The Bank of England can always be expected to bang on about banks’ financial health. But with the eurozone slowly imploding on its doorstep and — as the FT notes, with the global financial crisis still vivid in the memory, the Bank “was never likely to show signs of complacency” in its latest Financial Stability Report, issued on Friday.
Not surprisingly, the Bank’s twice-yearly report warns of the severe stresses faced by the European financial system in recent months and also expresses concern about the many other risks to financial stability in the UK and around the world.
But it is the indirect exposure of UK banks to eurozone instability that most concerns the Bank, as the report notes:
“The main credit risks to UK banks stem from the possibility of losses on lending to euro-area households and companies, should sovereign and banking concerns spill over to weaker-than-expected growth in the euro area” .
So, urges the BoE, British banks should stop paying large cash bonuses and dividends in order to gradully build better capital buffers while the going is good, so to speak.
As the FT notes, the Bank is concerned that while banks have improved their ability to absorb losses, “the interconnectedness of the European banking system will amplify losses from peripheral economies, such as Greece, Ireland and Portugal”.
Among other key points of the report, Knight Capital neatly sums up:
- UK banks face an even larger funding challenge in 2011; Lower interest rates could be hiding weakness.
- The global recovery remains uneven. Risks to the downside could place further strains on balance sheets in both the public and private sectors. Sovereign and banking sector risks have re-emerged across parts of Europe and remain closely intertwined… burden of unsecured debt on households in the UK has increased.
- Corporate and household defaults have so far been contained by temporary government support, bank forbearance and the exceptionally low level of interest rates. But balance sheets remain overextended in some sectors, so pressures would intensify if these factors were to reverse, crystallising latent credit losses.
- Strong capital flows are a risk to emerging markets.
- Low yields on government bonds in advanced economies may cause bubbles in Asia and junk bonds.
- UK is only partially insulated from EU debt crisis.
- UK banks have made important progress in improving resilience.
- There needs to be a comprehensive solution to sovereign debt problems
- Banks need to keep wages and dividends lower and not stop lending.
- Banks are more worried about property prices and economic downturn than they were in May.
In a separate article, the FT examines other points the Bank makes on areas including clearing houses, funding and securitisation.
UK banks, no doubt feeling a little battered and bruised by verbal attacks from British leaders and calls for their break-up, can breathe easy that the Bank is not proposing any new sanctions to force them to curb pay-outs and build their capital cushions.
But this time, they might do well to take such urgings more to heart than usual — given the Bank’s forthcoming new supervisory role over the sector.
Interestingly, in suggesting that banks could use “equity or other loss-absorbing capital” to fund bonus pay-outs or dividends, the FSR report makes the clearest suggestion yet of the Bank’s interest in Contingent Capital, or CoCos.
Especially in the form of bonus payments:
Prudent distribution of profits to equity holders and staff would allow banks to raise capital internally. For example, if discretionary payments to staff took the form of equity or other loss-absorbing capital, this would help boost banks’ capital. There are also risk-sharing and incentive benefits to paying staff and shareholders in these instruments, perhaps especially through contingent capital or subordinated debt.
Just the thing to thrill a shareholder or employee of a struggling British bank after a long, hard year…
Related links:
CoCos can cost – your bonus – FT Alphaville
In-depth report: UK banks – FT
Bank of England – Lex