Evercore Pan Asset

Sometimes an event occurs or a figure is released which is a game changer.  The publication of the GDP numbers for the last quarter of 2010 in the UK could prove to be one such occasion. The City had pencilled in slower growth, expecting a final quarter increase of about 0.5%. Instead, the preliminary figure came out at minus 0.5%, a full 1% lower than expected.
 
The government said it was the result of the bad weather. It is true that December saw unusually cold conditions, with a great deal of ice and snow giving people a reason to stay at home. Some of the lost output will come bouncing back in the first quarter of 2011, when the comparisons with an ice and snow bound January 2010 will flatter the figures.  The big fall in construction may well have been largely the result of frozen building sites. Manufacturing output accelerated, the one bright spot in the figures. 
 
However, the official statisticians think only half the disappointment came from the weather. They think if you could adjust for the climate, output would have stayed flat.  The impact of all this will be to stay the hand of those who wanted to raise interest rates to curb inflation, and to cause many to question whether more needs to be done to ensure growth in the years ahead.
 
The authorities now have the difficult task of trying to tackle persistent price rises at the same time as offsetting a reduction in output. One of the problems they face is the state of the banks, and the impact of regulation on the banks. If we look at the housing market, we will see a slowdown in many parts of the country. Tougher rules over mortgage advances are deterring banks from lending more, and making it difficult for borrowers without large deposits. The capital rules are also urging the banks to be more cautious about lending volumes. A tax on bank balance sheets reinforces this message.
 
It was against this background that Sir John Vickers made his first speech as Chairman of the Banking Commission. He reminded us that he is charged with making recommendations that promote both stability and competition in UK banking. His recent speech concentrated on the stability part of the brief.
 
As Sir John argued, if you ask regulators to recommend a way of having a more stable system, they will propose that banks hold more capital relative to their risks. Banks can do this in two ways: by raising more money, or by lending less. In the current climate lending less is the easier option. The Chairman of the Commission rightly recalled that in the last decade bank regulators allowed banks to expand their balance sheets from 20 times to more than 30 times their risk capital. These structures proved dangerous when money market conditions tightened in 2008-9. Sir John favours higher capital ratios for the future. He remains open minded as to whether investment and retail banks should be split, or whether conglomerate banks should be given room to create separate structures for their different activities, with differential capital requirements to reflect their risks. 
 
One way or another the Banking Commission is likely to conclude prudently that banks need more capital. The government will have to reconcile this with the fact that the economy needs more credit, so that construction output and other sectors can find work based on projects financed from borrowings. Similarly, the Bank will have to reconcile the obvious need to curb inflation, with the understandable reluctance to tighten money when output is falling. 
 
This week probably means a further delay in raising interest rates, with less upward pressure on the pound. It also means a bit more inflation, as we sit out the current surge in world commodity prices. It also may mean that banks will become more prudent, but not immediately.

As published in Investment Week