

We can also think of this market value vs book value issue in terms of loss absorbency. In general terms, we can think of loss absorbency as the ability of a bank to experience losses and still be able to function normally. For a bank, the losses would arise from a fall in asset values. Equity capital is loss absorbing because it is a liability whose value is determined by the level of asset value. By contrast, a bond or a bank deposit is not loss-absorbing because its contractual value, the amount owed, remains the same regardless of fluctuations in asset values. So the greater the bank’s equity, other things being equal, the greater its loss absorbency. The issue then is whether we should measure a bank’s loss absorbency in terms of its market cap or its book value share capital.

Consider two schools of thought. School M says that we should use market cap as our measure of capital. School B says to use book value. Now suppose that the market cap and book value capital are initially the same. Suppose too that the bank reports on an annual cycle and had only yesterday reported its book value. Tomorrow the share price falls. According to School M, the bank’s capital (=market cap, the product of the number of shares outstanding and the share price) then falls. School B however maintains that the bank’s capital (=book value capital, e.g., the book value of shareholder equity reported yesterday) stays the same, market cap irrelevant.

Now suppose that the share price keeps falling. By its logic, School B must continue to maintain that the bank’s capital remains constant, however low the share price goes, so market cap is still irrelevant.

After a few days equity market investors conclude that the bank will never pay them any further dividends, so the share price and market cap go to zero. School M says that the bank’s capital has gone to zero, bank irretrievably bust. School B maintains that the bank’s capital hasn’t changed because the book value hasn’t changed, so (presumably) the market cap is still irrelevant. School M maintains that the capital losses have already occurred, School B maintains that the losses to capital, if there are to be any, will occur or should be deemed to have occurred only when the next annual report comes out in fifty one weeks’ time.

Substitute a dead parrot for the bank and you have a situation reminiscent of a well-known comedy sketch.

To continue. Suppose you are still supporting School B by this point. You reread the last annual report that contains the capital number, book value, that you believe to be the appropriate one to use. You then discover that the bank was planning to move from a one year reporting cycle to a two year reporting cycle. OK, the example is getting a little silly, but logic being what it is, you must now believe that the capital losses that we think have already occurred will now occur or should be deemed to have occurred in almost two years’ time. OK, you say. But what if the new reporting cycle is five years instead of two, or ten years? Are you OK with those too? You can see where we are going here. Book value is irrelevant if it was last reported in 1926. School B does not end up in a happy place.

Still not convinced?

Then ask yourself, what is the bank’s loss absorbency at this point? School M gives a clear answer: zero. The shareholders who own the bank can’t absorb further losses because they have lost their entire investment (i.e., have nothing left to lose) and, because shareholders have limited liability, the bank’s creditors cannot sue them for any further losses that they (the creditors) might experience.

You disagree and continue to insist that loss absorbency is still book value. Then explain to us why purported loss absorbency numbers like book value capital are still the preferred numbers to use even though market conditions have changed drastically since those numbers were released, so those numbers are no longer remotely relevant to current market conditions. What useful information do you think those numbers are telling us? Perhaps they are telling us that the bank will come back from the dead.

There is also the issue of timeliness. Consider the following quote from Morris’ Goldstein’s book Banking’s Final Exam:           

             (a) Note that when former Federal Reserve Chairman Ben Bernanke testified to Congress in 2007 about the subprime crisis, he estimated that it would generate total losses in the neighborhood of $50 billion to $100 billion [over period of years] … (b) But … when Bernanke gave testimony in an AIG court case … he explained that, by September and October of 2008, 12 of 13 of the most important financial institutions in the United States were at risk of failure within a period of a week or two. The question for stress test architects and modelmakers is, How do you make your models generate a transition from (a) to (b) in the course of, say, a year or two? This is not a technical sideshow. In stress modeling, it is the main event.14 (Goldstein, 2017, p. 251)

Goldstein is referring to the lack of timeliness of the Fed’s stress tests, but the same point can be made about the lack of timeliness of book value capital numbers. When a crisis occurs, market prices fall so fast that book values become irrelevant.

For the avoidance of doubt, we are not saying that book value measures have no merit. We are saying that for reasons especially of (a) loss-absorbing capacity and (b) timeliness, market cap is generally to be preferred to any book value measure.

Regarding the use of total assets as the denominator, we would point out that there are two alternative denominator measures, Risk Weighted Assets (RWA) and the Leverage Exposure (LE). These are both highly flawed however.15 The drawbacks of the former are explained in Appendix Five and the drawbacks of the latter are explained in Appendix Six.

Capital ratios and leverage for UK banks The next table shows the Big Five banks’ ratios of Market Cap (MC) to Total Assets (TA) and their corresponding leverage numbers (i.e., TA/MC):

These MC/TA capital ratios vary from 1.4% for Barclays to 3.2% for HSBC, with a weighted average of 2.3%. These are on the low side considering that many experts led by Anat Admati have been calling for minimum capital requirements of 15% or more. If we accept the Admati Capital Standard, and there are compelling reasons why we should accept it), 17 then UK banks’ capital is a small fraction of what it should be, to be considered capital adequate.

The average current MC/TA ratio of 2.3% can be interpreted as suggesting that a loss on total assets of under 2.3% would be enough to wipe out the banks’ entire capital, and that any higher loss would push the banks into technical insolvency.

The corresponding leverage (=TA/MC) numbers vary from 31.5 for HSBC to 72.3 for Barclays, with an average of 43.3. The dangers of high levels of leverage were vividly described by John Cassidy in the FT in 2010:

Leverage kills. In March 2008, Bear [Stearns] had tangible equity capital of about $11bn supporting total assets of $395bn – a leverage ratio of 36. For several years, this reckless financing enabled the company to achieve a profit margin of about a third and a return on equity of 20 per cent; when the market turned, it left Bear bereft of capital and willing creditors. During the ensuing months, the same story was to be played out at scores of other banks and non-banks.18

By the Admati Standard, the maximum leverage should be at most 1 divided by 15% or 6.7.

Alchemists of Loss19 quotes a traditional leverage rule of thumb used in the City:

“The maximum safe leverage is 10 to 1 for banks and 15 to 1 for brokers dealing in liquid instruments.” This Copybook Heading was widely ignored [in the run up to the GFC], most openly by investment bankers operating at leverage ratios of over 30 to 1 by the end of 2007, the sin made worse by banks hiding their risks by pushing assets off their balance sheets by use of “structured investment vehicles” funded by commercial paper that was apt to become illiquid when most needed. This god’s revenge is traditionally very painful and is proving so again.20

As of the end of 2006, the MC/TA ratios varied from 4.6% for LBG to 19% for RBS, and the weighted average was 11.2%.

The corresponding leverage varied from 5.3 to 21.5, and the average was 8.9. Thus, UK banks are considerably more leveraged now than they were going into the GFC, and yet reasonable people agree that excessive leverage then was a key factor aggravating the severity of the GFC. 21

The elephant in the room then trumpets: if the average leverage of 8.93 at end 2006 was too high, why is the current average leverage of 43.3 not way too high?

And what does the Bank of England’s spreadsheet tell us? It tells us that the average market-based capital/asset ratio (it actually uses the term ‘market-based leverage ratio’) falls from 8.31% at end 2006 to 5.28% by Nov 2015 (see cells C87 and C194), and the corresponding average leverage rises from 12 to almost 19. The BoE spreadsheet agrees with us that (market value) capital ratios were higher pre crisis than post, and market-value leverage, lower.

Therefore, the current weakness of the banks cannot be ascribed to the impact of COVID-19 or to the introduction of IFRS 9, because banks were in poor shape well before those came along.

 

 

 

 

Edited March 31, 2023 by sancho panza

[sancho panza]

Section 6. HSBC and Hong Kong

However, the UK’s strongest bank, HSBC, is not looking that strong itself, and has its own issues quite apart from being leveraged well over three times more than was the UK banking system going into the GFC.22 To quote an article by Patrick Jenkins in the FT on January 6th this year:

'In the third quarter of last year, the latest reported period, the Hong Kong and Shanghai Bank, true to its name, made about 80 per cent of its profits in Hong Kong and mainland China.

For much of the bank’s 155-year history, that often vibrant home market has been a strength, offering high profit margins and high growth. But, with the fate of Hong Kong as a semi-autonomous Chinese territory hanging in the balance, it is starting to look like a vulnerability. '

He then mentions three risks facing the bank.

'The first is a set of risks relates to sustainability of its business in the region. These include slowing Chinese growth, the impact of China-US trade tensions and slowing trade growth. He also mentions the “direct fallout for HSBC from the US-China stand-off as well: last summer the bank infuriated Chinese officials after it provided information that helped US prosecutors build a case against telecoms group Huawei, leading to the arrest of its finance director.”

A second risk for HSBC is Hong Kong-specific and pending. The hit to travel and tourism as a result of the protests will soon feed through to the banking system — a prospect foreshadowed when HSBC more than doubled its estimated credit losses from the territory in the third quarter. …

The third headache is far more fundamental. The conflict between Hong Kong and Beijing could not clash more awkwardly with HSBC’s core business model. Hong Kong is by far its biggest market. But good relations with Beijing have been crucial as it has expanded across the Pearl River Delta and beyond. If tensions escalate further, HSBC is bound to upset one or other camp — with four-fifths of profits hailing from greater China, the downside risk is substantial. …'

[Viewed from the broader historical perspective] Hong Kong and greater China are coming once again to dominate the bank’s revenues and profits just as the fragility of the region is more evident than ever.

