The British Mess (III): Bank of England Tiptoes Around Sovereign Risk Worries

By Richard Smith

The latest Bank of England Financial Stability Report is worth decoding.

My last post on the UK sketched a scenario in which the very large 2011 funding programme for UK banks, discussed in the June BoE FSR (back issues all available here), could be quite problematic, in adverse markets. I hinted that if there was sufficient disorder, we might find the limits of the Implicit Sovereign Guarantee Moral Hazard Trade. It looks as if the Bank of England agrees, and it has sharpened its commentary, though you still have to read between the lines a bit, perhaps with the assistance of Robert Peston:

According to the Bank of England, up to £500bn of wholesale debt is due to mature by the end of 2012. That includes something over £200bn effectively owed to taxpayers through the Treasury’s Credit Guarantee Scheme and the Bank of England’s Special Liquidity Scheme.

Of that £500bn or so, between £350bn and £400bn falls due for payment this year.

Now that is a substantial amount of money to raise, in wholesale markets that are a long way from the kind of depth and liquidity of the pre-2007 boom era. It is on a par with the peak amounts raised by banks in the balmy years, so it is by no means certain they will be able to raise it all, in this chillier climate.

To put the challenge in context, the Bank of England regards it as almost miraculous that gross issuance of term debt by the UK’s banks over the past year was more than £130bn – a fraction of what will be needed in the coming year.

Commenter jon livesey was unimpressed with the fear-mongering in my prior post:

I think this is basically a non-issue. They will try to raise the funding on the market, about #30bn a month, and if rates go too high, the BoE will step in.

Banks are so big these days that trying to draw a “them/us” distinction is meaningless. If the Banks have difficulty raising funds, then *we* have difficulty. So *we* will step in.

If we still haven’t learned from this crisis that trouble for big institutions quickly translates into costs for taxpayers, and fro very good reasons, then we haven’t learned much.

Fear not, jon:  along with many other NC regulars, I had puzzled that out. Nevertheless it will be interesting to see whether BoE does have to “step in”; for that intervention may not turn out well. Clearly, the market now understands well that big bank risk and sovereign risk are the same thing; consider the recent travails of Ireland, which, as it happens, impinged some more on the UK’s semi-state megabanks today; or Portugal, or Spain (where our crippled banks also built up big exposures pre-2008). Given the size of the UK numbers, a UK bank funding crisis (provoked by some Eurozone spasm, say) could quickly morph into a sovereign funding crisis, which would not be pretty, since IIRC we have the biggest total-debt-to-GDP ratio of any of the G20 economies.

The BoE expresses the consequential effects of a bank funding seize up more gently (decoding assistance provided by Bloomberg this time):

Concern the sovereign-debt crisis may spread, undermining demand for government bonds, as well as the risk of accelerating inflation may cause an “abrupt snap back” in bond yields, the U.K. central bank said in its Financial Stability Report. The bank said such a scenario could destabilize the market as happened in 1994, referring to a bond sell-off that occurred when the prospect of rising inflation led the Federal Reserve to begin tightening monetary policy. The Fed funds rate nearly doubled to 5.50 percent that year.

“A yield spike may lead to trading losses for banks even if the assets are liquid,” the report said. “Any sharp reversal in low rates could therefore be a concern for financial stability as this may lead to a value-at-risk shock for banks, resulting in asset disposals.”

One mitigant that the BoE brandishes hopefully, again basing its analysis on 1994 (the last time there was a really sharp bear market in bonds, sharp enough to require our flagship IB, SG Warburg, caught long of tons and tons of Eurobonds, to merge):

“One reason why volatility increased in 1994 was because of the leveraged positions of investors and the margin calls they faced,” the report said. “Derivatives such as structured notes are better understood today, and there is currently weaker appetite for riskier investments. That would be expected to mitigate the impact of any shock to the shape of the yield curve.

Well, I hope they are right about that. Knowing the ways of the banks and the investing community, it doesn’t sound all that likely.

The BoE notes another side effect of such a reversal in short rates: a reduction in bank profit margins. UK banks, like US ones, have made a pretty good profit out of the contrived steep yield curve of the last 18 months or so; profit that, if retained, would be a useful cushion:

Prudent distribution of profits to equity holders and staff would allow banks to raise capital internally. For example, if discretionary payments to staff took the form of equity or other loss-absorbing capital, this would help boost banks’ capital. There are also risk-sharing and incentive benefits to paying staff and shareholders in these instruments, perhaps especially through contingent capital or subordinated debt.

If the BoE is still saying that, it makes it sound as if our banks have paid a lot of the 2009-10 profits out in cash. I hope that is not so.

So, to sum up a plausible bad scenario, the banks can’t fund, the sovereign has to pay high short rates, and the UK is once again left with a bunch of undercapitalized, unprofitable megabanks whose employees have just paid themselves a ton of money. That’s October 2008 revisited, except that this time there’s an extra helping of sovereign contagion a la Ireland or Iceland; and we thought we’d bailed our banks out already. Higher funding costs wouldn’t help our heavily-leveraged and politically crucial housing market much, either.

Now, with a spot of luck, I am just being a worrywart; for instance, the UK banks’ stock of liquid assets, reported by the BoE, is very large, at ~£475Billion: that will help, if there’s a crunch. But it happens that UK officials do judge this to be a good time to indulge in a bit of backscratching with the Eurozone, on funding. And no wonder the politicians are piping up about bonuses again; so we see some proaction there, too, in word, if not in deed:

Britons facing years of budget austerity find it “galling” to see banks continuing pay large bonuses after billions of pounds of public money was used to bail out some of the biggest institutions, Cameron told a news conference in Brussels today.

Galling indeed, though not as galling as watching the continuing unwillingness, or sheer inability, of politicians everywhere to tackle the problem of moral hazard in the financial markets, without which all this “austerity”, even if you believe the economics, is obviously pointless.