UK banks three years after the financial crisis

Laurent Nahmias
K banks are gradually recovering from the global financial shock of 2007. The least diversified banks are still highly dependent on national economic prospects. After six quarters of contracting GDP, the UK economy finally pulled out of recession in Q4 2009. Yet budget consolidation measures announced last fall will probably continue to strain activity. Assuming that real GDP growth is limited to 1.7% in 2010 and 1.2% in 2011, economic activity in volume is unlikely to return to 2008 levels before 2013. The financial crisis hit the big UK banks to differing degrees. Only two reported full-year losses in 2008 and 2009, but they were so great that it was necessary to inject public funds. Although the banks in our selection1 strengthened their solvency and were profitable as a whole in 2010, they still face with the risk of a deterioration in the quality of their banking books and high direct exposure to the peripheral countries of the euro zone.

Misleading balance sheet growth The total assets of the banks in our selection virtually doubled as a share of GDP, from 273% in 2005 to 506% in 2008 (see chart 1). This trend was reversed in 2009, and total assets returned roughly to 2007 levels. The growth of balance sheets in 2008 was not due to the dynamic momentum of traditional intermediation activities as much as to valuation effects pertaining to the interest rate environment and the reintegration of off balance sheet commitments. As the same time, in a tight interbanking market, UK banks increased their holdings of liquid assets between 2007 and 2009 (low risk short-term securities or central bank assets), which rose from less than 1% of the total bank assets of our selection in 2007 to 4% in 2009. Off balance sheet commitments, which include the liquidity lines or "back up" granted as part of securitisation activities 2 , increased at a much faster pace than banking assets between 2005 and 2007. On average, they rose from 427.6% of total assets in 2005 to 830.7% in 2007 (see chart 3). They abruptly fell back to 27.1% of assets in 2008 before rising again to 93.6% in 2009. In the wake of the home loan crisis, securitisation activities contracted sharply in Q3 and Q4 2007 before recovering strongly in 2008 and collapsing again in 2009 (see chart 4). Part of their off balance sheet commitments have been reintegrated on bank balance sheets since 2009 either for legal reasons or to boast the banks reputation. European Union regulations also provided a more restrictive framework for the size of off balance sheet commitments. To preserve the quality of risk monitoring, in April 2009 the European Commission proposed to amend existing banking regulations by requiring banks to hold 5% of the underlying loans on their balance sheets. The Capital Requirement Directive II (CRDII) adopted by the European Parliament in September 2009

The authorities come to the rescue of ailing UK banks

Several banks encountered troubles that led to massive interventions by the Bank of England and the government. The financial crisis shakes the banking sector The financial crisis reached its peak in Q4 2008 following the collapse of Lehman Brothers. Banks had to partially reintegrate their off balance sheet commitments, which had swollen rapidly through 2007, due notably to a major surge in securitisation.

February 2011

Conjoncture

Total assets for the largest UK banks (% of GDP)

600 500 400 300 200 100 0 2005
Chart 1

Drop-off in off balance sheet items (% of total assets)

900 800 700 600 500 400 300 200 100 0

2006

2007

2008

2009
Chart 3

2005

2006

2007

2008

2009

Sources: Bankscope & OECD, BNP Paribas calculations

Source: Bankscope, BNP Paribas calculations

Financial resources for the largest UK banks (% of total)

Debt with customers Debt with credit institutions and central banks Short-term financing Long-term financing Derivatives Financial instruments (market value)

Drop-off in securitisation since 2009 (EUR bn)

120 100 80 60 40 20 0
1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3

45 40 35 30 25 20 15 10 5 0

2005
Chart 2

2006

2007

2008

2009
Chart 4

2005

2006

2007

2008

2009

2010

Source: Bankscope, BNP Paribas calculations

Source: European Securitisation Forum

has been applicable to EU member countries since 31 December 20103. Substantial losses and writedowns in 2008 Even as losses and asset writedowns eroded their solvency, the banks were also faced with the scarcity of interbank liquidity due to the mutual mistrust among credit institutions. Cumulative losses and asset writedowns since the bursting of the financial crisis amounted to 125.4bn in January 2011, of which nearly 44bn was concentrated in Q4 2008 (see chart 5). Asset writedowns alone (excluding losses on loan portfolios) were mainly due to losses on asset-backed securities (ABS), the deterioration of monoline guarantees and collateralised debt obligations (CDOs). Together, Royal Bank of Scotland (30.6% of total losses), HSBC (27.8%), Barclays (21.5%) and HBOS (14.2%) accounted for nearly 95% of reported losses and asset writedowns (see chart 6). Measured as a percent of total banking assets (1.6%), the UK banking system ranks in an intermediary position between the French and German
February 2011