The BoE also flagged up UK banks exposures to Hong Kong in its December 2019 Financial Stability Report (p. 27):

UK banks have significant exposure to Hong Kong, representing around 160% of their common equity Tier 1 (CET1) capital. The recent political protests in Hong Kong have been accompanied by a sharp slowdown in growth and falling asset prices. GDP growth contracted by 3.2% in Q3 — the weakest quarterly growth rate since the peak of the financial crisis in 2009 (Chart C.2).

Chart C.2 Hong Kong is now in recession Hong Kong real GDP

 

Sources: Eikon from Refinitiv and Bank calculations.

The major Hong Kong equity index is 12% lower than its level seen in April when protests began. Transactions in the commercial real estate (CRE) market since April contracted by 31% when compared to the same period last year …

There have also been significant portfolio capital outflows from investment funds in Hong Kong. The total cumulative outflows since April were around US$5 billion, accounting for around 11⁄4% of Hong Kong GDP (Chart C.3).

The protests, and their impact on the real economy, highlight political risk as a key vulnerability in Hong Kong. And these political tensions pose risks, given Hong Kong’s position as a major financial centre.

The latest figures just out show that Q1 [20]20 GDP declined Year-on-Year by 8.9%, the biggest fall on record, bigger than the previous largest fall of 8.3% in 3Q 98.23

There is also the question of HSBC’s exposure to the HK and to a lesser extent Chinese property markets. To give a sense of this exposure, consider the HK residential price indices in Figure Two:

We see an initial rapid rise, then a dip of nearly 70%, followed by a rise to current value of nearly 500 to almost 650, depending on the index.

As an aside, this chart would provide the basis for a good stress test. A ‘prudent’ (in the PRA sense) stress test would be to assume only a 70% fall in HK prices, then see how that hits the HSBC loan to value. One does not have to do the actual analysis to see that the results would not be pretty.

We give a more detailed analysis of HSBC’s Hong Kong exposure in Appendix Nine.

And so we have the unprecedented situation that the financial condition of the UK banking system depends on one bank which is itself not only highly leveraged but also has enormous exposures to one of the most volatile regions in the world.

The UK banking system is now dependent on one humongous bet that the (presumably overvalued?) Hong Kong property market won’t go into a meltdown – and that nothing much else will go wrong in the region either.

We have here a most remarkable failure of prudential regulation.

 

 

 

 

 

 

After Table 8 there's a discussion on Credit Book Accounting regarding risk weighting by individual banks.As far as I'm aware the larger institutions are allowed to calibrate risk weightings based on their own data (IRB approach) from bank customers.Smaller institutions such as say the Coventry Building Scoiety,will use the 'standardized' and apply parameters drawn from the data of other big banks.

So the possibility exists of different banks risk weighting loans differently.Happy to be corrected.

 

                                                                                               Section 7. Off Balance Sheet and Other Hidden Problems

Returning to the main theme, you might say that the capital ratios we reported don’t take account of off-balance-sheet (OBS) positions and you would be right.

They don’t. The implication is that our leverage numbers paint a rosier picture of banks’ leverage than is warranted. Who knows what hidden leverage or hidden losses lurk beneath?

We can however surmise that there is quite a bit of it.

There are four sets of issues here: OBS, ‘Fair Value’ valuations, credit book valuations and the impact of IFRS 9.

Let’s consider each of these in turn.

Off-balance-sheet positions

The problems of OBS positions were nicely summarised in a perceptive analysis by Frank Partnoy and Lynn Turner:

'Abusive off-balance sheet accounting was a major cause of the financial crisis. These abuses triggered a daisy chain of dysfunctional decision-making by removing transparency from investors, markets, and regulators. Off-balance sheet accounting facilitated the spread of the bad loans, securitizations, and derivative transactions that brought the financial system to the brink of collapse. ...

Off-balance sheet problems have recurred throughout history, with a similar progression. Initially, balance sheets are relatively transparent and off-balance sheet liabilities are minimal or zero. Then, market participants argue that certain items should be excluded as off-balance sheet. Complex institutions increase their use of off-shore subsidiaries and swap transactions to avoid disclosing liabilities, as they did during both the 1920s and the 2000s. Over time, the exceptions eat away at the foundations of financial statements, and the perception of the riskiness of large institutions becomes disconnected from reality. Without transparency, investors and regulators can no longer accurately assess risk. Finally, the entire edifice collapses. This is the story of both the 1920s and today.

As in the past, the off-balance sheet complexity and exceptions have gone too far. The basic notion that the balance sheet should reflect all assets and liabilities has been eaten away, like a piece of Swiss cheese with constantly expanding holes.

What is off the balance sheet swallows up what is on the balance sheet. Off-balance sheet abuses render banks’ financial statements virtually useless and their true exposures become impenetrable.24

Insert “almost” before “impenetrable” and we would agree.

Problems with ‘Fair Value’ valuations

Then there are banks’ Level 1, Level 2 and Level 3 ‘fair value’ valuations.

Roughly speaking: Level 1 assets have readily observable prices and reliable fair market values. Level 1 assets include listed stocks, government bonds, or any assets that are regularly marked to market. Level 1 is not easy to manipulate, unless you manipulate the underlying market prices, which is more difficult, but not unknown.

Level 2 (or ‘mark to model’) assets do not have directly observed market values and are traded less frequently in thin markets, but have (one hopes) approximate fair values that can be obtained from models calibrated to observed market prices. Examples include some corporate and most municipal bonds. Level 2 valuations are at best approximate and can sometimes be gamed by selecting the model or proxy price that gives the preferred valuations.

Level 3 (or ‘mark to model’ or less politely, ‘mark to myth’) assets are highly illiquid and can only be fair-valued using models calibrated to guesstimates of key parameters. Level 3 valuations are unreliable and potentially highly gameable, because both models and calibrations can be chosen to manipulate valuations and because this gaming is difficult for outsiders to detect. Examples of Level 3 positions include asset-backed and mortgage-backed securities and many forms of CDS. The experience of the GFC showed that Level 3 positions can lose much of their value in a crisis. To paraphrase Warren Buffet, its only when the tide goes out do you discover who's been swimming naked. Therefore it would be prudent to presume that Level 3 valuations might have been manipulated and that this manipulation would be revealed in a crisis when some Level 3 valuations might, e.g., collapse.

Enron provides a good example of the potential unreliability of Level 3 valuations due to unscrupulous gaming of both valuation models and fair value accounting standards, but it is far from being the only one.25 Now suppose we are reading these valuations with an eye to how they might be affected, i.e. what might go wrong, in a stress: (a) When we read the Level 1 FV valuations, it might be prudent to presume that Level 1 valuations would go with the market, i.e., down. We should also be asking about the volatility of the market prices on which the valuations are based and be concerned not with normal market volatility, but with potential market volatility in a stress, which could be considerably higher.26 (b) When reading Level 2 valuations, we might start with the Level 1 valuations and look for adverse slippage between the Level 1 and Level 2 valuations. (c) When reading the Level 3 valuations, we might ask what would happen if those were to fall further than the Level 2 valuations, keeping in mind the possibility that those involved might have succumbed to the temptation to game the system by fiddling models or adopting an ‘aggressive’ approach to accounting valuations to produce preferred outcomes.

There are some red flags here.

Credit book accounting

A former City analyst recently told one of us, “Credit book accounting and IFRS 9 are worse than IFRS 13 level 3. Most of the valuation of a loan book is just fantasy.” By the former, he was referring to the problems arising from the use of credit risk models to value banks’ credit books.27

To explain: Credit exposures on the trading book are marked to market on the assumption that the market price reflects all information on credit risk. However, there is typically no market information on the credit risk of a bank’s loan book and banks traditionally relied on valuations based on the expertise and subjective judgments of their internal credit teams. But under Basel III’s ‘advanced ratings based’ (AIRB) approach, qualifying banks (i.e., the big ones) are allowed to produce valuations by inputting their own calibrations into a credit risk capital model approved by the regulators. There are many problems with this approach, but the one that stands out is the dependence of the resulting valuations on the input values of the default probabilities involved. Unfortunately, the default probability is both notoriously difficult to calibrate and easy to game. Therefore, loan book valuation can be highly unreliable.28

IFRS 9

Finally, there are the problems from the implementation of the accounting standard (IFRS, International Financial Reporting Standard) 9, which deals with the reporting of expected loan losses. 29 IFRS came into force on January 1st to replace the old (IAS, International Accounting Standard) 39 which stipulated an ‘incurred loss’ model, i.e., banks’ expected losses were typically not recognised.30

The main departure regarding impairment accounting is that IFRS 9 requires the recognition of (at least some) expected credit losses. IFRS 9 also introduces a three-stage model for classifying credit assets.

