Bank of England stress tests inadvertently reveal the weakness of the UK banking system

For the first posting in this two-part series on the 2016 UK stress tests, see here.

The Bank of England’s latest stress test results are important for the following reason: in acknowledging the financial weakness of RBS, the Bank of England is implicitly acknowledging that its own past policies have failed. After all, had those policies worked, then RBS should have returned to financial health long before now. [1]

The results of the stress tests properly interpreted also show that RBS is not the only bank in trouble. The Bank of England flagged up ‘issues’ with Barclays and Standard Chartered too, but the truth is that all the banks are financially weak. The elephant in the room is that the Bank of England’s policies towards the UK banking system have failed to restore it to financial health despite the vast public subsidies involved and despite Bank of England protestations to the contrary.

Read on here:

To start with, we can dismiss the Bank of England’s headline results based on the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets (RWAs). A substantial body of research – including work by its own chief economist Andy Haldane has discredited the RWA measure. Consider:

·      Average RWA fell in the years running up to the Global Financial Crisis (GFC), suggesting that the banking system was getting safer when in fact risks were actually building up (see, e.g., Haldane, 2013).

·      Using latest data for the big four UK banks – Barclays, HSBC, Lloyds and RBS – the ratio of average RWA to Total Assets was 30.6%. However, many assets assigned zero or low risk weights are quite risky.

Thus, the RWA measure hides many (and maybe most) of the risks in the banking system. It did so before the GFC and is doing so still.

The only ratio that matters is the ratio of a bank’s core capital to an appropriate measure of its total amount at risk. The ratio used by the Bank in its stress tests is the Tier 1 Leverage Ratio, Tier 1 capital divided by an amount-at-risk measure known as the Leverage Exposure.

Unfortunately, Tier 1 capital is not a good measure of core capital because it includes items known as Additional Tier 1 (AT1), some of which (such as Deferred Tax Assets) are of no use as a capital resource to a bank in a solvency crisis. AT1 capital also includes items such as Co-Co bonds, whose usefulness in a crisis is also controversial. There is therefore a good argument that a prudent assessment of UK banks’ financial health should focus on CET1 and not include questionable AT1 items, i.e., we should use the CET1 Leverage Ratio instead of the Tier 1 Leverage Ratio. [2]

When we replace Tier 1 with CET1 as the numerator in the Leverage Ratio, then the average post-stress Leverage Ratio for the big 4 UK banks – Barclays, HSBC, Lloyds and RBS – falls from 3.9 percent to 3.6 percent. [3]

This figure of 3.6 percent can be compared to both regulatory standards and expert opinion:

·      Under the Basel III capital rules, the absolute minimum required leverage ratio is 3 percent. However, the best practice in this field is represented by the Federal Reserve: under rules coming through in the United States, the subsidiaries of the 8 big U.S. G-SIBs (Globally Systemically Important Banks) are soon to be required to maintain leverage ratios of at least 6 percent, i.e., twice that specified in Basel III.

·      Many experts recommend that the minimum required leverage ratio should be at least 15 percent, i.e., five times the Basel III minimum requirement. [4]

There is also a second elephant in the room whose presence has been emphasised by Anat Admati and Sir John Vickers: the price-to-book (PTB) ratio.

For a healthy bank, the PTB ratio would be comfortably above one indicating that the bank had a positive franchise value.

A PTB ratio below one indicates a bank that is sickly: for example, with a PTB ratio of 50%, then the bank has managed to convert £2 of capital provided by shareholders into just £1 of market value.

Yet the PTB ratios of major UK banks are all below 1 and in most cases, well below 1. For the big 4 banks the latest PTB ratios are 79 percent for Barclays, 71 percent for HSBC, 72 percent for Lloyds and 43 percent for RBS.

Such low PTB ratios contradict any narrative that the banking system has been fixed.

They also indicate that the market is signalling major problems that the book values are overlooking and we should take account of these signals.

When we do so, we get the following results for the post-stress market-value CET1 Leverage Ratios:

Market-Value CET1 Leverage Ratios Post BoE Stress

The post-stress market-value CET1 Leverage Ratios vary from 1.08 percent for RBS to 2.93 percent for HSBC and the average is 2.2 percent. All the big four banks fail the test. [5]

The natural inference is that the whole UK banking system is under water. [6]

An obvious follow-on is that the Bank of England narrative – “Banking system fixed because of our wise policies and you can see its resilience from the stress tests” to paraphrase Governor Carney from last year’s stress test press conference – is demonstrably falsified by the results of the BoE’s own stress tests.

References

Admati, A. et alia (2010) “Healthy banking system is the goal, not profitable banks.” Financial Times 10 November. 

Bank of England (2016) “Stress testing the UK banking system: 2016 results.” Available at

http://www.bankofengland.co.uk/publications/Pages/news/2016/stresstesting.aspx

Haldane, A. G. (2013) “Constraining discretion in bank regulation.”  Speech by Andrew Haldane iven at the Federal Reserve Bank of Atlanta Conference on ‘Maintaining Financial Stability: Holding a Tiger by the Tail(s)’, Federal Reserve Bank of Atlanta, 9 April. Available at

http://www.bankofengland.co.uk/publications/Pages/speeches/2013/657.aspx

End Notes

* Kevin Dowd (kevin.dowd@outlook.com) is professor of finance and economics at Durham University. He thanks Tim Bush, James Ferguson, Joel Hills, Martin Hutchinson, Gordon Kerr, Sir John Vickers and Basil Zafiriou for helpful inputs. The usual caveat applies.

[1] Steve Baker MP, Tim Bush (from PIRC), Gordon Kerr (from Cobden Partners) and I have been trying to tell them for over five years that RBS was an unfixable zombie that needed to be put through bankruptcy.  The response? A deafening silence.

[2] In its Stress Test report, the Bank of England set out a variety of alternative sets of results: (a) outcomes before assumed management actions or AT1 conversion, (b) outcomes after assumed management actions but before AT1 conversion, and (c) outcomes after assumed management actions and after AT1 conversion. I prefer the latter for reasons suggested in the text.

[3] If we had assumed case (b) in the above footnote, the difference would only have been slight: the average post-stress CET1 Leverage Ratio for the big four banks would have been 3.7 percent instead of 3.6 percent.

[4] For example, a famous letter drafted by Professor Admati and co-signed by 19 other distinguished economists suggested a minimum leverage ratio (although it did not use that term) of at least 15 percent and some signatories wanted the minimum to be much higher than that. See A. Admati et alia, 2010. Former BB&T chairman John Allison has also supported this position.

[5] We can also say that the post-stress leverage ratios reported here are over-estimates because they are based on Leverage Exposure numbers that fail to incorporate many derivatives exposures. Gordon Kerr, an expert in this area, assures me that the true exposures are at least twice those reflected in the Leverage Exposure numbers used here. Were we to take account of these additional exposures, we would obtain post-stress Leverage Ratios of less than half those reported here.

[6] Note too that the results in the chart are based on the lower of the Bank’s two pass standards, i.e., its so-called hurdle rate or 3 percent. It’s new, higher, pass standard, the ‘systemic reference point’ is in general higher: 3.4 percent for Barclays and HSBC, 3.2% for RBS and (unfortunately) ‘n.a.’ for Lloyds (but even so, presumably not less than 3 percent). Had I used these latter pass standards, the picture would have been worse than suggested by the chart.