banking systems on the one hand (whose figures were two thirds and half as high, respectively) and on the other, the American system (5.1%) (see chart 7). In 2008, aggregated net banking income for the banks in our selection rose 2.8%, a resilient performance at a time of stagnant real GDP growth (-0.1% vs. +2.7% in 2007), despite the losses reported in their trading business (13.9bn loss after a net gain of 15.3bn in 2007). 4 Despite the strength of NBI and an aggregate profit of nearly 30bn in 2007, which provided a comfortable safety mattress, the big UK banks failed to avoid an overall loss of 36bn in 2008 due to the upsurge in the cost of risk, which rose 156% to 43.7bn (see chart 8), and 33.2bn in net exceptional charges, mainly due to the impairment of goodwill and intangible assets by RBS. The three key components of rescue plans The immediate responses to the financial crisis by the UK government and the monetary authorities can be divided into three components. The first line of attack

Conjoncture

UK bank losses and depreciations ( bn)

50 45 40 35 30 25 20 15 10 5 0 3 2007
Chart 5

Bank losses and depreciations by country (% of assets)

6 5 4 3 2 1

1 2008

1 2009

1 2010

0 USA
Chart 7

UK

Germany

France

Spain

Source: Bloomberg at 17/01/2011

Sources: Bloomberg, ECB & FDIC

Breakdown of cumulative losses and depreciations (% of total)

Alliance & Leicester Lloyds Nothern Rock Bradford & Bingley Standard chartered

Cost of risk Ratio and GDP growth rate

%
45 40 35 30 25 20 15 10 5 0 2005
Chart 8

Cost of risk ratio (provisions/NBI) GDP growth rate

Inverted scale, %
-5 -4 -3 -2 -1 0 1 2 3 4

HBOS

RBS

Barclays HSBC
Chart 6 Source: Bloomberg at 17/01/2011

2006

2007

2008

2009

S1 2010

2011 (f)

Sources: Bankscope, Datastream, BNP Paribas forecasts

was to boost liquidity through monetary easing and to set up a system of public guarantees for bank debt. The second was to strengthen the equity of banks by injecting public funds into their capital. The last solution was to set up a bad bank, largely inspired by measures to handle banking crises in the 1990s, although a less radical approach was used since partial guarantees were granted instead of traditional asset transfers. Boosting liquidity: restoring confidence in the interbanking market Easing monetary policy was the first leverage used to restore the banks' access to liquidity and to facilitate their short-term refinancing. Before the crisis, faced with the risks of overheating, the Bank of England adopted a more restrictive bias in summer 2006. Inversely, the central bank gradually began to ease the base rate in 25bp increments from 5.50% in December 2007 to 5% in April 2008, and then more energetically after the collapse of Lehman Brothers, from 5% in September 2008 to 0.5% in March 2009 (see chart 9).

At the same time, the monetary authorities broadened the refinancing base by extending the maturities of refinancing instruments, extending the range of eligible collateral and by setting up the Asset Purchase Facility in January 2009 to purchase giltedged securities.

Interest rates in UK
10-year governement bonds - 3-month LIBOR 12 % 11 Base rate 10 SONIA 9 3-month LIBOR 8 10-year governement bonds 7 6 5 4 3 2 1 0 -1 -2 -3 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Chart 9 Sources: BoE & Datastream

February 2011

Conjoncture

They played the role of lender of last resort by largely stepping in for the interbanking market, which had suddenly dried up. The Bank of England's balance sheet almost tripled from 93.7bn in August 2008 to 244.1bn in October 2010, with most of the increase occurring by January 2009 (225.9bn) (see chart 10).
Bank of England assets ( bn)
300 Other assets 280 260 Bonds and other securities acquired 240 via market transactions 220 Treasury advances 200 180 Long-term reverse repo operations 160 140 Short-term open-market operations 120 100 80 60 40 20 0 2006 2007 2008
Chart 10

Equity/Total assets
% 0
31/12/06 31/12/08 30/06/10
1 2 3 4 5 6 7

Barclays RBS HSBC

Standard Chartered Lloyds HBOS

Chart 11 Source: Bloomberg

Tier 1 Ratio
% RWA 0
2 4 6 8 10 12 14

31/12/06
2009 2010
Source: BoE

Barclays
31/12/08 30/06/10

RBS HSBC

In addition to the intended effect on the real economy, the Bank of England's successive key rate cuts helped boost intermediation margins, which had eroded under four consecutive years of an inverted yield curve (2004-2008). The second leverage was to strengthen existing public guarantee mechanisms on client deposits and to introduce new ones on newly issued bank debt. To limit the risk of bank runs, the Financial Services Authority (FSA) raised the ceiling on deposit guarantees from 35,000 to 50,000 in October 2008. In compliance with European legislation, the ceiling was raised again to the equivalent in sterling of 100,000 on 31 December 20105. The government did not create an ex nihilo bank refinancing structure (like the French SFEF, for example), but in fall 2008 rolled out a simpler mechanism of government guarantees on new bank debt issues. Boosting solvency: public capital injections and nationalisations The government also responded to the financial crisis by implementing measures to strengthen the equity capital of banks. The impact of capital injections on the ratio of equity/total assets was wiped out by the swelling of assets in 2008 (see chart 11). In contrast, the average Tier 1 ratio picked up significantly, in keeping with the decline in weighted assets (see chart 12).

