Thursday, December 1, 2011

Where is extra capital going to come from for UK or European banks?

The Bank of England's financial policy committee thinks that now would be a good time for banks to raise additional capital.

Setting aside my reservations about bank capital, where exactly is this capital going to come from?

As the Bank of England's Andy Haldane has said, banks are 'black boxes'.

Who is going to invest in a black box where they cannot assess the risk of the investment?

Since the beginning of the solvency crisis on August 9, 2007, I have been saying that in order to restore confidence, opacity must be eliminated throughout the financial system.

One place where there is considerable opacity is the black box that represents a bank.  To shine light into this box requires that the bank discloses its current asset, liability and off-balance sheet exposure details.

Without this data, it is simply impossible to assess the risk of a bank as the bank's exposures can and do change rapidly in today's financial markets.

Regulators confirm this fact every day by having bank examiners on-site at the largest financial institutions.

Nils Pratley has an interesting article in the Guardian focused on the question of where the capital is going to come from.

Alarm bells are ringing at full blast in Threadneedle Street. The current environment is "exceptionally threatening," says Sir Mervyn King. The spiral of decline - falling confidence, lower asset prices, tighter credit conditions, damage to the economy - is "characteristic of a systemic crisis." 
But what should banks do? On this score, the governor of the Bank of England offered only a broad description. The gist was: whatever it takes. 
The banks actually know that ultra transparency is required.  Notice how SocGen, BNP Paribas and Jefferies turned to it briefly when faced with bank runs.
So banks should raise their capital levels to preserve confidence and maintain lending capacity.
But how much capital is required? "There is no simple answer," said Sir Mervyn. In other words: just keeping jumping and don't stop to ask 'how high?'  
This advice comes with the usual qualification about the dangers of deleveraging: don't make matters worse by stopping lending to the economy. That implies cuts to bonuses and, possibly, straightforward capital-raisings since the Financial Policy Committee thinks bank boards should "give serious consideration to raising external capital in coming months." 
But how is the latter going to work? Take Royal Bank of Scotland, already 83% owned by the state. If wholesale funding markets become fully frozen (and ice has been forming since the spring), where should the bank turn? Are taxpayers meant to subscribe for a rights issue? Are we meant to nationalise RBS all over again? Is that where we are? 
It's not the governor's job to delve into specific mechanics of capital raisings - and, in theory at least, there are many sources of new capital before the buck lands on shareholders' laps. But the problem looks acute since, for three out of four UK banks, capital levels (as opposed to capital ratios, which can be improved by deleveraging) have been going down or sideways over the past year. 
And it gets worse. Hope is fading that a strong recovery in profits could raise capital levels. 
 "The outlook for UK banks' profits has deteriorated since the previous report [in June], particularly since the start of October, which would limit banks' ability to build capital without taking other actions," says the report. ... 
Two other points flow from the above. More capital implies lower returns on capital if other factors remain the same. So bank shareholders should probably prepare to kiss goodbye to the sunny thought that double-digit returns can be earned within a year or two. Most investors had already worked this out for themselves; it's only the bank managements that are clinging to the idea that 13% is in sight. 
But, since the banks may wish to cling to the hope that capital-raisings can be avoided, the Bank and Financial Services Authority may face a big battle to get their way on capital levels. 
Second, remember that the UK is not at the heart of this "exceptionally threatening" environment. The eye of the storm is the eurozone. And if UK banks need more capital, imagine the demands on eurozone lenders.

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