As soon as a financial instrument is originated or purchased, and if expected losses have not increased significantly, the instrument is categorised as Stage 1 (i.e., low-risk) with the requirement that its expected losses over the next year should be reported and provided for. If the credit risk has ‘increased significantly’ but the instrument is not considered credit-impaired, then the instrument is categorised as Stage 2 and its expected losses over its lifetime should be reported and provisioned. Reclassifying a hitherto Stage 1 loan as a Stage 2 loan then creates a ‘cliff edge’ effect, i.e., a significant increase in reported losses and associated provisions, an effect aggravated further by the banks not being able to offset the lifetime expected losses by lifetime expected income. Credit-impaired instruments are categorised as Stage 3 and full lifetime expected credit losses are to be recognised for them too.

JohannesBorgen on Twitter31 has a nice take on the way IFRS 9 works:

'Under IFRS 9, there are three types of loans: Stage 1 (all good), stage 3 (defaulted) and the tricky Stage 2, which does not depend on the credit quality of a loan but whether that credit quality has deteriorated.

You can have a Stage 1 loan rated CCC if you originated it at CC and a A-rated loan in stage 2 if you originated it at AA. I know, it is very weird, but that’s how it works.

The HUGE difference between S2 and S1, is that in S1, you book a provision for the Expected Loss (EL) over a year whereas in S2 you take EL over the loan’s *entire lifetime*. The difference can be huge for some long-dated loans, like … Mortgages!

When the macro becomes shitty, IFRS 9 has a double blade effect; 1) A-year EL increase, but that was already taken into account in bank regulations so it’s not a significant change.

2) a bunch of loans go to Stage 2 and therefore losses have to be calculated over a much longer horizon (and for a low probability for default (PD) a 5-year PD looks a lot like 5 times the 1y PD … Ouch. '

This cliff edge makes banks reluctant to reclassify Stage 1 loans that have become problematic to Stage 2 where they belong. The accounting standards also give banks considerable discretion in how they classify their loans, i.e., IFRS 9 gives banks the means, motive and opportunity to disguise problem loans by keeping them classified as Stage 1 instead of moving them to Stage 2, where higher losses would be reported which would entail higher provisions and a bigger hit to capital. We might then infer that many Stage 1 loans are misclassified and that banks are carrying higher reported losses than they are reporting.

Since banks (a) have large Stage 1 positions and (b) are strongly incentivised to keep loans classified as Stage 1, then it is reasonable to suppose that the problem would be on a considerable scale and will worsen as the economy goes into recession. As an example of this cliff edge effect, LBG has a large (£500 billion) loan book. 90% of that loan book is in Stage 1 with an impairment rate of 15 pbs.32 The expected loss on its Stage 1 loans is therefore nearly 0.0015 times £450 billion = £675 million. But if its Stage 1 loans were reclassified as Stage 2 then the expected loss and associated provisions rocket up by about £15 billion, which is 22 times as much. The capital hit is two thirds of its market cap. Furthermore, this calculation is based on the optimistic assumption of a 3.5% expected lifetime loss on a Stage 2 book. The actual loss would likely be higher than that in a severe downturn, so the capital hit would plausibly be higher still.

Table Ten shows the Stage 1/Stage 2/Stage 3 positions for the Big Five banks. Their Stage 1 loans are £2.1 trillion. Were we to apply the same impairment rates to these as we did with LBG, then the expected losses would rise from £3.3 billion if the loans remained in Stage 1 to almost £74 billion (or over 21% of market cap) if they were moved to Stage 2, and to even more if the Stage 2 loss rate were to increase as well.

In short, the classification of loans into Stage 1 vs Stage 2 under IFRS 9 provides us with another promising source of hidden losses on a large scale. To quote Jonathan Ford:

'Of course, UK regulators are not blind to these pitfalls [of IFRS 9]. Last week they urged companies to go easy on Covid-related provisioning, having already urged them to take advantage of transitional arrangements, which permit them to shield their regulatory book equity from IFRS 9-related losses, only taking them over several years.33 There are other measures designed to defer crystallising provisions, linked to sectors in receipt of relief, or government-backed loans.

But while this might be expedient to deal with the “cliff-edge” problem, the immediate recourse to forbearance is unfortunate. Not least because it defeats the rule’s whole original aim.

Remember the “bad” old days when banks used to deal with the difficulty of valuing loans through a process of obfuscation; smoothing their profits almost at will through the use of hidden reserves? Fine-grained accounting rules were devised in the hope of giving greater transparency in the accounts of financial institutions.

There are doubts about the efficacy of this switch, and the propensity of rules-based (and hence gameable) systems to drive out prudence and judgment in the boardroom. But one thing is clear with rulemaking: it can never succeed in enforcing executive accountability if each time there is a crisis, the rule is either waived or withdrawn.'34

He is correct, and in any case, such responses from the regulator do not make the underlying problem (that there could be a lot of losses coming through) go away. Instead, they only hide that problem.Such responses are akin to breaking the thermometer when it gets too hot in the kitchen: ‘fair value’ valuation is of little use if it is only implemented on a ‘fair weather’ basis.

There are further problems too. The PRA has no legal authority to interfere in how banks report their statutory balance sheets. To quote Cardale and Buckner in a recent FT letter:

'The PRA … is responsible for capital adequacy only, and has no business interfering with the reporting of the statutory balance sheet. Statutory reporting is governed by the True and Fair requirement set out in the Companies Act, and it is the responsibility of company directors and auditors, not the bank, to provide assurance the financial statements meet that requirement, and taken as a whole, are free from material misstatement.'35

In any case, the regulators’ retreating at the ‘first whiff of grapeshot’ by immediately putting further transitionals in place suggests that they have little confidence in their own capital adequacy system and subverts the whole point of having any such system in the first place.

[sancho panza]

Section 8:The Uselessness of Existing Capital Regulation

 

The bank regulatory capital regime Basel III imposes a bewilderingly complicated set of constraints on minimum required capital ratios, most importantly those based on the ratio of CET1 capital to Risk Weighted Assets. This point made, a significant innovation in Basel III was the introduction of a leverage constraint.

So what is the maximum permitted leverage under Basel III?

The Basel rules on this point as they apply to the UK are set out in the PRA Rulebook:

3. Minimum Leverage Ratio

3.1

03/10/2017

A firm must hold sufficient tier 1 capital to maintain, at all times, a minimum leverage ratio of 3.25%.

3.2

01/01/2016

For the purposes of complying with 3.1, at least 75% of the firm’s tier 1 capital must consist of common equity tier 1 capital.

The attentive reader will note an entertaining error here. “A firm must hold … capital …” We encounter here a good example of the ‘hold capital’ fallacy that we address below36 and in the PRA Rulebook of all places. Bank don’t ‘hold’  capital, they issue it. To say that a bank ‘holds’ capital is to treat capital as an asset to the bank (it is not!) and put it on the wrong side of the balance sheet, which is an elementary mistake. And since banks cannot ‘hold’ their own capital, this requirement is impossible for them to meet and therefore impossible to enforce. Well done PRA but let’s move on.

The Basel III leverage ratio is the ratio of Tier 1 capital to TE and, somewhat confusingly, is the inverse of the leverage, where leverage is measured as TE divided by Tier 1 capital.

Thus, Basel III imposes a maximum leverage level of 1 ÷ by 3.25% equals 30.8, where leverage means TE over Tier 1 capital.

Now Tier 1 capital = Common Equity Tier 1 (CET1) capital plus Additional Tier 1 (AT1) capital, which are capital measures set out in the regulatory rulebooks. The point to note is that AT1 capital includes ‘hybrid’ instruments known as Contingent Convertible bonds (CoCos), which ought not to be considered as capital instruments at all.37 CET1 should then be considered a more reliable measure of capital than Tier 1.

Translating into a maximum permitted leverage expressed in terms of CET1 rather than Tier 1 as the denominator, the maximum permitted leverage (=LE/CET1) becomes 48.3. The calculations are set out in Appendix Thirteen. The 48.3 number does not take account of hidden leverage either.

In English, the Basel III capital rules allow banks to maintain remarkably high leverage and still be Basel III-compliant.

You might say that a maximum permitted leverage of 48.3 plus hidden leverage is a loose leverage constraint and we would agree. But here is the punchline: since CET1 capital is a book value regulatory capital measure and Basel III does not impose any constraint on market-value leverage, the maximum permitted market-value leverage under Basel III is theoretically unbounded: Basel III does not impose any maximum constraint on market value leverage!

The single most important capital measure that Basel should have addressed is the one it left out.

 

 

 

   Section 9: The BoE Position: UK Banks are Strongly Capitalised

Great Capital Rebuild

The BoE’s position, repeated many times, is the narrative of the ‘Great Capital Rebuild’, i.e., that UK banks are now so strongly recapitalised after the trauma of the GFC that they could go through a much worse than GFC event and still emerge in good shape. 38 The following quotes are typical:

The resilience of the system during the past year in part reflects the consistent build-up of capital resources by banks since the global financial crisis. ... As a result the UK banking system is well placed to provide credit to households and businesses during periods of severe stress.

That conclusion is corroborated by the 2016 stress test ….39

This stress is a big, big hit to capital.40 (Mark Carney, 2016)

“The 2019 stress test shows the UK banking system would be resilient to an unprecedented combination of simultaneous recessions in the UK and global economies that are more severe than those during the global financial crisis, large falls in asset prices, and a separate stress of misconduct costs.

