Bank of England weakens economy by demanding further bank capital

March 28, 2013

The Financial Policy Committee (FPC) of the Bank of England has announced the findings of an FSA enquiry into whether Britain’s banks needed additional capital to meet more stringent stress tests of their lending books and reserves.

The FSA looked at three areas: banks’ exposure to losses on commercial real estate and Eurozone loans, additional future conduct losses (in areas like payment protection insurance, Libor and swap mis-selling) and a “more prudent” approach to risk-weighting assets so that they have more capital set against them. In total, the FSA estimated that these more stringent stress scenarios would result in an increase in the capital required of some £50bn.

Given that the FPC wants the banks to hold a minimum of 7 per cent common equity tier 1 capital against their risk-weighted assets, the banks which drop below this floor are being required to raise capital or restructure balance sheets to meet the ratio by the end of the year. The total these banks are being asked to find comes to some £25bn. The FPC wants them to do so in a way that “does not hinder lending to the real economy.” But this is surely an exercise in wishful thinking.

The evidence clearly points the other way. Over the four years or so since the end of the financial crisis, as Britain’s banks have been deleveraging and building up their capital ratios, bank lending to the non-financial private sector has fallen by more than £10bn a year. It was still falling last year despite the introduction of the Funding for Lending scheme, with the bulk of the weakness in lending to businesses. It is easy to understand why when you consider that a loan to a small to medium-sized business often requires four to five times as much capital as a mortgage.

For those banks that have to raise capital, it is going to be an expensive exercise. It is likely that most will not choose to go down the equity route, but through instruments like contingent bonds. These are not costless. Barclays paid 7.625 per cent on its contingent notes last year. RBS and Lloyds may well have to pay more. If we assume an average coupon of 8 per cent, the £25bn of capital that has to be raised is going to cost the banks £2bn before tax. Even if they raise enough capital and don’t need to shrink their current balance sheets, this will reduce profits that would otherwise have generated capital to support lending in the future.

Then there are the banks that don’t have to raise capital – those with ratios above 7 per cent, even after the new stress tests. As a result of the FPC’s changes, they now have £25bn less capital against which they can lend. Are they going to ask investors for more capital so that their lending potential is the same? Almost certainly not. The Bank of England seems to think that, if only the banks had enough capital, they would start to lend. Yet as it said in its release yesterday, it expects more capital increases in the years ahead. What message does that send?

But it doesn’t have to be this way. Basel III explicitly expected regulation to be counter-cyclical, and the higher capital ratios were meant to be implemented gradually. Indeed, under Basel III banks are only required to have 3.5 per cent core equity tier 1 capital at the moment, half of what the Bank of England is demanding. Banks don’t have to get to 7 per cent until 2019 under Basel III, although if you are a global systemically-important bank, as most of the UK banks are, it is more likely to be 2017 or 2018. The key point is that the Bank is forcing UK banks to run ahead of what is necessary.

If the Bank of England really wants the Funding for Lending scheme to work, it should be allowing the banks to use their capital to support new lending, rather than forcing them to raise more capital to support current lending. Without credit growth, the Bank can do as much QE as it likes and it will not work. That is why broad money growth has been negative for most of the last three years and the economy has failed to recover.

Simply put, the Bank of England is going in the wrong direction. By trying to make the banks safer it is actually making the economy weaker. We can only hope Mark Carney’s first decision when he takes over in July is to reverse this course of action.

This article originally appeared on City A.M.’s website

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