United Kingdom: Selected Issues
Author:
International Monetary Fund
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Publication Date:
09 Nov 2010
eISBN:
9781455208449
Language:
English
Keywords:
ISCR; CR; UK banking sector; bank; part-nationalized bank; RBS branch; places LBG; RBS Sempra Commodities; UK Treasury; Commercial banks; Stress testing; Loans; Capital adequacy requirements; Global
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This paper estimates the extent of spare capacity in the U.K. economy using a range of methodologies pointing to an output gap and the behavior of inflation during large output gaps. The usefulness of fiscal rules in supporting fiscal consolidation is generally positive, and a more permanent rules-based fiscal framework is required. The banking system has recovered fast; however, the sustainability of the sector’s recovery is still uncertain, and risks remain. An update on reforms to the financial sector’s regulatory and supervisory framework is also provided.

Abstract

This paper estimates the extent of spare capacity in the U.K. economy using a range of methodologies pointing to an output gap and the behavior of inflation during large output gaps. The usefulness of fiscal rules in supporting fiscal consolidation is generally positive, and a more permanent rules-based fiscal framework is required. The banking system has recovered fast; however, the sustainability of the sector’s recovery is still uncertain, and risks remain. An update on reforms to the financial sector’s regulatory and supervisory framework is also provided.

V. Recent Developments and Outlook for Major UK Banks1

The financial crisis severely affected the UK banking sector, prompting a forceful and wide-ranging policy response that helped increase financial stability. Over the past year, the UK banking system has recovered faster than expected: capitalization levels have increased, impairment charges have come down, and better margins led all major UK banks—including the part-nationalized ones—to return to profitability in the first half of 2010. The recent Committee of European Bank Supervisors (CEBS) stress tests confirmed the relatively good health of the largest UK banks. However, the sustainability of the sector’s recovery is still uncertain, and both domestic risks (e.g., from commercial real estate exposures) and external risks (e.g., from sovereign turmoil in parts of the Eurozone) remain.

A. Policy Interventions Helped Increase Financial Sector Stability

1. The UK authorities took a number of forceful measures during the crisis to help shore up the financial system. Key measures include the following:

  • The UK Treasury injected a cumulative £70 billion of capital into four banks. In November 2008, the government established UK Financial Investments Ltd (UKFI) to manage its shareholdings in banks. UKFI fully owns Bradford & Bingley and Northern Rock. In addition, it holds 41 percent of the total share capital of Lloyds Banking Group (LBG) and 83 percent of the total share capital of Royal Bank of Scotland (RBS). All four banks have undergone significant restructuring (Table 1).

  • In January 2009, the Government announced the creation of an Asset Protection Scheme (APS). The APS was set up to provide participating institutions with protection against future credit losses on defined portfolios of assets in exchange for a fee. The initial plan was to insure £260 billion of assets from LBG and £325 billion of assets from RBS. However, LBG subsequently took steps to stay out of the APS—notably a £13.5 billion rights issue and a £9.0 billion swap of existing debt into “contingent capital”—and paid a one-off fee of £2.5 billion to the government. RBS, in turn, reduced the amount of insured assets to £282 billion. On these assets, RBS remains liable for the first £60 billion of losses as well as 10 percent of all losses beyond this amount. The Asset Protection Agency (APA) stated in its July 2010 annual report that it projects an eventual net loss of £57 billion for RBS on the APS assets, just below the first-loss threshold. The APA thus expressed confidence that the government would not have to make a payment under the APS in the central scenario. In April 2008, the Bank of England introduced exceptional liquidity support through the Special Liquidity Scheme (SLS) to allow banks to swap their high-quality but illiquid mortgage-backed and other securities for UK Treasury bills for up to three years. The SLS was extended in October 2008, leading to a total utilization of £185 billion by the end of the drawdown period on January 30, 2009. At end-February 2010, £165 billion remained outstanding, but banks have continued to make repayments since. The final swap transactions under the SLS will be unwound by end-January 2012.

