Despite mounting loss provisioning UK banks can take more pain, says Bank of England

UK banks are suffering a torrid time due to the devastating economic impact of the Covid-19 pandemic, yet the Bank of England (BoE) believes they can stomach more pain if necessary.

The five main UK based banks – HSBC, Barclays, Lloyds Bank, NatWest Group and Standard Chartered – reported in their second-quarter earnings loan-loss provisions of around £17bn, which was worse than analysts’ expectations. 

Analysts say the UK is facing a deeper downturn than many European countries, with the UK economy forecast to plunge by 11.5% this year – one of its worst performances in a century, versus 9.1% for the eurozone, according to the Organisation for Economic Co-operation and Development. 

And UK banks tend to be more exposed to riskier unsecured consumer lending than many European peers. A second wave of the virus, which some scientists believe to be highly likely later in the year, would also pile more pressure on the economy and banks following the resultant shutdowns. 

Checking the pulse

All of this has left the BoE’s Financial Policy Committee (FPC) having to monitor the pulse of the UK’s banking system carefully in case it runs into severe trouble.

But so far the FPC is confident that the system is up to the challenge, thanks to the decade-long regulatory reforms that have left banks far better capitalised and prompt intervention from the authorities.   

In its August 2020 financial stability report, the FPC said it expects credit losses to be below £80bn and believes banks are sufficiently well capitalised for this outcome. And thanks in part to the government’s lending guarantee schemes, the FPC reckons banks can continue supporting the UK economy. 

As an exercise, the FPC conducted a ‘reverse stress test’ to see how much worse than the central projection the economic outcome would need to be to deplete regulatory capital buffers by as much as seen in the 2019 stress test that informed the setting of those buffers. That test theoretically saw bank capital ratios depleted by over five percentage points. 

However, the FPC noted that bank capital buffers are actually larger, therefore the depletion of capital would only eat into 60% of bank capital buffers – still leaving them above minimum requirements. 

The report explained that for capital ratios to be depleted by more than five percentage points, banks would need to suffer credit impairments of around £120bn. To generate such big losses would require a fall in economic output to be double the BoE’s projections and unemployment would need to soar to 15% 

The BoE is forecasting a 9.5% drop in economic activity and an improvement on the original forecast for a 14% fall, and it expects unemployment to peak at 7.5% by the end of 2020. Many analysts believe these forecasts to be overly optimistic, however. 

The unemployment rate in May was 3.9%, thanks largely to extensive government support schemes that are set to end later this year. 

Seeking to reassure 

“The FPC’s tone is one of reassurance. Its analysis shows that banks have plenty of headroom to absorb losses before they have used up their regulatory capital buffers, both in a scenario in line with the BoE’s expectations, or in a more severe, double-dip recession,” says David Strachan, head of Deloitte’s EMEA centre for regulatory strategy. “In contrast to the European Central Bank, the BoE has not set out how long it will give banks to rebuild their capital and liquidity buffers, leaving the timing of this uncertain.”

He explains that the BoE seems more concerned about finding ways of making banks less reluctant to use the buffers because of the consequences of doing so, such as automatic restrictions on shareholder distributions, and is even prepared to contemplate temporary changes to the capital framework if necessary. 

However, in a research note, Goldman Sachs picked up on the BoE governor Andrew Bailey being categorical during the press conference that negative rates were feasible, which would crush bank profit margins if it happened. 

The investment bank believes that the BoE could open up the effective lower bound on the Bank rate and expects it to announce another £100bn in quantitative easing towards the end of the year. Meanwhile, the monetary policy committee voted unanimously to leave the QE target unchanged at £745bn

Fear of deficits

Looking at the wider economy, the FPC estimates that companies could face a cash flow deficit of up to around £200bn, though many do hold substantial cash buffers. It said there has been a surge in credit demand from firms with government-backed loan guarantees schemes. It added that since the start of the Covid-19 pandemic, businesses have raised over £70bn of net additional financing from banks – mostly via these schemes – and through access to financial markets. Over the same period, they have borrowed £18bn through the Covid corporate financing facility.

“We are seeing a resurgence in ‘zombie companies’ where businesses are servicing debt from remaining cash flows with little or no capital for investment and according to The City UK, it is estimated that UK businesses may build up £100bn of debt by next March which they would be unable to repay with 780,000 small and medium-sized enterprises in danger of insolvency,” warned Douglas Grant, director at Conister Finance & Leasing, a specialist lender to small firms. 

On a more positive note, the FPC reported that households entered the Covid-19 shock in a stronger financial position than before the 2007-09 global financial crisis. Meanwhile, some 1.9 million people took up mortgage holidays, which has relieved debt servicing pressures. 

But it acknowledged that the outlook is highly uncertain, therefore its projections could turn out to be wide of the mark, creating an environment that makes banks reluctant to lend.