Evercore Pan Asset

We are enjoying a rally in shares based on expectations of a major reflationary package from incoming President Obama, on top of the substantial fiscal loosening carried out by President Bush to subsidise and recapitalise financial institutions and motor companies.

In the UK the government and regulators are revealing how they think they can borrow £157 billion this year, followed by another high borrowing year next year. They will tap into three sources of demand for government paper. The banks will need to be substantial buyers, as the authorities are currently consulting on proposals to “significantly” tighten liquidity standards for banks. The pension funds will need to be buyers, as their black holes come to be filled by more company contributions which the regulators and actuaries will direct to a considerable extent into gilts. There will also be some volunteer buyers, concerned about equity risk and taking note of the large buying demand from the first two sources. Many investment managers who held large positions in equities during the 2008 collapse are now increasing their government bond holdings.

The trouble with this approach by the regulatory authorities is that it makes increasing bank lending and getting things moving again in the real economy that much more difficult. Compare these two regulatory statements:

“We continue to expect Basle II to result in a reduction in our regulatory capital requirement compared with Basle I” (Northern Rock Accounts published in 2007)

“Firms will be obliged to hold sizeable buffers, and we would expect a marked increase compared with holdings under the predecessor regimes” (FSA December 2008*)

In the heady days of 2007 before the August tightening of the money markets, many banks like Northern were lending large sums, and were concluding that they could either lend even more or return some capital to shareholders under the future regime. Today banks are told that they need to hold a lot more in liquid government bonds, lending to the government at low rates of interest.

The FSA itself says that its new policy will entail a substantial revenue loss for the banks. Capital that could have been employed lending to companies and individuals at higher interest rates will be lent to the government at low rates. The FSA says of bank turnover*

“…diminution in revenues – this diminution could be in the order of £1-5 billion (or even higher if the spread between the yields on government bonds and other debt widens).”

This change to banking capital is a fundamental one and will mean less lending and therefore a slower economy. The Regulators no longer like reliance on some wholesale market funding, where banks borrowed through the money markets. Instead Regulators wish banks to rely more heavily on deposit taking from the High Street and the web. Paradoxically it was the High Street deposits which pulled Northern Rock down, for it was only when that run became apparent that action had to be taken. Aware of this the Regulator says a bank needs more cash and government bonds as a buffer. That means lower bank profits, which in turn means the banks have less capacity to lend to others.

The round trip of money between banks and government should be seen in this context. If we take the example of the money lent to 3 of the banks as Preference capital by the government at 12%, we can see what damage this does to banks profits and therefore to their future balance sheets. The money effectively has to be lent back to the government at 4%, leaving the banks with a loss of around 8% each year, or £1100 million of losses between them. Far from strengthening the banks, this adds to their problems.

The UK Stock market has rallied a bit on the back of US hopes. It is going to take a stronger banking sector to get back to proper levels of growth, however much money the UK government flings at it. In the short term the UK government has come up with a way of paying for its bills by borrowing, but borrowing too much from the UK banks makes it more difficult for them to lend to others.

*Source: Financial Services Authority CP08/22 “Strengthening Liquidity Standards”