Bad LUC for banks, bad luck for us

If the market doesn't have confidence then share prices fall, bond yields shoot up and eventually a bank is in solvency trouble as its own liquidity dries up despite fire sales

Pound by pound, our LUC is running out
Simon Miller
On 6 November 2012 12:43

With credit lines still slow, this is one sort of law of unintended consequences (LUC) that neither banks, business nor consumers need to get the economy moving again.

One question that I always get asked is whether an event or a reaction to an event is deliberate. Now as much as I would like to credit some semblance of intelligence to politicians and regulators, I am afraid to have to tell you that ultimately, accident plays a larger part in the world than design and generally we see the LUC being triggered.

Over the past few years businesses have gone to the wall because credit lines have seized up preventing expansion or simply not allowing companies to tie themselves over as they wait for debtors to pay their bills.

Since the financial crisis, regulators and politicians alike have strutted around demanding that banks behave themselves, stock up the money and protect themselves in case of further crises.

Now, as I have said many times before, banks should have sufficient capital on their books to offset the bad times but politicians should not be surprised when as a result of their demands, lending and credit from banks simply dry up in order to meet capital requirements.

Indeed, only last month the Financial Services Authority (FSA) told UK banks that they did not have to hold extra capital against new loans made under the £80bn Funding for Lending scheme.

With leverage rules already seizing up credit lines and leading to cash hoarding by banks, there has been a dawning realisation that the core capital ratios of 10 percent were undoing all attempts to get the circulation pumping again.

And that is despite the ridiculous asset purchase scheme - otherwise known as quantitative easing - plus other lines of liquidity support in an attempt to get money back into the system.

And yet, somehow, regulators manifestly failed to see this problem. They failed to see how demanding over-the-top protection demands would lead to this seizure.They also failed to see that the very availability of liquidity support from the Bank of England (BoE) would be perceived as a weakness.

Since the leaking of Barclays’ access to liquidity support (Operational Standing Lending Facility) in 2007 which saw the bank come under attack for a perceived weakness, banks do not want to access BoE schemes.

Granted the idea that there are these levels of support available in times of crises may have allowed greater access to private or corporate financing, but the fact is that banks will not risk their reputation by taking advantage of the schemes available.

Today saw three reports into the actions of the BoE during the financial crisis and its modelling system. One of these reports, Review of the Bank of England’s Framework for providing liquidity to the banking system by Bill Winters looks directly into how the liquidity schemes worked and is working. Winters comes up with a very simple idea that there is a massive stigma surrounding these
liquidity support schemes.

Despite their algorithms, despite risk analysis, despite the billions of pounds shifted each day by financial institutions, the heart of their business remains confidence.

If the market doesn’t have confidence, then share prices fall, bond yields shoot up and eventually a bank is in solvency trouble as its own liquidity dries up despite fire sales. On street level, this lack of confidence is ably demonstrated by the queues surrounding Northern Rock five years ago.

So any idea that you as a bank have gone to the BoE - even, as was the case with Barclays that it was actually a routine call - leads to a risk of a confidence run, hence the stigma.

Banks in the UK have an ‘Individual Liquidity Guidance (ILG) ratio that in essence shows models where money flies out of the bank in stress situations. It is a system that is sensibly designed to show that banks can cover liabilities and do not under-insure against such a situation. It is also the basis where banks calculate their minimum liquid asset buffers that are required to offset liabilities.

So far so sensible, but LUC has successfully seen to it that, according to Winters, UK banks hold £120bn more of liquid assets than the £380bn that current ILG ratios suggest are needed.

That’s £120bn that could be out in the system but isn’t.  As the report estimates, even if only half of that excess was used to expand lending to households and businesses, that is around 4 percent more than the current stock of lending.

So instead of tapping into facilities provided by the BoE because of the stigma attached, banks provide for themselves, removing credit from the system.

Now, there are other factors, including demand and risk management models, but here in essence is where you see LUC in play, somehow taking regulators and politicians by surprise when everyone else seems to have worked out that if you demand banks hold greater capital, whilst at the same time markets respond harshly to the idea of tapping into a liquidity support scheme, you end up with the perfect storm as the two fronts meet and businesses go to the wall as credit dries up.

I do not approve of these schemes but can understand the panic embedded in the system in these austere times. Also, I disagree with Winters’ suggestion of normalising these schemes as now, more than ever; moral hazard has to be strictly enforced - because despite what the BoE says, guaranteeing a bank as a result of its actions is a moral hazard no matter how much you charge it. Banks should survive or fall on their actions.

We constantly hear of this growth scheme or that from the government but if this LUC is holding on, then what it does will make not one blind bit of difference.

However, perhaps one day we will see regulators and politicians alike realise that actions have consequences, and the only reason they are unintended is that you couldn’t or wouldn’t envisage this scenario.

Simon Miller is a Contributing Editor to The Commentator

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