All seven major banks and building societies in the test can not only withstand these extreme shocks but also continue to meet the demands for credit from UK households and businesses.

In part, that’s because their capital ratios [DB/KD: by which he means their CET1/RWA ratios] are currently over three times higher than they were at the start of the global financial crisis. Even after stress, their capital ratios would still be more than twice their precrisis levels.41 (Mark Carney, 2016)

Consider the following table.

Table Eleven: Big Five Banks’ Capital:

December 31st 2006 vs December 31st 2019

Dec 31st 2006                           Dec 31st 2019             Increase                  % Increase

                                Book Value Shareholder Capital (£ billion)

143.2                                                   344.5                      +201.3                          + 141%

                                     Market Value (=Market Cap, £ billion)

360.9                                                   246.0                     -114.9                              -32%

As of December 31st 2006, the Big Five banks’ shareholder equity was £143.2 billion. By December 31st 2019, it was £344.5 billion, an increase of £201.3 billion and a percentage increase of 141%.

Now we could hardly not acknowledge that £344.5 billion is a lot larger than £143 billion, but these numbers are book value and for reasons explained above (and also in Appendix Two), it would be preferable to use market value numbers instead. Looking at the lower line in the Table, market cap was £360.9 billion on December 31st 2006 and fell to £246.0 billion on December 31st 2019, a fall of £114.9 billion and a percentage fall of 32%.

Book value capital rose, but market value capital fell and it’s the market value that really counts.

Let’s face it: the ‘Great Capital Rebuild’ isn’t there in the data.

CET1 ratio

What about the BoE’s capital ratios? The BoE’s favourite illustration of the banks’ capital rebuild is to present a chart showing the increase in CET1 ratios since the GFC.

Consider Chart B.3 in the Bank’s November 2016 Financial Stability Report

 

 

  The title states that “Most capital rebuilding to date has reflected falls in riskweighted assets” – a delightful piece of duckspeak – and then gives a breakdown of this ‘rebuild’ in terms of its constituent components. The rebuild it is referring to is not quite what it might seem, however: it refers to the rebuild in the banks’ average ratio of CET1 capital to RWA relative to 2009. Now the CET1 ratio was 6.92 percent in 2009 and had risen to 12.61 percent by end-2015. That increase breaks down into 0.45 percentage points in new equity raised, 1.02 percentage points in retained earnings and 4.22 percentage points in reductions in risk-weighted assets. Therefore, only 0.45 + 1.02 = 1.47 percentage points of that increase in the capital ratio represents actual increases in capital; the rest merely reflects the decrease in the RWA denominator, which is irrelevant to the actual amount of capital.

The increase in the CET1 ratio from 6.92 percent to 12.61 percent might seem impressive at first sight – an increase of 82 percent – but the actual capital rebuild was only from 6.92 percent to 8.39 percent, an increase of only 21 percent. That, and that alone, is what the chart should have shown.

A big increase in a regulatory capital ratio is one thing, but a big increase in actual capital is quite another. The sin is to pass off the former as the latter.

These tricks are straight out of Darrell Huff’s classic How to Lie with Statistics. 42 The main trick here is known in the trade as the ‘semi-attached figure.’ To quote:

'If you can’t prove what you want to prove, demonstrate something else and pretend that they are the same thing. In the daze that follows the collision of statistics with the human mind, hardly anyone will notice the difference. … There are many forms of counting up something and then reporting it as something else. The general method is to pick two things that sound the same but are not.' (Huff, 1954, pp. 71, 81)

But going to substance as opposed to (misre)presentation, the Bank is right that the CET1 ratios have considerably increased. By December 2019, they had increased over threefold.

CET1 ratios are unreliable indicators of capital strength, however. The RWA denominator is unreliable, both because it is unsound on principle and because it is highly gameable.43 The unreliability of the CET1 ratio is confirmed empirically by the poor track record of regulatory capital ratios with RWA denominators: time and again, banks have appeared strong by such ratios and then suddenly defaulted out of the blue. There are many examples during and after the GFC, including banks from the UK and Europe, and virtually the entire Icelandic and Irish banking systems. 44

The implication is clear: regulators would be wise not to rely on such ratios.

Leverage ratio

Then there is the leverage ratio. The following chart is a reproduction of Chart B.2 from the BoE’s November 2016 Financial Stability Report:

 

 

   

 

 

 

This chart shows some of the BoE’s estimates of UK banks’ leverage ratios spanning 2001 to 2016. In essence the BoE uses the chart to show that the leverage ratio in 2016 was higher (in fact, about 25% higher) than it was on the eve of the GFC. Table Twelve below confirm the increase (here 47%) in the average leverage ratio interpreted as the average ratio of book value capital to total assets.

Table Twelve: Big Five Banks’ Capital Ratios: December 31st 2006 vs December 31st 2019

31 Dec 2006                    31 Dec 2019                           Increase                                      % Increase

                                      Book Value Shareholder Capital (%)

4.4%                                    6.5%                                           2.1 %                                        + 47%

                                                   Market Value  (=Market Cap, %)

11.2%                                 4.7%                                          -6.5 %                                           -58%

 

However, the Table also shows that the average ratio of market value capital to total assets ratio fell by 58% over the same period.

Capital requirements ‘10 times’ higher

Another plank in the Great Capital Rebuild fairy story is that minimum bank capital requirements are ten times higher than they were before the GFC. Mark Carney is fond of making this point.45 To give one example,

“The largest banks are required to have as much as ten times more of the highest quality capital than before the crisis … (Mark Carney, 2017, his emphasis)46

The implicit suggestion is that, since multiplying by ten times is a lot, then Basel III capital requirements should now be considered high.

Even 10 times higher, bank capital standards are still low, in the sense that they still allow high leverage. Using latest average risk weights, we calculate that under Basel II UK banks can operate at a leverage level of almost 35 and still be Basel III compliant. And that is maximum permitted leverage in book value terms, let alone in market value terms. Basel III imposes no limit on market value leverage.

The bottom line is that a large percentage increase in capital requirements does not represent a large absolute increase in capital requirements if the base is low to start with.

And why was the base so low? Because Basel II had imposed extremely low minimum capital requirements.

The technical term for the BoE’s ‘10 times’ trick is statisticulation:

“Buy your Christmas presents now and save 100 per cent,” says an advertisement. This sounds like an offer worthy of old Santa himself, but it turns out to be merely a confusion of base. The reduction is only fifty per cent. The saving is one hundred percent of the reduced or new price, it is true, but that isn’t what the offer says.47

Correctly interpreted, Carney’s ‘10 times’ narrative does not imply that banks now face high capital requirements. It is, instead, a damning indictment of the inadequacy of both Basel II and Basel III.

Martin Wolf got it right when he said that Basel III was the mouse that did not roar.48

The financial health of the UK banking system not confirmed by the Bank of England’s stress tests

The final plank in the ‘Great Capital Rebuild’ fairy story is that the strength of the UK banking system is confirmed by its stress tests. But how is this even possible? UK banks are weak now, so it is impossible for a set of weak banks to go through a stress that is at least as severe or even multiple times more severe than the GFC and still come out strong. If you weren’t smelling too good when you fell into the sewer, how could you come up smelling of roses? The only logical explanation for the UK banks’ ‘strong’ performance in the BoE’s stress tests is poor modelling and more detailed analyses confirm that that is the case.49

The many weaknesses of the BoE’s stress tests include: unreasonably demanding pass standards; insufficient numbers of adverse scenarios; reliance on unreliable and gameable metrics such as RWAs and Tier 1 capital; reliance on book value instead of market value numbers; failure to address the PtB issue; the use of loss models that implied (and by a long shot) implausibly low losses that fail basic reality checks; and more. Correct almost any one of these problems and the results of the stress tests start to look a lot different.

The credibility of the stress tests is also undermined by a conflict of objectives. On the one hand, the BoE wants to use the stress tests to investigate the financial resilience of the banking system, but on the other, the BoE has a responsibility to promote confidence in the system. So what would happen if the BoE were to carry out an intellectually defensible stress test that found (and it would) that the banking system was weak? The BoE could hardly publish the results, because doing so would undermine confidence in the banking system and in the BoE’s stewardship of it. So when the BoE publishes the results of stress tests, and leaving aside that the modelling is obviously flawed, then the results have all the hallmarks of a Communist election in which the Party always wins, i.e., the stress tests always show that the banking system is strong.

One last point about these tests. A recurrent theme in the BoE’s stress test PR is that the BoE’s main stress scenario is a lot more severe than the GFC, the point being to emphasise that the stress is very severe. Since the GFC was bad, a scenario multiple times more severe is, you might say, Doomsday.

Consider as an example the Bank’s statements about its 2016 stress tests. To quote the then Governor, the adverse stress scenario in this set of tests led to “system-wide losses of £44 billion over the first two years of the stress – five times those incurred by the same banks over the two years at the height of the financial crisis.”50

This statement misled some commentators into thinking that the stress scenario was five times more severe than the GFC, but it wasn’t.

