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How Resilient are UK Banks?

By Professor Kevin Dowd - July 2020

As the UK economy enters its biggest downturn since 1709, it is natural to ask if UK banks are strong enough to withstand the downturn and still function normally.

The mood music coming from the Bank of England is certainly reassuring. As Deputy Governor Sam Woods told the Treasury Committee on 15 April, “We go into this with a well-capitalised banking sector.”

But are UK banks really as strong as the Bank says?

The answer, sadly, is no.

The following chart shows the share prices of the Big Five UK banks (Barclays, HSBC, Lloyds, RBS and Standard Chartered) since the end of 2006, the eve of the Global Financial Crisis (GFC).

Big Five UK Banks’ Share Prices Have Collapsed Since 2006

Source: Financial Times. Figures correct as of 22nd May 2020.

It is striking how much banks’ share prices have fallen: 53% for HSBC, 68% for Standard Chartered, 85% for Barclays, 90% for Lloyds and 98% for RBS.

These falls suggest a marked deterioration in banks’ financial conditions since the eve of the last crisis and don’t sit easily with the Bank’s narrative about a strong banking system.

Share price falls are relevant because they impact banks’ market capitalisations (‘market cap’). Banks’ market cap was £360.9 billion at the end of 2006 and is now £138.8 billion, a fall of 62%.

A loss of only £140 billion would be enough to wipe out the entire capital of the banking system.

We can also assess banks’ strength by their leverage, the ratio of their total assets to market cap. The banks’ average leverage has increased almost fourfold from 8.9 then – and banks were widely regarded as being excessively leveraged going into the previous crisis – to an almost off-the-chart leverage of 44 now. A traditional bankers’ rule of thumb is that leverage should be no more than 10 to be considered safe.

A final health indicator for a bank is its price to book ratio, the ratio of its market cap to the book value of its capital. A healthy bank would have a price to book ratio well over 100% reflecting, among other factors, healthy future profitability. The banks’ average price to book ratio is 38.4%, however.

The market clearly believes that there is something wrong with the banks.

One is reminded of Nobel economist Merton Miller’s comments about a 50% price to book ratio: “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.”

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

The result is that the UK banking system enters the downturn in an unnecessarily fragile state.

Naturally, it would be unfair to criticise the Bank for failing to anticipate the pandemic. However, as Sir John Vickers, the former chair of the Independent Commission on Banking, recently stated:

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

It is reasonable to criticise the regulator for leaving the system frail when its mandate is to ensure the banks’ systemic resilience. A more serious regulatory failure is difficult to imagine. The Bank’s failure is all the more regrettable because the Bank could have ensured that banks had built strong capital buffers at no cost to the economy. The Bank’s stewardship of the banking system has turned out to be a disaster, again.

The problem is that the Bank has repeatedly shown itself unable to resist lobbying pressure from the banks, whose primary objective is to boost short-term profits by taking excessive risks, safe in the knowledge that they will be bailed out when things go wrong. The bank regulatory capital system is well and truly broken. 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.

There is a solution to this problem, but it isn’t a regulatory one. The standard response – another reshuffling of the regulatory deck of cards, they come about once a decade – will fail for the same reason that such reforms have always failed in the past: the regulatory system gets captured by the firms it seeks to regulate, who then manipulate the system to their advantage. Do away with the regulator, make bankers personally and strictly liable for their losses and the banks will soon sort themselves out. There is no other solution. I said as much nearly twenty years ago to a senior Bank official who was responsible for the Bank’s contributions to the Basel II international capital regime. What a fiasco that turned out to be: the banking system collapsed as the new regulatory system was being rolled out. “Yes, that would work,” she said, “but I can’t possibly say that in my position.”