Standard Chartered Lloyds HBOS

Chart 12 Source: Bloomberg

The government's capital injections mainly took the form of ordinary shares (70.56bn, or 94.6% of injected capital), which is the highest quality of equity capital (Core Tier 1) and thus eligible under Basel 3. Three institutions benefited from over 90% of the government's purchases of ordinary shares: RBS (45.5bn), Lloyds (10.3bn) and HBOS (8.5bn)6. In November 2008, a public entity, UK Financial Investments LTD (UKFI), was created to manage these banking stakes. After these initial equity purchases, the government held 70% of RBS and 43% of Lloyds. The smaller-sized Northern Rock and Bradford & Bingley were fully nationalised. On 3 November 2009, the government increased its stake in RBS to 84%. In contrast, following a new share issue and the reimbursement of the government's preferred shares, UKFI reduced its stake in Lloyds to 41% in February 2010. With the exception of HSBC, Standard Chartered and Barclays, which called on little or no government assistance (about 1.5bn since the beginning to the financial crisis for Barclays, less than 8% of the total increase in capital), virtually all the big UK banks benefited from the injection of public capital

February 2011

Conjoncture

Box 1: Defeasance
Principle Defeasance consists of regrouping the impaired or "toxic" assets of a bank into a separate special-purpose vehicle in order to restructure the bank's balance sheet and protect it from default. Isolating toxic assets enables a bank to pursue its business while limiting the impact of a downgraded solvency ratio on loan distribution. By setting up a defeasance structure, a bank also gains time to sell off assets, which become illiquid at the height of a crisis due to contracting demand. One of the shortcomings of this system is determining the value of toxic assets. The classic defeasance mechanism described above is different from the asset protection schema used in the UK, which provides guarantees against risks. Under this configuration, ailing assets remain on bank balance sheets and the government insures the value of the assets in exchange for an annual fee paid to the central bank. If the assets fall in value, the bank must absorb a franchise and a percentage of the loss (10% in the case of the UK). Setting up an insurance-like system with a franchise places a lid on the amount of losses while limiting the risk of moral hazard.

Implementation and accounting From a technical perspective, in the American example, assets transferred to the special purpose vehicle are generally debt portfolios or sub-prime financial assets. The defeasance structure can be private, in which case management of assets and liabilities is entrusted to a private trust, which finances debt servicing through the interest received on the assets in the trust. In general, however, a public agency purchases the most risky and/or impaired assets below market value and ensures their management during a transition period. From an accounting perspective, this operation results in the removal of financial assets from the balance sheet at a disposal price below book value, resulting in a loss on the income statement. In this case, the reported loss is smaller than it would have been if the assets had been sold at rock-bottom prices, and the bank is able to limit the impact of the lack of liquidity in certain markets on its balance sheet and income statements.

Simplified schema of a defeasance structure

Bank A Assets Impaired and/or toxic assets Debt Liabilities Special Purpose Vehicule Assets Liabilities Impaired and/or toxic assets Debt Equity capital Financial markets Other assets Equity capital Disposal to SPV Issue of debt securities guaranteed by shareholders

Interest received on isolated assets

Payment of debt servicing

February 2011

Conjoncture

(see chart 13). Since the beginning of the financial crisis, the UK banking system has raised about 151.3bn in equity capital (120.7% of cumulative losses to date), half of which is public funding (74.6bn). This proportion reached 77% for RBS (45.5bn), 74% for the former HBOS (11.5bn) and 36% for Lloyds (11.3bn).
Capital injected in UK banks
bn
80 70 60 50 40 30 20 10 0
s S H SB C B ar cl ay R B

Public funds Private funds Public funds as share of total

% 100 88 75 63 50 38 25 13 0
ch ar te re d B in gl ey

nc e

B ra d

Chart 13

A lli a

Source: Bloomberg at 17/01/2011

St an

As in the United States 8 , illiquid and/or highly impaired assets following the financial crisis, mainly those of RBS and Lloyds, were isolated within a "bad bank". Yet the UK only set up a virtual bad bank that was not a distinct legal entity. Toxic assets remain on the balance sheets of each of the guaranteed banks, in exchange for the payment of a commission, comparable to an insurance premium. This system, which resembles a pure insurance mechanism more than a classic defeasance structure, nonetheless has the same goals. Both are designed to restore the solvency of banks and to allow them to concentrate on their core business while minimising the impact of losses on current operations. The main advantages of the UK mechanism, according to the government, are that it can be rolled out relatively rapidly and offer more flexible management, because it avoids the question of valuing toxic assets.

