Double Secret British Probation

Evidently, it’s bank stress test season. Following the recent release of US bank stress test results, the UK has followed suit.

Our chief gripes with the US stress tests were the assumptions were fairly arbitrary and backward looking, and they addressed the effects, not the causes, of the last credit crisis. Then, too, the testing methodology was fairly murky. While stress tests with a high passing rate might help sentiment in some way, in our view, the tests do little to actually stave off future weakness.

And the UK stress tests seem to be all that but more so. According to the Bank of England (BOE), UK banks must raise £25 billion in new capital this year. The good news is this was less than anticipated. The bad news is the BOE didn’t specify which banks needed to raise how much. Also lacking details and transparency were the BOE’s methodology and the reasoning behind it. BOE did disclose they assumed ongoing eurozone weakness, exposure to a weakening housing market and more expected losses from “conduct redress” (i.e., paying the piper for naughty behavior, like LIBOR rate fixing). BOE is free to make any assumptions they choose, but these seem a tad rearview-mirror like. Now, UK regulators insist the UK’s accounting standards allow banks to “hide” nonperforming loans. Fair enough. But the stress tests still do nothing to uncover nonperforming loans. What’s more, it’s likely, at this point a healthy chunk of losses tied to eurozone and housing market weakness have already been realized.

At any rate, bank spokespeople are either staying mum or assuring depositors/investors that their particular bank is just fine. And it may be! The BOE indicated some banks have already surpassed the key benchmarks they were looking for (7% equity capital ratio, taking into account presumed losses). But since banks who failed are effectively on double-secret probation, how is anyone to know?

Now, to raise said capital, banks can sell assets, retain more earnings rather than paying dividends or issue more shares. All relatively harmless activities, albeit they can generally diminish shareholder value in the near term. None of that matters much in the longer term if banks can start lending more aggressively. And in fact, England’s Financial Policy Committee (FPC) cautioned banks should “either raise capital or take steps to restructure their business and balance sheets in ways that do not hinder lending to the real economy.”

No doubt, the FPC realizes that UK lending has overall contracted over the past four years—contrasting with the direction of overall global lending. It’s no coincidence that over the same period, UK economic growth has been overall stagnant. But it’s not clear to us how the FPC expects banks to raise capital/restructure while increasing lending all at the same time. A bank that must raise capital can’t lend as aggressively—if you can even figure out if you’re the bank the BOE wants to raise capital. (Maybe the BOE sent them a private letter? Which doesn’t seem very transparent—seems like that’s the sort of thing depositors would want to know.)

Plus, UK political will to bank bash hasn’t diminished as much as it has in the US—and may have only strengthened in the wake of the LIBOR scandal. In an attempt to offset the uncertain regulatory environment, the BOE has simultaneously offered a series of schemes intended to incentivize bank lending. The latest, Funding for Lending (FLS), makes cheap funds available to banks if they guaranteed to lend that money to small businesses and individuals. This scheme, like the decidedly unmagical Project Merlin and the National Loan Guarantee Scheme before it, hasn’t much boosted lending. And in fact, net lending fell in Q4 2012—not what the BOE had in mind.

UK banks can get all the cheap-as-free money and excoriations to lend-lend-lend politicians can dish out. But so long as banks remain uncertain about just where the next round of regulatory pain is coming from, they’ll be much happier to collect a small but risk-free return on parked reserves. No amount of opaque stress testing with unclear consequences will change that.