Carney’s statement implies that the system-wide losses over the two height years of the crisis were less than £44 billion/5 = £8.8 billion. Such an inference is clearly wrong, however: the system-wide losses were vastly greater than that.51 His £44 billion loss estimate is also inconsistent with the BoE’s own estimates that HBOS alone experienced losses of £34.6 billion in 2008-2009 and losses of £52.6 billion in the period 2008-2011.52 Among the big 4, RBS experienced a loss of £40.7 billion in 2008 alone. 53 Carney’s claim about the losses banks experienced in the crisis is demonstrably wrong.

The trick here is to pass off something (reported net losses, £44 billion) that sounds similar to something else (actual GFC losses, £500 billion plus, over ten times as much). One cannot really blame the journalists. They have only hours to file their stories and are overwhelmed with stress test gobbledegook (and however well they might be prepared, there seems to be more of it every year), so they look for leads from the BoE and pick up on the ‘losses five times worse than GFC’ theme – which the BoE helpfully highlighted in its exec summary. And so the Doomsday scenario is born.

So well done BoE. It successfully co-opted the press into promoting its PR line that UK banks could withstand a stress five times more severe than the GFC and still be in good shape. If only it were true. 54

 

Edited March 31, 2023 by sancho panza

[sancho panza]

Section  10. The Bank’s Track Record: The Global Financial Crisis Revisited

When assessing the BoE’s confident claims about the banking system being strong enough to withstand a crisis more severe than the GFC and still be in good shape, let’s not forget how badly the Bank got it wrong the last time round.

As late as July 2007, the Bank had no idea of impending trouble. There were some liquidity problems in the markets, the Court of the Bank was told, but these were not sufficiently serious to warrant any action. The crisis started the next month when hedge funds started to experience their once in a zillion years 25 sigma events. 55

On September 12th 2007 the Court was told that despite some market turmoil, the Tripartite (BoE, Financial Services Authority, Treasury) System was working well and the banking system was sound. The next day, they were called to an emergency meeting as the BBC announced that Northern Rock had applied for a rescue. The run on the Rock – the first English bank run since Overend Gurney in 1866 – occurred a day later.

Even after that, the Bank continued to downplay the nature and scale of the crisis: it confidently maintained that there was only a liquidity problem and that the banking system was more than adequately capitalised.

By as late as January 2008, the Bank was still reassuring Treasury Committee that the crisis, such as it was, was merely a liquidity one and that there was no question of the banks’ capital adequacy. As Governor King told the Committee

'I do not believe that in a year’s time people will look and say that there was any lasting damage to the British banking system. It is very well capitalised, it is very strong '…56

The next month, Northern Rock began revealing losses and went from liquidity support to full nationalisation.

However, Northern Rock was relatively minor; it represented less than 1% of the total capitalisation of the UK listed banking system in 2007.57

Then came the shock of the Lehman crisis in September 2008. That was swiftly dealt with and a month later, the Bank gave itself a well-deserved pat on the back: “there was now a real sense that a corner had been turned and the bank could be proud of its work,” the minutes reveal.58

Except that the BoE had got it wrong again.

By 2009, 30% of the UK listed banking system had failed and most of the rest were on state support.

The losses incurred by the banks from the GFC (and bear in mind that many of these losses took a long time to be revealed, and it appears that some still haven’t been) were perhaps £500 billion59 and still counting. Estimates of the banks’ GFC losses vary from at least 139% to at least 349% of their starting capital, depending mainly on how one estimates the latter. The banks’ GFC losses more than wiped out the capital of the UK banking system and arguably over three times over.

What most people failed to appreciate at the time was that a liquidity problem (the inability to obtain or renew creditor funding) is often a consequence of well-founded suspicions that the banks could be harbouring hidden losses aka a capital problem.

In June 2011, Governor King at last confirmed that the crisis was not a liquidity crisis, but was, and always had been, a capital (or solvency) crisis:

'Right through this crisis from the very beginning ... an awful lot of people wanted to believe that it was a crisis of liquidity,” Sir Mervyn said. “It wasn’t, it isn’t. And until we accept that, we will never find an answer to it. It was a crisis based on solvency ... initially financial institutions and now sovereigns.'60

As Tim Bush observed:

It is perhaps an indictment of conflicts of interest in the financial (and regulatory) system that the obvious takes four years to emerge as the true reason for something, when capital markets (equity, debt and money markets) had intuitively deduced the problem in 2007 and reacted accordingly. For a banking crisis to have been confused for four years as a “liquidity” rather than a capital crisis is not an insignificant matter, given that many policy decisions will have been made on a false diagnosis.

Because the banking crisis was in truth a capital crisis, there has to have been a systemic failure in the capital adequacy regime, making what was, in truth, capital consumption appear like capital generation.61

In short: (a) the BoE’s crystal ball completely failed to see the crisis coming, despite market signals that something was amiss; then, when the crisis did come, (b) the BoE persistently misdiagnosed the true nature of the crisis as being a liquidity crisis (which is not a big deal) rather than the capital or solvency crisis that it was (which is a real big deal), despite the fact that markets had been signalling capital problems since 2007; and (c) the scale of the losses overwhelmed the UK banking system and blew the UK’s fragile regulatory capital framework out of the water.

Two further lessons to be learned from the GFC are that we should use market cap as our metric (not the accounting or regulatory book value numbers!), because market cap numbers gave the best signals of impending trouble, and that banks then, though better capitalised than banks now, were far from being adequately capitalised going into the GFC.

Fast forward to the present, markets are again signalling major problems and the Bank of England is again insisting, against the evidence, that all is well. As Sam Woods reiterated to the Treasury Committee on Wednesday April 15th, “We go into this with a well capitalized banking sector.”

Cue Yogi Berra: “It's like déjà vu all over again.”

 

 

 

 

 

 

 

 

 

     Section 11The Political Economy of Bank Capital

 

It is helpful at this point to consider the big picture, the underlying political economy of bank capital. In a laissez faire world with no central bank and no financial regulation, banks would sink or swim with no expectation of being bailed out by the state or its agencies if they get themselves into difficulties.

Enter central banks and regulators, who set up lender of last resort facilities, deposit insurance and such like, and associated expectations of bailout. The bankers respond to these incentives by increasing their leverage and taking more risks to boost their returns on equity, which are the basis of bank CEOs’ remuneration. High leverage seeks to maximise the value of the (often implicit) central bank or government guarantees by letting banks borrow at rates subsidised by society at large, thereby privatising profits on the upside and socialising losses on the downside. The bankers’ social contract is not a good one for everyone else, however. The central bank huffs and puffs that banks should not take excessive risks and threaten to let them fail, but the bankers see through these empty threats and call their bluff, knowing that in a crisis, central bankers will bail them out for fear that not doing so might collapse the financial system. Round One to the bankers.

The central bankers’ respond with capital adequacy regulation, the aim of which is to impose an upper limit on leverage. The industry responds with calls for greater ‘risk-sensitivity’ in the system. Greater risk sensitivity seems like a good idea and the regulators buy into it on ‘appliance of science’ grounds greased by plenty of revolving doors, first with the Market Risk Amendment to the original Basel Accord, now known as Basel I, in 1996, and then with the Basel II project, which took nearly a decade to complete. The hallmark of Basel II was the use of credit risk models to determine banks’ capital requirements for credit-risky positions. The bankers then use their credit risk models to obtain much lower capital requirements and boost their leverage, and so defeat the whole purpose of the Basel system. Round Two to the bankers.

Basel II is then rolled out to great fanfare, the GFC hits shortly afterwards and it became clear (admittedly, earlier to some than to others) that Basel II had allowed banks to be woefully under-capitalised.

One of the main problems of Basel II was its complexity. Complexity produces gameability and the big banks, being heavily involved in the drafting of the Basel II rulebook, had ensured that there was plenty of it. The complexity of the system was key to its ineffectiveness and you might say this complexity was not so much a flaw as a design feature, at least from the bankers’ point of view: Basel II offered almost unlimited scope for arbitrage. Basel I was 30 pages long 45 and had only 5 risk weights, Basel II was 347 pages long, an order of magnitude longer than Basel II, and a big bank operating under Basel II might easily have several million parameters to calibrate.62 Then Basel III was pushed out in an unholy rush in 2010, weighing in at 616 pages, nearly twice the length of Basel II, and experts were anticipating that the eventual rulebook might run to over 60,000 pages.63 More of the same that didn’t work before is rarely the right answer. Round Three to the bankers.

The banks promoting higher leverage means the banks promoting excessive leverage, and excessive leverage periodically crashes the financial system, leading to one disaster after another and repeated taxpayer bailouts, each bigger than the last, until eventually the public refuse to put up with it any longer.

The remuneration received by the bankers for taking the excessive risks that led to the crisis was but a small fraction of the banks’ subsequent losses which was in turn but a small fraction of the damage inflicted on the economy.64 So huge damage is being inflicted on the economy so that bankers can extract relatively small rents from it. The bankers have become the new unions.

It is, accordingly, imperative for those with the public interest at heart to appreciate the game that the banking lobby has been playing so successfully against the public, who are repeatedly called on to bail the bankers out.

If the bankers were to pursue their socially destructive high leverage agenda out in the open, where everyone could see it for what it is – that the bankers make a lot of profits for themselves in the good times, and the public bail them out in the bad – then it would be harder for them to get away with it: there would be a public outcry and politicians would be under enormous pressure to put a stop to it. The bankers therefore need some cover story to give them a fig leaf of respectability, the objective being to make high leverage seem reasonable, and even desirable.

