UK bank demonstrates regulators' capital ratio conundrum

Regular readers know that your humble blogger thinks that bank capital requirements are incredibly dangerous (without transparency, they suggest banks are stronger and less risky than they really are) and bank capital requirements suffer from numerous problems like the fact that they are implemented on a pro-cyclical basis.

The Guardian carried an interesting article on this pro-cyclical implementation of capital requirements featuring Nationwide and the Bank of England.

The Bank of England has denied that its insistence on Nationwide holding a bigger capital cushion had forced the UK's largest building society to slow its launch of small business lending. 

The Bank of England's actions are pro-cyclical if in fact requiring the bank to hold more capital reduces its lending capacity and this reduced lending capacity has a negative impact on borrower access to funds for growth and reinvestment in the economy.

Nationwide admitted plans to expand lending to small- and medium-sized enterprises (SMEs) are unlikely to take effect until 2014 at the earliest. 

It said plans to begin lending to smaller firms were still under development but "moving slowly"; , it denied a report that it had shelved a planned launch date for later this year....

Where there is smoke, ....

The Bank of England refuted any suggestion that Nationwide's decision to hold off from a launch into the SME sector was due to its demands on capital strength. 

A very tough assertion to prove.

A spokesman added: "The plan agreed with Nationwide to meet the 3% leverage ratio in 2015 will not result in them restricting lending to the real economy. Therefore it is wrong to blame their SME decision on the regulator."...

Banks have a limited number of ways to increase their ratio of equity to assets.  They can retain earnings or sell stock to increase the amount of equity.  Alternatively, they can decrease the amount of assets on their balance sheets.

The Bank of England spokesman suggests that Nationwide intends to meet the 3% leverage ratio by retaining earnings and/or selling stock.

However, regulators warned the lender had rapidly expanded its mortgage business while still wrestling with an overhang of bad commercial property loans. 

It was rebuked in July by the regulator, the Prudential Regulatory Authority (PRA), for running an aggressive lending policy without adequate reserves to insure against a possible collapse.

So much for retaining earnings to increase equity.

To build up reserves, banks take a provision for loan loss as an expense through their income statement.  This drives down earnings, so there is a lower level of earnings that can be retained.

Apparently Nationwide is planning a stock offering if meeting the higher capital ratios is not going to reduce its lending capacity.

But can it sell stock?

Analysts at credit ratings firm Standard & Poor's followed with a warning that a doubling in the losses on commercial property loans to £450m weakened the lender's financial position. 

S&P downgraded Nationwide's credit rating this month and signalled that further downgrades could follow without a rapid improvement. 

"These impairment charges have hindered Nationwide's internal capital generation. As a result, we have revised down our assessment of its risk position to 'adequate' from 'strong'," it said.

In the absence of disclosure of Nationwide's current asset, liability and off-balance sheet exposure details, why would anyone buy stock in Nationwide?

Without this information, there is no way of knowing what additional losses might be hidden on and off its balance sheet.

So if Nationwide cannot increase its equity from either retained earnings or stock sale, then the only way to increase its leverage ratio is by decreasing its assets.

Decreasing assets strongly suggests a reduction in Nationwide's lending capacity and that it will be more difficult for borrowers to access credit for growth and reinvestment (i.e., sure as heck looks like regulator's requirement to increase capital levels is pro-cyclical and is making downturn in economy worse).