Can UK Banks Pass the COVID-19 Stress Test?

Eumaeus is pleased to release our report Can UK Banks Pass the COVID-19 Stress Test? on the dire state of the UK banking system as the UK economy enters the COVID-19 stress test.

In his final remarks as Governor, Mark Carney reiterated the same upbeat message that he has always given, that the UK banking system is superstrong:

Some watching will recall the financial crisis a little more than a decade ago. Then, the financial system was the core of the problem. Now, it can be part of the solution.

Over the past decade, the UK financial system has been transformed. We didn’t build this strength for its own sake.

This is prudence with a purpose.

Resilience with a reason.

Deputy governor Sam Woods said much the same to the Treasury Committee on Wednesday April 15th:

We go into this with a well capitalised banking sector.

We don’t think so. Our report explains why.

Here is the abstract:

“As the UK economy enters the COVID-19 downturn, the Bank of England (BoE) continues to maintain that the UK banks are strongly capitalised. Yet there is considerable evidence that they are anything but.

The core metrics of the Big Five UK banks have deteriorated sharply since the New Year, and even more since the end of 2006, i.e., the eve of the Global Financial Crisis. Their market capitalisation is now £148.5 billion, down 40% since the New Year and down 57% since December 2006; their average price-to-book ratio is 42.7%, down from 71% at the New Year and 255% at end 2006; their average capital ratio, defined as market capitalisation divided by total assets, is 2.7%, down from 4.7% (end 2019) and 11.2% (end 2006); their corresponding leverage levels are 36.7, up from 21.5 (end 2019) and 8.9 (end 2006). By these metrics, UK banks have much lower capital ratios and are more than four times more leveraged than they were going into the previous crisis.

These metrics indicate a sickly banking system. If the banks were in good financial shape, their PtB ratios would be well above 100% and their capital ratios well above current levels. Traditional rules of thumb also suggest that leverage levels should be no greater than 10 or 15 to be considered safe.

In addition, UK banks have hidden problems relating to their off-balance-sheet positions, their gameable ‘Fair Value’ Level 3 (or ‘mark to model’) and loan book valuations, and their problematic implementation of IFRS 9, all of which have further adverse consequences for their capital adequacy.

The BoE’s ‘Great Capital Rebuild’ narrative about a strongly recapitalised UK banking system is little more than an elaborate, and occasionally shambolic, window dressing exercise. The BoE focused most of its efforts on making the banking system appear strong by boosting banks’ regulatory capital ratios instead of ensuring that the banking system became strong through a sufficiently large increase in actual capital meaningfully measured. The result is that the UK banking system enters the downturn in a worryingly fragile state and avoidably so.

Another massive bank bailout now appears inevitable.”

The report itself is a bit on the long side (only 142 pages!) and includes detailed analyses of a range of topics including:

  • the implications of banks’ ultra-low price-to-book ratios;
  • a primer on bank capital;
  • market values vs book values;
  • the need for much higher minimum capital standards;
  • the bifurcation of the UK banking system into two parts, the stronger bit being HSBC, and the weaker bit being the rest, and how HSBC is terrifyingly exposed to Hong Kong and China;
  • the hidden losses and hidden risks in the UK banking system due to off-balance-sheet vehicles, Level 3 Fair Value abuses, the gaming of credit risk models and the problematic implementation of IFRS 9;
  • the uselessness of the regulatory capital framework, due to its reliance on gameable metrics and unreliable regulatory capital ratios instead of relying on market value capital instead;
  • the ‘worse than useless’ BoE bank stress tests;
  • a debunking of the Bank of England’s ‘Great Capital Rebuild’ fairy story;
  • a timely refresher on how badly the BoE got it wrong the last time round; and
  • a guide to the underlying political economy of bank capital – the Bankster Social Contract, in which bankers promote excess leverage to create privatised gains and socialised losses, and the regulator lets them get away with it because the regulator is captured.