UK banks: what’s really happening

Here at MoneyWeek, we first began warning readers against Icelandic banks shortly after Northern Rock happened.  We sincerely hope you don’t have an account with Icesave, nor that you own much in the way of banking stocks (the cheaper they’ve become, the more we’ve said ‘sell’).

Icesave savers – and if you are one, you have my genuine sympathies – are in the horrible situation where it looks as though they’ll be the first people to test the effectiveness of both the Icelandic deposit compensation scheme and the UK one in this crisis. And anyone with savings of more than £50,000 may well lose the excess (read more on this here). Update: The Chancellor said today that the government will guarantee the deposits of all UK savers in Icesave accounts.

As for the banking stocks, well that’s where the bad news comes in. Until yesterday, you may not have owned any shares in the sector (and thus missed out on single-session falls of 9%, 13%, 39% and 42% in Barclays, Lloyds, RBS and HBOS respectively).

But as of today, if you’re a British taxpayer, you’ll almost certainly be buying some soon. Unfortunately, that means the government has messed up everyone’s asset allocation…

Darling has unveiled plans to nationalise the banking sector

This morning, just before the stock market opened, Chancellor Alistair Darling got up and gave the British people the news that they will soon be the proud part-owners of a clutch of banks.

The government is offering £25bn to buy preference shares or permanent interest-bearing bonds (the building society equivalent of preference shares) as appropriate right away, and has another £25bn on standby. Meanwhile, the Bank of England is going to make £200bn available for banks to borrow, while the government is also going to guarantee £250bn of debt, to enable banks to refinance loans that are coming due.

We’ll have more on how the deal works later, as the details aren’t yet decided. The Times reports that Abbey, Barclays, HBoS, HSBC, Lloyds TSB, Royal Bank of Scotland and Standard Chartered have all signed up to be eligible for the scheme, and “committed to raise their Tier 1 capital ratios”, as has Nationwide Building Society. But that doesn’t mean they’ll all be cadging off the taxpayer. HSBC, for example, has said it has “no plans to use” the facility.

If an institution does want to use the facility, the government will take into account dividend policies, executive pay, and “will require a full commitment to support lending to small business and home buyers.” What does that mean? Probably that any bank asking for help won’t be paying dividends for some time. And boards may well (as they should) see a forced reshuffle.

Will it work? Well, the FTSE 100 has already fallen by 350-odd points this morning. I guess the jury’s out.

How did we get here?

I imagine right now a lot of people are thinking “how on earth did we get here?” So here’s the short version. Banks got careless and loaned too much money to people who couldn’t pay it back. If a lender makes too many bad loans, they go bust. But because these lenders are so vital to our economy, the government has decided we can’t let them go bust. So we have to bail them out instead.

The slightly longer, but still simplistic version goes like this. The banking business model roughly works like so. The banks have capital – shareholder equity. They then borrow money in proportion to this equity, which they lend out or invest at higher rates. The gap between the price at which they buy the money (borrow it) and the price at which they sell it (lend it out or invest it), gives them their profit.

How do banks borrow money? They borrow it from you and me (through savings deposits), or from commercial lenders (through the wholesale money markets), or through issuing bonds. So say the bank has £1 in shareholder equity. It then borrows £9 on top of this. It then writes £10-worth of loans based on this.

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The two obvious vulnerabilities of the banking business model

There are two obvious vulnerabilities with this business model. The first one is, you need to make sure the people you lend to will repay you. The second one is, if everyone you’ve borrowed from wants their money back at the same time, you’re in trouble, because you’ve loaned most of it out. So you have to keep an eye on when your payments are falling due.

Now most bank lending is done over the long-term – a 25-year mortgage for example. The bank can charge more for this, as it’s taking a bigger risk. Most bank borrowing, on the other hand, is done short-term, for example savers (via instant access deposit accounts for instance) and commercial lenders via 30 or 90-day loans from the money markets, for example. This borrowing is cheap, because it’s short-term.

Obviously, there’s a mismatch between these two things. But that’s OK – when a short-term loan comes to an end, the bank just rolls it over, which the lender is usually happy to do.

The key word here is ‘usually’. When the US sub-prime mortgages started going wrong, it became clear that the loans that banks had been writing were duds. Would you be keen to fund a bank that’s writing bad loans? If it doesn’t get its money back, maybe you won’t either. More to the point, many of the people doing the lending are banks themselves. So they realise they’re going to need that ‘spare’ money, and hang on to it.

So the money markets dry up as institutions hoard cash. And so far, that’s what central banks have been trying to address. This is the liquidity problem, which is what scuppered Northern Rock. It relied too much on wholesale markets, couldn’t repay its debts when they fell due and couldn’t be rolled over, so it went to the wall.

Solvency problem is only now being addressed

But the bigger problem – which is only now being addressed – is the solvency one. Think of this like your mortgage. You’ve got a house which you bought for £100,000 – that’s your asset. You funded the purchase with £10,000 cash (equity) and £90,000 in a loan from the bank (debt). The house price falls by 10%, or £10,000. Suddenly you have no equity.

It’s exactly the same for banks. Their assets are the long-term loans and investments they make. If those fall in value, because no one’s paying them back, then that gets taken off their equity cushion. And unlike your average householder (though not a buy-to-let investor), banks technically aren’t allowed to go into negative equity. Once their capital looks like it may fall below a certain level, they need to top it up.

But if everyone believes assets will fall further, no one’s going to give them more money only to see it written down again. So it’s fallen to the government – in other words, you and me – to do it.

What does all of this mean?

It means we’ve acknowledged that banks are broke. It means existing shareholders will be diluted, while the national debt may well soar, and taxes may have to rise at some point to pay for it. We may see some sort of return from this in the very long term, but don’t bet on it.

As for banks, they may be recapitalised, but they can’t return to rampant lending. None of this will be over until the property crash ends, because as long as property markets continue to tumble, the asset side of banks’ balance sheets remains under question. We’ve more on when the crash might end in this week’s issue of MoneyWeek (out on Friday – get your first three issues free here).

But suffice to say, it won’t be for a long while.

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