Bag a Brexit Bargain with the Banks

Release the Buffers

The Brexit backlash shows that the UK banks have better prospects than their European counterparts. A buying opportunity, perhaps?

Now gather up the wee bairns and tell Grandad to put his ear trumpet in. I have some weighty news to impart. I don’t know how to put this in a way that will not scare you; but here goes…

Mr Carney has decreed that the additional Counter-cyclical Capital (CCC) buffer of 0.5 percent decreed last March for UK banks will be scrapped…

It’s no good staring at me gormlessly like that – don’t you see what this means? I mean, it’s massive. The Old Lady of Threadneedle Street has spent the last eight years since the Crash arm-twisting the banks to raise their capital ratios, using every trick in the Basel III stroke Capital Requirements Directive IV[i] rulebook – plus a few home-grown ruses. And now, for the first time in the Post-Credit Crunch world, she is rowing back. It is as if Nanny, after years of drilling the children never to besmirch their pristine sailor suits, turns round and invites them to make mud pies.

If you do not enjoy a cosy familiarity with the Basel III framework, may I elucidate? Under the beefed-up bank capital adequacy framework, banks had to maintain a ratio of capital to Risk-Weighted Assets (RWA) – that is, their loan exposures weighted according to relative riskiness, where risk is normally determined by ratings – of at least 10.5 percent. This was up from 8 percent under Basel II – though, in practice, the amount of new capital required was raised by more than that implies because the formula for calculating RWA was also tightened.

This capital is mostly made up of shareholders’ equity, but certain other instruments may be included in the so-called “Tier 2” component of bank capital. Here, Contingent Convertible (“Co-Co”) bonds have become increasingly important, especially for banks in the Eurozone. These are debt instruments, which carry a generous coupon, but which may be converted into equity in stressed market conditions such as those which prevailed during 2008-09.

Additionally, Basel III provided that the Central Banks of each jurisdiction where Basel III/CRD4 applied could impose Counter-cyclical capital buffers of up to 2.5 percent of RWA.  The idea here was that banks intensify so-called pro-cyclicality. This means that banks tend to lend out too much money in an economic upswing when things are booming, and also tend to restrain lending suddenly in a downswing. This has the effect of amplifying the normal business cycle over time: booms are more sudden and quickly get out of control while recessions bite more quickly and are more protracted. By imposing a requirement for additional capital during periods of rapid expansion and by alleviating those requirements when the economy contracts, the Central Bank – in theory, at least – can attenuate the business cycle.

Basel III also provided for another layer of additional capital specifically for (excuse the mouthful) Global Systemically Important Financial Institutions or G-SIFIs. These are the guys who are deemed too big to fail. Or, if you prefer, they are the banks that, if they collapsed, they would most likely take the entire global financial system with them. That is what nearly happened after the collapse of Lehman Brothers in September 2008. (There are not more than about 30 G-SIFIs worldwide.) This additional buffer equates to another 1.5 percent or so of RWA. So, all told, the minimum capital requirement for a big international bank went up from 8% to potentially 14.5 percent (10.5 plus 2.5 plus 1.5).

Now as we said, the Counter-cyclical Capital Buffer is discretionary and, as far as I am aware (no doubt clever readers will correct me) has only been imposed to date by the Central Banks of the UK and of Sweden since most of Europe has been mired in near-recession over the last five years. The Bank of England’s decision to reduce this buffer can only be interpreted as a signal that the chance of a recession has increased.

Now, well before the Brexit vote undid the Pound it seemed to many of us that another recession was due. That now looks more likely, not only because of the uncertainty prevailing in the UK (which will hopefully be alleviated under our new lady PM), but also because the news coming out of Europe is pretty much all bad. The Italian banks are teetering and the Italian government is desperate to circumvent the EU no-bail-out rules and to intervene without the massive losses to savers that a bail-in would involve. The apparent political unity of the post-Brexit EU summit appears to be fading. The Austrians will re-run their presidential election on 02 October and the far-right anti-EU Freedom Party candidate has every chance of winning. On the same day, the Hungarians will go to the polls on the migration issue and will most likely raise two fingers to Frau Merkel. A recent IMF report on the outlook for the Eurozone made gloomy reading.

Shares in the big UK banks have tanked since the vote, even though they are better capitalised, have greater liquidity and are more internationally diversified than most of their European counterparts. The average capital ratio of the big UK banks is 13.5 percent – well ahead of European rivals.

European bank stocks have performed dismally over the last year or more, not least those of the major German banks (as I have discussed elsewhere). The list of European banks which have cut or scrapped their dividends of late is a long one. But if the equity markets reflect the future earnings potential of the sector, there is another key indicator which reflects the extent to which markets believe that banks are adequately cushioned against future financial shocks. And that is the spreads on the Co-Co bonds, mentioned above, which have been used to bolster bank capital. These have been widening recently.

So there is a case emerging that the fall in UK bank shares since 23 June is overdone – and that, relative to their European competitors, they might yet snap back. A lower bank capital ratio, all things being equal, implies higher return on equity. The single biggest factor in declining return on capital in the banking sector is that, since the Credit Crunch, they have had to de-leverage (that is, shrink their balance sheets) while bolstering their capital. I have argued elsewhere that banks can still make money in a low interest rate environment so long as they maintain their spreads.

Barclays Bank (LON:BARC) slumped from 186 pence on 23 June to as low as 125 pence on 27 June but are now (13 July) back to 146 pence. RBS (LON:RBS) tumbled from 248 pence on 23 June to a low of 159 pence but are now back to the 180 pence mark. HSBC (LON:HSBA) is UP from 453 pence on 23 June to 476 pence today.

But shares in some of the so-called challenger banks have been slower to recover since 23 June. Aldermore Group PLC (LON:ALD), which lends normally on a secured basis to SMEs, is currently trading at 138 pence, down from 207 pence on 23 June. OneSavings Bank (LON:OSB) is down from 334 pence on 23 June to just 220 today. Supposedly, this is because its mortgage book is skewed to London where property prices are thought to be most vulnerable. Shawbrook Group (LON:SHAW) is trading at about 170 pence, down from 295 pence on referendum day. Methinks the market doth protest too much.

Of course, Mr Carney may want banks to lend more money out to clients, but that doesn’t mean that they will. In a climate of risk-aversion, banks might use additional capital to increase provisions rather than generate new loan assets. But I’d rather invest in UK banks than in French or German, let alone Italian ones.

Did Grandad get that? Don’t tell me he’s lost his ear trumpet…

[i] Or CRD4 as bankers call it.