This is where the ‘hold capital’ fallacy – the claim that banks ‘hold’ capital – comes in. This fallacy feeds into the widespread misperception, promoted both by the banking industry and by the BoE, that high capital requirements are somehow a constraint on bank lending. “Of course we know that excessive debt is a bad thing,” they say, as if excessive leverage was anything but that, “but if we have to hold more capital, then lending and unemployment will be badly affected, and no one wants that.”

The bankers’ pitch sounds right, but it isn’t.

To quote Admati:

'If capital is falsely thought of as idle cash, the discussion of capital regulation is immediately derailed by imaginary trade-offs. Nonsensical claims that increased capital requirements prevent banks from making loans and ‘keep billions out of the economy’ may resonate with media, politicians and the public just because the jargon is misunderstood. In light of this confusion and its ability to muddle the debate, it is disturbing that regulators and academics, who should know better, routinely collaborate with the industry to obscure the issues by using the misleading language and failing to challenge false statements. If, instead, the language that is used focused attention properly on funding and indebtedness, the debate would be elevated and more people would be able to understand the issues.'65 (Admati, 2016)

And again:

'This is not a silly quibble about words. The language confusion creates mental confusion about what capital does and does not do. This confusion helps bankers, because it creates the false impression that [more] capital is costly and that bankers should strive to have as little of it as regulators will allow. For society, there are in fact significant benefits and essentially no cost from much higher capital requirements.'66 (Admati and Hellwig 2013, p. 98)

It is, then, unhelpful when the regulator, who should be holding the fort on the public’s behalf, buys into the industry PR campaign with statements like this one:

The FPC was concerned that banks could respond to these developments by hoarding capital and restricting lending. (Mark Carney, 2016, our emphasis)67

When the regulator itself promotes industry PR instead of debunking it, then we should not expect the regulator to be effective. In truth, the regulator has long since been captured by the industry and the regulator’s dismal performance, while shocking, is only to be expected. The bank capital regulatory system is broken and it will take a lot more than any Basels IV, V or VI to put it right. At some point, there will need to be radical reform to reverse the ever more destructive banksterisation of the economy and re-establish a Social Contract in which the bankers serve the public and not the other way round.

 

    Section 12: Conclusions

We asked earlier (p. 7) whether the UK banking system has the financial resilience it needs to withstand a major shock and still emerge in good shape.

The BoE gives a reassuring upbeat answer, essentially the ‘Great Capital Rebuild,’ the merits of which we have discussed at some length.

In his final remarks as Governor, Mark Carney reiterated much the same message:

'Some watching will recall the financial crisis a little more than a decade ago. Then, the financial system was the core of the problem. Now, it can be part of the solution.

Over the past decade, the UK financial system has been transformed. We didn’t build this strength for its own sake. This is prudence with a purpose. Resilience with a reason'.68

We hope he is right.

Our concern, however, is that the evidence points the other way.

Using the latest available figures, the Big Five UK banks have an average priceto-book ratio of 39.2%, an average market cap to total asset ratio of 2.3% and an implied leverage of 43.3. These are not healthy metrics. The PtB ratio for a healthy banking system is well over 100%. The average capital ratio is far below the minimum values recommended by many experts, and the leverage is far above any accepted reasonable safe level. And these numbers ignore the hidden leverage, hidden losses and other problems in banks’ books, and there appear to be plenty of those too.

UK banks are not only in poor shape, but they are also in considerably worse shape now than they were going into the GFC. Taking the end of December 2006 as a yardstick, their average PtB ratio then was 255% and has since fallen by 212 percentage points, their average capital ratio has nearly halved and their average leverage has close to doubled. Remember too that insufficient capital (or if you prefer, excessive leverage) was rightly blamed as a major contributor to the severity of the GFC.

By these metrics the BoE’s medicine has not only failed to restore the patient to health, but has left the patient in worse shape than before. It stands to reason that even a milder version of the earlier ailment would be enough to land the patient back in ICU.

Look at it this way. The UK banks’ capital in market value terms is now a mere £140.6 billion, but the Big Five banks’ losses from the GFC were likely over £500 billion, well over three and a half times as much as their current market cap. Therefore, a GFC repeat that inflicted similar losses on the banks would wipe out their capital more than three and a half times over. UK banks are not nearly sufficiently capitalised to withstand a shock on anything close to the same scale as they experienced then and still emerge solvent, let alone in good shape and able to operate normally. Or, to put the argument the other way round, a shock mild enough to inflict a loss of £140.6 billion on the banks would be enough to wipe out their capital. UK banks might be able to withstand a mild cold, but nothing more severe.

The projections being made suggest that the economic impact of the COVID-19 shock is much worse than the economic equivalent of a cold, however. The OBR projected a 35% fall in real GDP in the second quarter of 2020, a crash on a scale not seen in this country since the early 18th century, with an overall fall of almost 13% over the year, and that was on the optimistic assumption that the economy would quickly recover.69 Other respected figures suggest worse scenarios:

“The best-case scenario would be a downturn that is more severe than the GFC (in terms of reduced cumulative global output) but shorter-lived …” (Nouriel Roubini)70

“We anticipate the worst economic fallout since the Great Depression …” (IMF head Kristalina Georgieva)71

“Forget ‘recession’: this is a depression. Although UK data lags behind the US, the evidence is mounting coronavirus makes 2008 look trivial” (David Blanchflower and David Bell)72

Does the UK banking system have the resilience it needs to face the downturn and still be in good shape? It would appear not, but we shall soon find out.

Given the fragility of the UK banking system and the severity of the crisis now engulfing it, a new round of bank bailouts would seem inevitable. We are already seeing the early signs of that in terms of increased forbearance and plans afoot to reduce capital requirements.

Naturally, it would be unfair to criticise the BoE for failing to anticipate the COVID-19 crisis. Yes, we knew that a new pandemic was inevitable but no one could anticipate when it would strike or how severe it might be, and it is a basic proposition of financial economics, and no criticism of central banks, that they can’t see shocks coming.

To go back to the Vickers quote with which we started:

Failure to anticipate systemic fragility in the face of such shocks is an altogether different matter. … Banks’ capital adequacy is a cornerstone of our economic system.” (Our emphasis)

It is reasonable to criticise the regulator for leaving the system frail when its mandate was to ensure systemic robustness. A more serious regulatory failure is difficult to imagine, and it’s not as if we haven’t all seen this movie before. The BoE’s stewardship of the banking system has turned out to be a disaster, again.

Credible experts have been warning the BoE for years that the UK banking system was far from being adequately capitalised. But instead of taking measures to ensure banks raised actual capital levels, the BoE focussed on raising regulatory capital ratios and those are not the same thing. In effect, the BoE took the easy way out, window dressing instead of fixing the under- capitalisation problem, let alone tackling its underlying causes, that is, the multiple incentives to excessive bank risk-taking that the BoE and its overseas counterparts were largely responsible for creating in the first place.

[sancho panza]

From a main thread psot ref the Coventry BS.If I remember rightly,I think I did have a dig through their 22 financials but can't find it.Recently packed in a Uni course so should have more time on my hands in between school runs.

Key thing with BS's like the Cov is tracking their BTL growth and whether losses might be large enough to bring it's capital ratio's into the danger zone.

 

 

'Coventry BS 21 FInancials(2022) financials looming but the points are still the same.Number 6 most importnant imho.

1) they've levered into the bubble

2) despite huge balance sheet expansion,profits flat over 5 years

3) page 32 impact of IFRS 9-clearly going to lead to an increase in expected credit losses (ECL) increasing need to set more cpaital aside on a risk weighted basis(and remember these results are form 21 so end 22 could make interesting reading.)

4) rise in wholesale funding costs will affect both loan origination and also remortgage activity.Likely leading to any potential rise in net interest margin vs retail savings being negated by rise in whoelale funding costs

5) also page 33 advacned £9bn mortgage funding in 2021,loan book stands at £46bn.

6) most importnant point last.looks like about 40% of laons are BTL(and remember this balance sheet has blown up in the last five years and they were banging 95% LTV loans into the top of the amrket

https://www.coventrybuildingsociety.co.uk/content/dam/cbs/member/pdfs/financial-results/2021/annual-report-and-accounts.pdf

PAge 32

page 33

point 6

Edited December 27, 2022 by sancho panza'

[reformed nice guy]

Cracking thread, glad you started it.

Allow me to be devils advocate. If the UK maintains a 500,000+ immigration rate then could BTL landlords looking for an exit offer an easy option for SERCO to house migrants?

Personally, I dont think its as simple as that but its a simple way to consider a way out.

I think that until the answer to the following question is "yes" then all companies with thin margins will hit the wall:

"is their a cheap source of energy immediately and continually available in the UK?"

[wherebee]

Amazing posts, thankyou.  Should be mandatory reading for every DOSBODDERS below the line.

[nirvana]

3 hours ago, reformed nice guy said:

Allow me to be devils advocate. If the UK maintains a 500,000+ immigration rate then could BTL landlords looking for an exit offer an easy option for SERCO to house migrants?

some old folks/nursing homes are half empty now since they killed the fukkers off so they'll probs fill them first?

really nice for poor old dears like my mum who bought a 'retirement house' around the back of them.....

