Banks must be honest about their toxic losses

This weekend, I’m feeling somewhat vindicated. More significantly, perhaps, for the first time in quite a while, I’m also rather hopeful. Vindication comes in the form of the latest Stability Report from the Bank of England’s Financial Policy Committee, published last Thursday.

For a long time, this column has focused on the multi-billion pound undeclared losses on the balance sheets of the UK’s largest banks as the major reason why our economy remains moribund, unable to stage a recovery. The FPC has just shown that it not only agrees with that view but wants to take some action.

Ever since the sub-prime crisis exploded, Western banks have been harboring huge hidden liabilities, burying them using off-balance sheet vehicles, complicit auditors and a host of obfuscation tactics. Financial markets know this, which is why banks have been trading at extremely low “price-to-book” valuations – with many priced at less than the value of their tangible assets.

If the UK economy is to fire on all cylinders again, our banks badly need to raise fresh capital, so providing finance to the creditworthy businesses that will pull us out of the recession danger-zone. Our politicians stick with the “growth versus austerity” soap opera, trading ideological jibes as they argue over future taxation and spending plans that are anyway largely fiction.

The genuine cause of our economic torpor, meanwhile, is that banks aren’t raising the new private sector capital needed to kick-start investment and commerce. That, in turn, is because no-one trusts their accounts given the huge smoldering sub-prime related losses which bank executives are pretending don’t exist.

What’s needed is “full disclosure”, forcing the banks to recognize such losses, taking the hit, and moving on. Some banks would fail, of course, executive egos would be bruised and reputations would suffer. Banks would be restructured, while protecting retail and commercial deposits, with the weak being taken over by the relatively strong. Then, though, banks could recapitalize, the wheels of finance could once again start turning, and capitalism’s “creative destruction” would be able to take its course.

Over the past year or so, the FPC has been emphasizing that UK banks need to maintain capital buffers against unexpected losses. Such “provisioning” is crucial in any economy. On paper, British banks are generally reporting acceptable capital ratios. But last week, Bank Governor Sir Mervyn King basically accused them of failing to tell the truth. While this is something financial markets have suspected and acted upon for a very long time – and some commentators have dared to articulate – it’s a very big step for the Bank of England to give voice to such concerns.

“In judging whether banks are adequately capitalized, we need to ensure that reported capital ratios do, in fact, provide an accurate picture of banks’ health,” boomed Sir Mervyn, as he introduced the FPC report. “At present, there are good reasons to believe they do not”.

The Governor went on to spell-out the dire economic implications of this lack of faith in banks’ balance sheets. “Investors need confidence that banks have adequate buffers against stress in order to be willing to fund them at the low rates necessary to support a recovery … we need banks to be more clear and more accurate about their positions”.

The FPC is now openly raising concerns about banks understating their future losses on many of the unwise loans they extended and investments they made, in the run-up to the sub-prime debacle. Regulators worry aloud that capital ratios, with risk-weighted assets as the denominator, are understated – not least as banks are still permitted to use their own in-house models to measure risk. That means such risks are under-stated, so less provisioning capital is put aside.

In addition, the FPC judges that UK banks are seriously under-estimating the cash they need to pay compensation related to the recent slew of bank scandals – not least the mis-selling of payment protection insurance and the Libor manipulation.

While Sir Mervyn didn’t quantify the level of capital banks need to raise, he described it as “material”. The Bank’s internal research suggests a shortfall of up to £50bn. Many investors think the damage could be much higher. But that’s the point – nobody truly knows. And until they do, our banking sector will remain paralyzed, acting as a brake on recovery.

Keen to avoid panic, but nevertheless determined to press for change, Sir Mervyn weighed his words very carefully. But his overall message was clear. “Our aim is to get to the point where private investors again have confidence in banks,” he said, “so banks have the confidence to lend”. Precisely. The fact that this hasn’t been in the case, with zombiefied banks allowed to hang on when they should have been dismantled, is the major reason why the UK – like so many other Western nations – has been so economically fragile in recent years.

Sir Mervyn has vowed to implement a tougher approach, with banks expected to identify how they will meet capital shortfalls early in 2013. This is grounds for hope, not least as the Old Lady will from next June be led by Mark Carney. By appointing the widely-respected Bank of Canada boss as the UK’s most powerful unelected official, George Osborne has shown genuine imagination and a seriousness of intent. For that, the Chancellor deserves credit.

I’d be even more impressed if Osborne used this week’s autumn statement to admit that it makes no sense to switch the £37bn of “surplus” funds built up at the Bank of England under quantitative easing to the Treasury’s balance sheet. The Chancellor recently said such interest payments from the Bank’s gilt purchases would be transferred, flattering the public finances. These surpluses will be needed, though, to meet the almost inevitable losses incurred when QE is unwound – unless, that is, these gilts are written-off. That really would amount to “banana republic economics”. For the sake of the UK’s reputation as an “advanced nation”, we must hope that doesn’t happen.

In the meantime, Carney’s upcoming arrival at the Bank is most definitely a positive development. In recent days, much has been written on his role in steering his native country through the credit-crunch relatively unscathed, and about Canada’s prudently-run banking sector. It is certainly true that long-standing limits on bank leverage, capped at 20-times assets and going well beyond the Basel requirements, helped Canada weather the storm.

Even if these provisions pre-date Carney’s involvement, that is the environment in which he cut his teeth as a central banker. And since being appointed as Chairman of the global Financial Stability Board, he has also been very firm about the need to force banks to restructure themselves in order to lessen the chances of relying on a state bail-out.

“We must address, once and for all, the unfairness of a system that privatizes gains and socializes losses,” Carney said last month, before news of his Bank of England appointment. “By restoring capitalism to the capitalists, discipline in the system will increase and, with time, systemic risks will be reduced”.

To my mind, in the high-octane world of UK banking, rather than the relatively placid Canadian back waters, the only way to ensure that our banking system is safe, and that “capitalism is restored to the capitalists”, is to separate commercial banking from investment banking in an explicit “Glass-Steagall” split. That’s certainly Sir Mervyn’s view. The pivotal question over the coming months is whether his successor agrees.


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