The sixth set of Bank of England stress tests for the UK banking system will be released on December 10th.
So what to expect? UK banks’ CET1 ratios better than ever, long march to higher capital is long over, UK banks are now so strong that they can undergo a crisis that is worse than the last one and still come out in good shape.
I am confident about these predictions because that’s what the Bank always says.
Let’s go back to basics. How strong are UK banks now? Perhaps the best ‘back of the envelope’ way to assess a bank’s financial strength is in terms of the ratio of its market cap to its total assets. The biggest five UK banks – Barclays plc, HSBC Holdings plc, Lloyds Banking Group plc, Royal Bank of Scotland plc and Standard Chartered plc – account for about 90% of total bank assets. If we take these banks’ market cap to total assets, weight these ratios by their share of total assets, then we get a weighted average ratio of market cap to total assets equal to 3.72%. Inverting this ratio, the banks’ average leverage, the ratio of total assets to equity in market value terms, is 1/0.0372 = 26.9. My spreadsheet is here. Such a level of leverage is positively enormous.
To put these numbers into perspective, a famous letter by Professor Anat Admati of Stanford Graduate School of Business and 19 other distinguished financial economists, recommended a minimum ratio of equity to total assets of at least 15%, with some of the co-signatories advocating much higher minimum ratios. A 15% minimum equity to total assets ratio implies a maximum permitted leverage of 1/0.15 = 6.67. In his book, former Bank of England Governor Mervyn King recommended a minimum equity to total assets ratio of 10%, implying a maximum permitted leverage of 10. Sir John Vickers, the former Bank of England chief economist and former chair of the Independent Commission on Banking, also supports capital standards that are about twice their current level. By these standards, UK banks are far from being financially resilient.
To put the UK banks’ current 3.72% market cap/total assets ratio into a temporal perspective, 46 weeks ago, the corresponding ratio was 3.62%. So the good news is that the UK banking system is getting stronger, but the not so good news is that at this rate of progress it will take an awfully long time to get where it needs to be.
By my reckoning, at the current rate of progress it will take 172 years for UK banks to hit a target market cap/total assets ratio of 15% and 86 years to hit one of 10%. These estimates also assume no intervening crisis in the meantime.
Clearly, if UK banks are this weak now, before any stress, then it would be a strange stress test that saw them coming up roses after a stress, especially a severe one. Yet it is this sow’s ear that the Bank will (I predict) transform into a silk purse.
So whilst I might be missing something, I just can’t see how the Bank can possibly mount a convincing case that the UK banking system is strong. And I have absolutely no idea how they could take such a weak banking system as we currently have, impose some “worse than financial crisis” stress on it, and then credibly have the banking system come out in strong shape after the stress.
This said, I can fully accept, and in fact fully do expect, that the Bank’s models will project some such outcome.
But the model is one thing and the real world is another, and that is the essence of the problem.