[Gloommonger]

Interesting stuff, will read more when I get time. Fundamentally, the banking system is held together with confidence and CBs are hamstrung in how to deal with solving the issues. Too much caution rattles the markets, too liittle caution rattles the markets. Using the swan analogy, they have to look calm whilst furiously paddling underwater. Bank runs are their greatest fear so the illusion of solvency is paramount even though the numbers suggest otherwise. Joe Public don't look at the numbers, they move on rumour and panic. 

[jamtomorrow]

7 hours ago, sancho panza said:

I tell this story to illustrate that the real shock of 2008 was not the shock – of subprime, the drops in property prices, &c – but the system’s lack of resilience to the shock. Put another way, the “it” that few saw coming was not the sharp movement of asset prices, but the fragility of the system. It is a basic proposition of financial economics, and no ground for criticism of economists, that you can’t see sharp asset price movements coming. Failure to anticipate systemic fragility in the face of such shocks is an altogether different matter.

Thanks for starting this thread @sancho panza.

First time I've read any of Dowd-Buckner, and I have to say this para really resonated with me - and not just as applied to banks, but to the system as a whole.

*If* we run into a crisis, the speed with which it unfolds - because of the fragility - is what will catch most participants out. Maybe *that's* the sense in which markets will inflict max mass pain this time?

I also find it fascinating (as an engineer) how engineering concepts keep cropping up in macro.

An engineering material can be strong (capable of withstanding high loads) yet brittle (will fail suddenly with little warning). Engineered systems can exhibit similar characteristics. I often wonder how many policymakers and pundits understand the difference.

[BurntBread]

Thank you for the thread @sancho panza, although I am wrestling with the key concepts before I can even think about whether I agree with any of it.

The really interesting point to me as an ignoramus, was the remark that banks don't "hold" capital, because it is a liability. At my current stage of understanding, I am therefore imagining that tier 1 capital is in part retained earnings (which the bank does indeed "hold" as an asset), but is mostly liabilities which can be painlessly (for the bank) vapourised in the event that something goes wrong,. This is necessary in order to keep the balance sheet looking pretty. Shareholder capital is a good example of this: it can be reduced to zero, and the bank still be an ongoing concern.

Dowd-Buchner then criticise including CoCo bonds in tier 1 capital. However, recent experience suggests that they are also extremely fissile, and can be nuked without any danger that the CoCo bond-holder could force a liquidation.

S o , am I understanding the key point here correctly: that T1C is mostly liabilities that can be easily shed, and that doing so keeps the balance sheet on life support, which is necessary for the bank to continue as a business (no forced bankruptcy), and also to have access to means of borrowing (capital markets or central bank lending facilities) ... and really it is this ongoing access to liquidity which is essential during a crisis?

If s o , then I'm still a bit puzzled why Dowd-Buchner think the BoE has not enforced the right kind of capitalisation on the banks? Their D-B-ratio measure uses market cap, which is basically the shareholders' capital. Do the regulators use book value ("total equity") instead of market cap?

Apologies for silly questions which I could probably resolve by reading the above posts more carefully.

 

[jamtomorrow]

Having read a bit more, it's interesting trying to estimate how much the UK authorities are eventually going to have to find to recapitalise the whole sorry edifice (again).

Using these 2020 numbers as the basis:

Based on a 10% rule of thumb, capital injection would need to be £470bn.

Based on 15%, £770bn.

So ballpark 25% to 35% of GDP at the time.

How would the same estimate play out today? Have market caps and ratios deteriorated further?

[Caravan Monster]

Thanks for posting this - came at just the right moment. Got some savings in Cov BS Was hoping things would be as easy as searching for retail accounts with the best rate, no such luck. Lots of technical reading to try to understand

 

[JFK]

Very interesting thread thanks 

[sancho panza]

On 01/04/2023 at 08:10, jamtomorrow said:

Thanks for starting this thread @sancho panza.

First time I've read any of Dowd-Buckner, and I have to say this para really resonated with me - and not just as applied to banks, but to the system as a whole.

*If* we run into a crisis, the speed with which it unfolds - because of the fragility - is what will catch most participants out. Maybe *that's* the sense in which markets will inflict max mass pain this time?

I also find it fascinating (as an engineer) how engineering concepts keep cropping up in macro.

An engineering material can be strong (capable of withstanding high loads) yet brittle (will fail suddenly with little warning). Engineered systems can exhibit similar characteristics. I often wonder how many policymakers and pundits understand the difference.

I'll return to the other posts later as I've come off nights but I jsut wanted to respond while I had this thought and that;s that the CB's/Regulators ref your engineering point..... that the regulators are trying to bring mathemtaical certainty into a fincaical system that is built on human emotion and prone to the frailites of those emotions.

eg  the banks in the US that recently hit the wall weren't particualrly overleveraged aiui but they suffered from that problem suffered by banks over millenia ie bank runs.

bank runs are basically humans utitlising inbuilt survival traits.Much like the first bit of the herd that start running from the lions are the most likely to survive.

 

ergo I think any attempt to leverage the system will run into this particualr problem at some point but the more the CB's keep the lions from the herd the more the herd clusters and stays in the same direction,the more it clusters and stays in the same direcetion, making it eventually easier for the lions when they strike/ambush.

we've seen that with hsouing here and the usa,the more the prices move north,the more people pile into the trade.The more people pile into the trade the more the banks lend,the more people borrow and further north hosue prices go.It's classic human/animal herding.

 

the problem comes when CB's think that as long as they regulate the speed and direction of the herd they can stop the lion ambush.we all knwo they can't.it's also becoming evident that the more they regulate the speed and movement of the herd the more wildebeest join the herd for safety but at some hard to notice point, by the very act of joining the herd the wildebesst actually make the herd less safe and make the eventual destruction of some of their number a certainty.

it was ever thus,but it hink with the age of computers CB's thought they could protect the fincail system from human emotion and they can't

[sancho panza]

On 01/04/2023 at 01:12, reformed nice guy said:

Cracking thread, glad you started it.

Allow me to be devils advocate. If the UK maintains a 500,000+ immigration rate then could BTL landlords looking for an exit offer an easy option for SERCO to house migrants?

Personally, I dont think its as simple as that but its a simple way to consider a way out.

I think that until the answer to the following question is "yes" then all companies with thin margins will hit the wall:

"is their a cheap source of energy immediately and continually available in the UK?"

I think that's really a question where the answeer is macro/main thread.WE have central govt tax receipts circa £715bn p.a,other sources of income lift that to £900bn or so.We have welfare runnign at £300bn,nhs £230bn, edcuation £100bn,debt interest £120bn,so 4 biggest expenditures wipe out central tax receipts.

the focus here is on banking elverage rather than the braoder macro issue of whether we can sustain spending on migrant flow and whetehr that spenidng will bail the system.I think that'd be the way to best use the thread RNG.

with the event sof thsi last week,I'm seeing the most leveraged BTLers hitting the wall(literally-month or two from not making their payments).AS the crisis progresses it will draw in the less leveraged on a progressive basis.

So if I'm right (and events from my personal epxerience this would idnicate that) has drawn in dud laons from 2006/7,LTV 100%+,no other income BTLers.Also we might be seeing FTBers who borrowed at 95%/100% during 21/22 starting to struggle due to IR rises.

Speaking a contact who used to repo for one of the bigger banks back in the nougties,he was saying 1st motnh you get a letter,second month default notice(this default notice can effectively ruin your credit score and stop you accessing the help that might bail you) and then after three months missed payments,they move for repo.That was in his time,things might be different now in terms of banks having help avaialable.

But essentially there comes there comes that oint when an LL/OO knows their loan is broke and it becoems academic whether they make the monthly payment as the end result is becoming unavoidalbe..I know we have some of the msot highly leverage LL's already facing that decisison and taking insolvency advice.

These houses are going to be dsitressed sales,no other way out besides the bank becoming a LL.

[sancho panza]

On 01/04/2023 at 07:38, Gloommonger said:

Interesting stuff, will read more when I get time. Fundamentally, the banking system is held together with confidence and CBs are hamstrung in how to deal with solving the issues. Too much caution rattles the markets, too liittle caution rattles the markets. Using the swan analogy, they have to look calm whilst furiously paddling underwater. Bank runs are their greatest fear so the illusion of solvency is paramount even though the numbers suggest otherwise. Joe Public don't look at the numbers, they move on rumour and panic. 

I think that's a super summation of the issues pertianing to human psychology

On 01/04/2023 at 09:00, BurntBread said:

Thank you for the thread @sancho panza, although I am wrestling with the key concepts before I can even think about whether I agree with any of it.

The really interesting point to me as an ignoramus, was the remark that banks don't "hold" capital, because it is a liability. At my current stage of understanding, I am therefore imagining that tier 1 capital is in part retained earnings (which the bank does indeed "hold" as an asset), but is mostly liabilities which can be painlessly (for the bank) vapourised in the event that something goes wrong,. This is necessary in order to keep the balance sheet looking pretty. Shareholder capital is a good example of this: it can be reduced to zero, and the bank still be an ongoing concern.

