Banks Warned Of Future Risks By UK Financial Stability Report

12.01.10

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The Bank of England?s Financial Stability Report (FSR), published in November, stated that the global financial system is significantly more stable than six months ago but will need a considerable

The Bank of England?s Financial Stability Report (FSR), published in November, stated that the global financial system is significantly more stable than six months ago but will need a considerable amount of time to adjust after such a prolonged period of exuberance earlier in the decade. The sector had been helped by monetary policy measures such as quantitative easing and low interest rates but there were still dangers ahead.

During the readjustment period some banks will remain ?vulnerable to the risk of less rapid than expected economic recovery?. It is inevitable that some banks around the world have overstretched their balance sheets, the report said. The refinancing needs of some global sectors, including commercial property, will be large in the coming years. While funding costs remain low, ?there is some risk of market participants accumulating excessively risky positions?.

Banks must extend the maturity of their funding, reduce leverage further and refinance substantial sums. Over the next five years, ?1 trillion of wholesale funding will have to be refinanced by UK banks. By 2012 they will have to have stopped leaning on the financial support provided by the Bank of England (BoE), which includes ?178 billion supplied under the Bank?s special liquidity scheme and a further ?134 billion of guarantees issued under the Bank?s credit guarantee scheme. Between 2013 and 2016, a further ?180 billion of European leveraged loans will have to be refinanced.

There is concern about the strength of the economy in central and Eastern Europe where some balance sheets remain stretched. ?Despite inevitable short-term costs, there is a strong case for banks acting now to improve balance sheet positions while conditions are favourable,? the FSR said.

Given their balance-sheet vulnerabilities, banks remain exposed to any future deterioration in macroeconomic and market conditions, which could substantially raise the cost of funding and capital raising in the future.

Dividends could have saved taxpayers

From 2001 to 2006 banks paid out 31% in staff costs and 46% in dividends. Between 2000 and 2008 they forked out ?425 billion in bonuses and dividends. The report concluded that a 20% cut in pay and dividends from UK banks between 2000 and 2008 would have raised more than the ?66 billion injected by the taxpayers. A cut in “discretionary distributions” would have generated an extra ?75 billion.

The Bank felt that a 10% cut in pay and a one-third reduction in dividends could raise ?70 billion over the next five years. “Given the scale of the challenge facing banks in rebuilding their balance sheets, they would benefit from distributions from reserves being materially lower than in the past, or paid in a non-cash form (shares) which retains equity within the business.

The report said “relatively modest limitations in the distribution of profits” would help banks meet capital requirements without shrinking their balance sheets. It added that there needed to be “a fundamental overhaul of the ‘rules of the game’ for the financial system, to deal with the root causes of systemic instability – a tendency for excessive risk-taking during the upswing of the credit cycle and insufficient resilience in the subsequent downturn.” In the medium term reform must remove the expectation that ?too important to fail? firms will receive public support.

Key risks

Banking sectors profits were more buoyant again, boosted by a market rally but banks should strengthen their balance sheets with more external funding and not distributing excessive profits. There were added risks of asset bubbles and property prices.

The FSR highlighted some key risks in the financial system:

? Banks repair their balance sheets too slowly

? A less robust than expected economic recovery could put heightened strain on borrowers with stretched balance sheets, including some companies and households internationally

? Market rally could end

? Increased concerns about national balance sheets of some countries

Regulation could be strengthened through:

? Higher capital reserves, comprising instruments that can absorb losses

? Holding large buffers of reliably liquid assets

? Reducing over reliance on external credit ratings, potentially through regulatory incentives

? Better disclosure, for example with regard to liquidity positions and exposures between financial institutions

Structural changes to support stability could include:

? Development of capital markets to reduce economic dependency on credit intermediated by the banking system

? Insulation of core financial services

Better crisis resolution arrangements should include:

? Pre-funded and risk-based deposit insurance to limit subsidies to riskier banks

? The use of recovery and resolution plans

? Clear principles for public provision of capital support that ensure banks? shareholders and unsecured wholesale creditors bear losses

It could be that the banking industry may have to fundamentally change in the future in the light of the financial crisis and the banks? reputation as reliable and infallible institutions could be irreversibly damaged. On top of that, UK taxpayers have been forced to support the banks unnecessarily creating a burden which could threaten income levels and the preservation of their future financial stability.

Banking risk can be averted by diversifying your savings and investments across a broad range of assets. Tax can also be mitigated with efficient tax planning. Talk to an established wealth and tax adviser like Blevins Franks that specialises in these areas with a tailor made portfolio to suit your circumstances and needs.

 

By Bill Blevins, Managing Director, Blevins Franks

 

2nd January 2010

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.

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