A rainy-day fund for what went wrong

UK banks are still paying for their pre-crisis mistakes, writes Martin Sandbu

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‘UK banks have a collective capital shortfall of £25bn and must close it by the end of the year with new capital and restructuring, the UK’s new financial stability regulator announced.’

FT.com, March 27

Wait a minute – start from the beginning. What’s bank capital?

Banks need to keep a safety cushion of cash and assets in case their investments go sour. That’s how they make sure people leaving money in banks can get it back.

How much do they keep?

Ah – that’s a difficult question. The amount is “risk-weighted”. They require less capital for investments that are safe.

Like government bonds ...

Maybe not all of them ...

... and they need more capital if they invest in something that is more likely to go wrong.

Exactly.

So banks needing more capital sounds like bad news. Wasn’t getting the banks back into shape the reason for throwing so much money at them?

It’s becoming a bit of a refrain to say that things are worse than we thought. But that’s what the Bank of England’s Financial Policy Committee is saying. The banks have too little capital because they are still likely to lose money from decisions they made before the crisis.

I see. What kind of decisions are we talking about?

You could divide them into mistakes and mischief. The mistakes were the bad investments they made – the FPC mentions the eurozone periphery and UK commercial real estate. The mischief was stuff such as manipulating the Libor benchmark rate and selling payment protection insurance and interest swaps to people who didn’t need them.

Haven’t banks paid for this already?

They have. But now the regulators think it could get even worse. They reckon that between them banks may still face a cool £10bn in fines or compensation claims. That’s if there’s no other scandal waiting to come out of the woodwork, mind you.

That’s reassuring. How do we know that the BoE is right this time and that £10bn is the end of it?

We don’t.

Right. And the bad investments?

That’s not exactly news either. Here, too, the eagle-eyed experts in Threadneedle Street have decided that losses could be worse than the banks have estimated.

Wait ... than the banks have estimated? You mean we are taking the banks’ word for how much they stand to lose?

Surprised? It’s been part of international bank regulation, set in Basel, for years. You know how banks need to hold that “capital” stuff against the investments they make? Well, the big ones may often use their own models to estimate how risky their investments are and how much capital they actually need to hold.

Are you kidding me? These banks thought subprime mortgages were ultra-safe!

Don’t yell at me, go talk to the gnomes of Basel. But, to be fair, the regulators are on to this. The third reason banks have to rustle up more capital – apart from investment losses and additional punishment for their sins – is that their risk weights have been found to be too low.

They have been cheating.

Using what they called a “more prudent approach”, the regulators suggested that UK banks were not holding enough capital, given the riskiness of their portfolios.

And all of this adds up to them needing £25bn more?

Er, no, it adds up to £50bn. But the Bank of England thinks some of the shortfall is in banks that have capital to spare. So only £25bn of new equity is needed.

Let’s hope they’re right. What does this mean for me, though? Are the banks going to let me do my own risk-weighting so I can get a better mortgage deal?

Not quite. Anyway, who do you bank with?

There’s not much choice.

Too right. The government wants more competition, so they are letting new banks get away with less capital for each deal. The hope is to make it easy for new banks to attract customers. You should give it a try.

What if I want to stay with my own bank? It’s such a hassle to switch accounts.

The government promises to fix that too. Until it does, if you’re stuck with your bank things depend on how it goes about raising capital ratios. If it finds investors who want to buy new shares, great. If not, it must choose between limiting bonuses and dividends, or shrink its lending to meet the ratio.

We know what that means!

The regulators promise they will not let banks react to the rule by lending less ...

We’re in safe hands then.