Dowd-Buchner then criticise including CoCo bonds in tier 1 capital. However, recent experience suggests that they are also extremely fissile, and can be nuked without any danger that the CoCo bond-holder could force a liquidation.

S o , am I understanding the key point here correctly: that T1C is mostly liabilities that can be easily shed, and that doing so keeps the balance sheet on life support, which is necessary for the bank to continue as a business (no forced bankruptcy), and also to have access to means of borrowing (capital markets or central bank lending facilities) ... and really it is this ongoing access to liquidity which is essential during a crisis?

If s o , then I'm still a bit puzzled why Dowd-Buchner think the BoE has not enforced the right kind of capitalisation on the banks? Their D-B-ratio measure uses market cap, which is basically the shareholders' capital. Do the regulators use book value ("total equity") instead of market cap?

Apologies for silly questions which I could probably resolve by reading the above posts more carefully.

 

Ill reply later

On 01/04/2023 at 10:40, Caravan Monster said:

Thanks for posting this - came at just the right moment. Got some savings in Cov BS Was hoping things would be as easy as searching for retail accounts with the best rate, no such luck. Lots of technical reading to try to understand

 

If you're udner theFSCS allowance,I wouldn't worry too much

On 01/04/2023 at 09:33, jamtomorrow said:

Having read a bit more, it's interesting trying to estimate how much the UK authorities are eventually going to have to find to recapitalise the whole sorry edifice (again).

Using these 2020 numbers as the basis:

Based on a 10% rule of thumb, capital injection would need to be £470bn.

Based on 15%, £770bn.

So ballpark 25% to 35% of GDP at the time.

How would the same estimate play out today? Have market caps and ratios deteriorated further?

will reply later

[One percent]

On 01/04/2023 at 09:33, jamtomorrow said:

Having read a bit more, it's interesting trying to estimate how much the UK authorities sap taxpayer are eventually going to have to find to recapitalise the whole sorry edifice (again).

Using these 2020 numbers as the basis:

Based on a 10% rule of thumb, capital injection would need to be £470bn.

Based on 15%, £770bn.

So ballpark 25% to 35% of GDP at the time.

How would the same estimate play out today? Have market caps and ratios deteriorated further?

FIFTY.  

what I can’t understand is why the government haven’t forced these banks to get into a healthy position. Instead, it seems to be as bad, if not worse, than it was in 2008, when they had to introduce emergency interest rates and print billions to keep it all afloat. Seems like they just kicked the can. 

[HousePriceMania]

@sancho panza sterling work 

[Chewing Grass]

On 01/04/2023 at 00:15, sancho panza said:

The thesis is simple,the UK banking system is overleveraged, poorly capitalised and facing losses in residential and commerical property that will require either equity raising for some of the systemic banks or mergers/bankruptcy(dare we even suggest it?) for the small BS's that have mispriced risk.

I shall take some photos tomorrow of the advertising signs outside a good proportion of the office buildings on a business park near me.

There was an excess of office buildings before 2020, now it's worse but they carried on building more.

Perhaps they think that the UK requires more office workers and the good times will return for commercial property.

They won't, they are just competing with other developers over what remains of a shrinking market.

[HousePriceMania]

, Barclays are fucked.

The currency is fucked

The Dollar is fucked

Everything is fucked

 

Is that a fair summary?

Will buy more gold this week.

[sancho panza]

On 01/04/2023 at 09:00, BurntBread said:

Thank you for the thread @sancho panza, although I am wrestling with the key concepts before I can even think about whether I agree with any of it.

The really interesting point to me as an ignoramus, was the remark that banks don't "hold" capital, because it is a liability. At my current stage of understanding, I am therefore imagining that tier 1 capital is in part retained earnings (which the bank does indeed "hold" as an asset), but is mostly liabilities which can be painlessly (for the bank) vapourised in the event that something goes wrong,. This is necessary in order to keep the balance sheet looking pretty. Shareholder capital is a good example of this: it can be reduced to zero, and the bank still be an ongoing concern.

Dowd-Buchner then criticise including CoCo bonds in tier 1 capital. However, recent experience suggests that they are also extremely fissile, and can be nuked without any danger that the CoCo bond-holder could force a liquidation.

S o , am I understanding the key point here correctly: that T1C is mostly liabilities that can be easily shed, and that doing so keeps the balance sheet on life support, which is necessary for the bank to continue as a business (no forced bankruptcy), and also to have access to means of borrowing (capital markets or central bank lending facilities) ... and really it is this ongoing access to liquidity which is essential during a crisis?

If s o , then I'm still a bit puzzled why Dowd-Buchner think the BoE has not enforced the right kind of capitalisation on the banks? Their D-B-ratio measure uses market cap, which is basically the shareholders' capital. Do the regulators use book value ("total equity") instead of market cap?

Apologies for silly questions which I could probably resolve by reading the above posts more carefully.

 

I think you're on it BB in terms of Tier 1.

The mroe generla point Dowd Buckner are making is that we're using the banks own estimations of what their asset are worth.Consdier that sharehlder equity is what the bank says their business is worth and the market cap is what the market thinks it is worth.Equity is what is left for the shareholders is they sell all their assets and pay off liabilities.

So barclays has a marekt cap of £22.88bn as of friday and the balacne hseet for end 2022 states shareholder equity at £69bn.this disparity could be a) time lag b) market worng about the value of the business c) barclays worng about the value of the business.

Hence why Dowd Buckner prefer using market cap to estimate equity rather than using Barclays stated view of their own book.

So in a collapse ,the

https://www.investing.com/equities/barclays-financial-summary?cid=32611

 

 

 BIS guidance on CET1 and tier 1.CET1 is a core stat we see quoted a lot in the bank annuals.The key thing to consdier is that as a bank implodes it eats the capital first before those who are owed laibilites take a haricut.

 

 

https://www.bis.org/fsi/fsisummaries/defcap_b3.pdf

Components of regulatory capital
Common Equity Tier 1 capital (CET1) is the highest quality of regulatory capital, as it absorbs losses immediately
when they occur. Additional Tier 1 capital (AT1) also provides loss absorption on a going-concern basis,
although AT1 instruments do not meet all the criteria for CET1. For example, some debt instruments, such as
perpetual contingent convertible capital instruments, may be included in AT1 but not in CET1. In contrast, Tier
2 capital is gone-concern capital. That is, when a bank fails, Tier 2 instruments must absorb losses before
depositors and general creditors do. The criteria for Tier 2 inclusion are less strict than for AT1, allowing
instruments with a maturity date to be eligible for Tier 2, while only perpetual instruments are eligible for AT1.
Total available regulatory capital is the sum of these two elements – Tier 1 capital, comprising CET1
and AT1, and Tier 2 capital. Each of the categories has a specific set of criteria that capital instruments are
required to meet before their inclusion in the respective category. Banks are required to maintain specified
minimum levels of CET1, Tier 1 and total capital, with each level set as a percentage of risk-weighted assets

Total available regulatory capital is the sum of these two elements – Tier 1 capital, comprising CET1
and AT1, and Tier 2 capital. Each of the categories has a specific set of criteria that capital instruments are
required to meet before their inclusion in the respective category. Banks are required to maintain specified
minimum levels of CET1, Tier 1 and total capital, with each level set as a percentage of risk-weighted assets.

as an example here's a Barclays Pillar 3 report year end 22

https://home.barclays/content/dam/home-barclays/documents/investor-relations/reports-and-events/annual-reports/2022/Pillar-3/Barclays-Bank-PLC-Pillar-3-Report 2022.pdf

https://en.wikipedia.org/wiki/Fractional-reserve_banking

On 01/04/2023 at 09:33, jamtomorrow said:

Having read a bit more, it's interesting trying to estimate how much the UK authorities are eventually going to have to find to recapitalise the whole sorry edifice (again).

Using these 2020 numbers as the basis:

Based on a 10% rule of thumb, capital injection would need to be £470bn.

Based on 15%, £770bn.

So ballpark 25% to 35% of GDP at the time.

How would the same estimate play out today? Have market caps and ratios deteriorated further?

I think it's hard to guess that.Historical precedent is one consdieration as you say but what if we're about to enter a once in an 80 year wipeout and punters start pulling deposits left right and centre? then I think historical precedent gets sidelined.

My working thesis is that the UK's 'sub prime' is going to be small BS's where basically the lenders didn't have the experience to discern riska nd price it appropirately.I say this from personal expereince,not in the last week but what I've witnessed in terms of ledning over the last year or two.The big systemic banks appear to have tkane a more careful approach to the riskiest sections fo the market. ie 75% LTV BTL and 90% +FTB.But time will tel on that.

I also have to add I have some personal knowledge of smaller BS's using 'sh1tstick at arms length' commercial lending arms to bascially rund risky lending that they couldn't run throuhg their main book.

My hunch(again based on some personal experience of what I've witnessed that I can't go into) is that these 'sh1tstick arms length' commerical arms are going to come back and bite those small BS's on the behind.I coudl be wrong.

The problem is trying to work out the scale of these off balance sheet vehicles and how much risk they carry to CET 1 capital because as yet,I don't know how CET1 capital is worked out for these instituions.Any understanding greatly appraciated.

Edited April 2, 2023 by sancho panza