  • The Bank of England also provided temporary liquidity support as a lender of last resort to Northern Rock in 2007 and to HBOS and RBS in 2008. Collateralized loans to the latter two banks reached a combined maximum amount of nearly £62 billion in October 2008. Both banks had repaid the cash by mid-January 2009, but the loans were only disclosed to the public in November 2009.

  • Additional funding support was introduced by the Treasury through the Credit Guarantee Scheme (CGS).7 Operational in October 2008, the CGS provided a government guarantee for short-and medium-term debt (one month up to three years) issued by banks. The CGS closed to new issuance at end-February 2010, but eligible institutions are still able to refinance debt already guaranteed under the scheme. The amount outstanding in late March 2010 was £125 billion.

Table 1.

Key Bank Restructuring Measures 2

article image
Sources: European Commission and HM Treasury

B. UK Banking System is on a Path to Recovery

2. The health of the UK banking system has improved considerably over the last year:

  • Profitability has continued to recover in 2010, with UK banks reporting solid results for the first half of the year. The five largest banks reported a combined net profit of £9 billion in 1H10 versus only £1 billion a year ago.8 Importantly, this included a return to profitability by both of the part-nationalized banks (LBG and RBS). Faster-than-expected cyclical recoveries in impairments and higher margins were the main drivers explaining the bottom-line improvement. Strong margin re-pricing, particularly on mortgages, was a key positive feature for LBG and RBS in the first half of the year. Investment banking revenues (primarily for Barclays) were still strong in the first quarter of 2010, but have gradually come down from their elevated 2009 levels; indicators for the third quarter point to a further moderation.

uA05fig01

Cumulative Half-Year Profits of the Five Largest UK Banks

(Billions of GBP)

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A005

Sources: Bloomberg; and IMF staff calculations.

  • Low interest rates and the relatively limited increase in unemployment over the last year helped maintain loan affordability and repayment capacity. Impairment charges peaked in 2009 and declined significantly in 1H10. Thus, cumulative loan loss provisions among the five major UK banks were 40 percent lower in 1H10 than a year ago.

  • Following the positive outcome of the CEBS stress tests and clarification of the Basel blueprint for regulatory reform in July 2010, the major UK banks were able to return to funding markets that had been effectively closed during the spring (when the sovereign debt turmoil in some Eurozone countries reached its peak). Issuance of senior unsecured debt, covered bonds, and residential mortgage-backed securities was strong in both August and September 2010. UK banks have also increased their use of private placements to diversify away from issuance in volatile capital markets only.

  • The large UK banks continued to strengthen their capital bases. Their average Core Tier 1 capital ratio increased significantly from 6.3 percent at end-2008 to 9.6 percent in 1H10. Banks have increased capital ratios through a combination of actions on the numerator and denominator, including (i) the issuance of common equity (Barclays, HSBC, LBG); (ii) debt buyback and exchanges (e.g., LBG); (iii) higher net profits and increased earnings retention through more prudent dividend and bonus policies; (iv) disposal of non-core assets (LBG and RBS); (v) a reduction in risk-weighted assets due to improving asset quality and, in the case of RBS, participation in the APS; and (vi) sale of profitable business lines (Barclays’s BGI sold to BlackRock). These developments also helped bring leverage ratios down significantly.

uA05fig02

Leverage Ratios of Major UK Banks 1/

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A005

Source: Bank of England.1/ Adjusted assets over adjusted capital. Assets are adjusted by netting derivatives and adjusting for cash items, tax, and intangible assets. Capital excludes Tier 2 instruments, preference shares, hybrids and intangibles.
uA05fig03

Major UK Banks, Core Tier 1 Capital Ratios

(percent)

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A005

Sources: Company reports; and IMF staff calculations.
uA05fig04

Variation in Core Tier 1 Capital

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A005

Source: Bank of England.

C. UK banks Stronger than Average in the CEBS Stress Tests 9

3. UK banks performed above average in the CEBS stress tests of European banks. The aggregate Tier 1 capital ratio (for the four UK banks included in the CEBS tests) would decline from 12.0 percent in 2009 to 11.1 percent in the worst case scenario, versus a decline from 10.3 percent to 9.2 percent for the average bank in the CEBS exercise. Three main reasons explain the comparatively good showing of UK banks: (i) a relatively good starting position, with end-2009 Tier 1 capital substantially higher than pre-crisis levels; (ii) good profitability, generating a continued build-up in capital under the baseline; and (iii) relative to the European average, more limited exposure (in percent of total assets, both in the banking and trading book) to the EU countries most vulnerable to a sovereign risk shock.10 That said, the UK banking sector’s exposure is significantly more concentrated on Ireland, notably for RBS (Table 2).

Table 2.

Exposure of UK Banks to Selected European Sovereigns

(Millions of GBP)

article image
Source: CEBS.

EU-4 refers to Greece, Ireland, Portugal, and Spain.

4. The CEBS exercise generally confirmed results from the FSA’s own earlier stress tests. The FSA’s 2009 stress tests, which informed the authorities’ decision-making surrounding the APS, were based on the following assumptions: (i) a peak-to-trough fall in GDP of 6.9 percent, with GDP declining by 2.3 percent in 2011 alone, versus the CEBS assumption of a 0.1 percent cumulative decline over 2009–2011; (ii) unemployment peaking at 12.5 percent, versus 9.1 percent in 2010 and 8.8 percent in 2011 under the CEBS scenario; and (iii) 50 percent and 60 percent peak-to-trough declines for residential and commercial real estate (CRE) prices, respectively, versus a 20 percent decline for both under the CEBS test). Conversely, the CEBS stress tests projected a sharper rise in interest rates, implying more adverse consequences for the probability of default among corporates.

D. Nonetheless, Challenges Remain

Extending the maturity of liabilities and strengthening liquidity ratios could prove to be challenging for some UK banks. Refinancing needs in the next two years are significant, as UK banks have to replace some £750–800 billion of funding by 2013 11, including the remaining support under the SLS and CGS. In addition, UK banks remain heavily reliant on short-term funding, with 44 percent of wholesale funding maturing in less than 3 months and 60 percent within a year. And although the average loan-to-deposit ratio for the five largest banks reached 115 percent at end-June—its lowest level since 2004—there was wide dispersion around this mean. LBG, notably, maintained a ratio above 150 percent, while HSBC and Standard Chartered both featured ratios below 80 percent. Looking ahead, tighter regulatory requirements are bound to prove more challenging for those banks that have previously relied to a larger extent on short-term wholesale funding sources.

uA05fig05

BondRedemption Breakdown for Major UK Banks

(Billions of GBP)

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A005

Sources: Bloomberg; and IMF staff calculations.* Last 5 months of 2010

5. Access to and the price of funding varies across banks. The tiering among major UK banks currently places LBG and RBS at the highest refinancing costs, Barclays in line with the European average, and HSBC and Standard Chartered at the lowest cost. As a general trend, competition for deposits has intensified among banks, but also from mutual funds, driving deposit costs higher.

uA05fig06

Major UK Banks, 5-Year Senior CDS Spread

(Basis points)

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A005

Source: Bloomberg.

6. Profitability may come under renewed pressure. Continued strong profitability cannot be taken for granted. While spreads have improved on mortgages and unsecured loans, there is little room for significant further increase. In addition, these better margins cannot offset low volumes, as mortgage approvals remain very subdued and demand for unsecured credits remains low.12 On the corporate side, loan growth is even more sluggish, to a large extent due to weak demand—in fact, many larger corporates have recently increased their reliance on market-based financing, while reducing their bank debt. Investment banking revenue, in turn, has been stabilizing at lower levels, due to reduced volumes of capital market activity and more moderate prospects for wealth management. Meanwhile, cost control was somewhat uneven in the first half of the year, with operating expenses trending down at LBG and RBS, but up at Barclays, HSBC, and Standard Chartered. More stringent liquidity requirements are also expected to weigh negatively on profitability in the future, as balance sheets need to be rebalanced toward more liquid, but lower-income products.

7. Asset quality will crucially depend on the further course of economic recovery. Loan impairments peaked in 2009, but are still above historical averages. S&P established that loan impairments were consistently below 15 percent of revenue between 1994 and 2007, half their 2010 level.13 Impairment charges as a percent of customer loans also remain elevated (146 basis points in 1H2010 versus an average of 77 basis points over the past 20 years). Loan performance was stronger for domestic activities, while loan quality continued to deteriorate in Ireland and Spain. One lesson from historical episodes is that impairment charges could rise as interest rates start going up.

8. Commercial Real Estate (CRE) is on the mend, but risks remain elevated in some banks. Property prices have recently bounced back, and according to the IPD index are currently some 15 percent above their latest through (though still around 30 percent below their 2007 peak levels). Relatively moderate unemployment, low interest rates, and lower vacancies than during the previous UK recession in the early 1990s (6-8 percent today versus 15-18 percent at the time), also point to an improving operating environment. Moreover, loan rollovers and debt-for equity swaps have allowed banks to smooth out problems over time. More importantly, margins have been improving, from very low 2007 levels (150-175 bps) to more adequate ones in 2010 (250-300 bps). However, the overall improvement masks significant dispersion in individual bank performance, with a continued high concentration of impaired assets in the legacy portfolio of HBOS.

E. Conclusion

9. The UK banking sector is on the road of recovery after a severe crisis in 2007–09, but challenges remain. The authorities’ wide-ranging interventions in the banking system have increased financial stability, allowing banks to gradually return to better health again. Aside from a further strengthening of capital cushions to meet future regulatory requirements, a key challenge for some UK banks is to improve their funding profiles as the remaining public support schemes are gradually unwound. Meanwhile, setbacks to the economic recovery could cause a renewed spike in nonperforming loans and depress net income, thereby constraining banks’ capacity to continue building up capital through earning retention. Gradually strengthening the financial system thus remains a key challenge going forward.

1

Prepared by Vanessa Le Leslé, with research assistance by Morgane de Tollenaere (both MCM). This chapter aims to provide only a brief overview of themes concerning selected major UK banks and is based only on publicly available information. As such, coverage of the most recent developments is constrained by the more limited extent of banks’ half-year reporting and the unavailability of detailed bank-by-bank information based, for example, on regulatory returns. A more in-depth analysis of the UK’s financial system will be conducted by staff in 2011 under the auspices of the “Financial Sector Assessment Program” (FSAP).

2

A more comprehensive timeline of crisis events is provided in the Annex of the June 2009 Bank of England Financial Stability Report.

7

More information is available on the website of the UK Debt Management Office.

8

The data generally refer to the five largest UK-owned banks (according to Fund staff’s classification): Barclays, HSBC, LBG, RBS, and Standard Chartered. However, this sample differs slightly in the chapter depending on data availability.

9

For more on the CEBS stress tests, see http://www.c-ebs.org/EuWideStressTesting.aspx

10

Although UK banks are less exposed to the EU-4 than many European peers in relation to total banking system assets, UK banks’ exposure is roughly similar to that of, say, French or German banks in percent of GDP, reflecting the UK’s large banking system relative to GDP.

11

Bank of England projections as of June 2010; funding efforts since June have likely reduced this number somewhat.

12

For more information on mortgage approvals, see British Bankers’ Association: http://www.bba.org.uk/statistics/article/september-figures-for-the-main-high-street-banks2

13

S&P, “Major UK banks’ interim results signal recovery, but a sustained improvement remains far from certain,”August 26, 2010.

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Cover IMF Staff Country Reports
United Kingdom: Selected Issues Paper
Author:
International Monetary Fund
Volume/Issue:
Volume 2010: Issue 337
Publisher:
International Monetary Fund
ISBN:
9781455208449
ISSN:
1934-7685
Pages:
88
DOI:
https://doi.org/10.5089/9781455208449.002

Cumulative Half-Year Profits of the Five Largest UK Banks

(Billions of GBP)

Leverage Ratios of Major UK Banks 1/

Major UK Banks, Core Tier 1 Capital Ratios

(percent)

Variation in Core Tier 1 Capital

BondRedemption Breakdown for Major UK Banks

(Billions of GBP)

Major UK Banks, 5-Year Senior CDS Spread

(Basis points)