Ll oy ds

H B O S

R oc k

N ot he rn

Le ic e

st er

&

& fo rd

da rd

Mixed prospects
The ranking of recapitalisation efforts by country can be correlated with the size of losses. Public and private capital injections amounted to 1.9% in the UK, behind the United States (3.7%), but far ahead of Germany (0.9%) and France (0.5%). The creation of a virtual "bad bank" In December 2009 the UK government set up a system of guarantees designed to contain highly impaired bank assets and to authorize their autonomous management. Open to resident credit institutions and to a lesser extent, foreign subsidiaries, this system was placed under the responsibility of a government agency, the Asset Protection Agency (APA) 7 . At the Treasury's discretion, as part of bilateral discussions with each bank and after examination by an ad-hoc commission, all sub-prime loan portfolios and portfolios of asset-backed securities (CDO, CDS, ABS, MBS, etc.) were eligible for guarantees, above a franchise for the first losses. At 31 March 2010, APA covered 230.9bn of the toxic assets held by RBS, which is 84% state owned, in exchange for a franchise of 60bn. Above this franchise, the government would cover 90% of any losses and RBS, 10%.
February 2011

Bolstered by support measures and despite an unprecedented economic contraction, our sample of banks as a whole swung back into positive territory in 2009. Eventually, the government gradual withdrawal from the capital of the big banks and the growing importance of non-banking players should lead to a reshuffling of the banking sector. Disparate results in 2009 The overall 2009 results of our selection must be interpreted carefully because they mask wide disparities between banks. Neither of the two lossmaking groups in 2008 (HBOS and RBS) have swung back into profits. In its new configuration, the Lloyds group managed to report a 2.9bn profit in 2009 thanks solely to an exceptional gain of 11bn on the acquisition of HBOS. Barclays also reported major capital gains on the disposal of assets to the BlackRock investment fund. Net banking income, half of which is comprised of net interest income (see chart 14), increased 13.7% between 2008 and 2009, buoyed by a slight upturn in the net interest margin (to 1.3% in 2009 from 1.1% in 2007 and 2008) and from an increase in other revenue. In 2008, the structure of net banking income was distorted by the collapse of other revenues, but
Conjoncture 8

has since returned virtually to normal (see chart 13). Nonetheless, higher administrative expenses (+3.6%) and the cost of risk (+25.7%) weighed down current income before tax, which was negative both years (2,991m loss in 2008 and 700m loss in 2009). In H1 2010, the big banks in our selection all reported earnings. Compared to H1 2009, net income of the five largest UK banks declined 16.7% after the elimination of exceptional items, which had a positive impact in 2009 (acquisition gain for Lloyds, loss on the buyback of debt for Barclays). Net banking income and operating income continued to rise 11.4% and 20.1%, respectively. The cost of risk fell significantly (-31.4%). Banks like HSBC and Barclays benefited from major gains on their own debt following the widening of their credit spread. Only two banks have released their Q3 2010 figures, but they offer a few indications. Unlike in 2009, Barclays and RBS reported losses on their own debt. RBS also reported a charge following a decline in the fair value of the Asset Protection Scheme CDS, the valuation of which benefited from tighter spreads. RBS reported a Q3 loss of 1,146m after a small H1 profit of 133m. Barclays barely managed to remain in positive territory with a profit of 49m, after comfortable performances of 1,067m in Q1 and 1,364m in Q2. HSBC simply announced that its Q3 pretax results would be lower than in Q1 and Q2 2010. Short-term operating conditions remain tough The UK banking sector's capacity to generate recurrent revenues will continue to be restricted in 2011 by a squeeze on margins. The cost-income ratio will also remain relatively high. Greater pressure on margins in 2011 A preliminary analysis of UK banks shows that the average net margin in 2009 had nearly returned to pre-crisis levels (1.3% in 2009) but was sharply lower than at the beginning of the decade. Between 2008 and 2009, the improvement was due to a faster reduction in interest paid on productive assets (+1.2% in 2009 down from +1.7% in 2008) than in interest received (+2.4% down from +2.8%). It is tempting to link the relative weakness of UK banking margins (see chart 15) to their rather unfavourable
February 2011

Structural net banking income Largest UK banks of our sample

Net interest income Net commissions Other net operating income

100 90 80 70 60 50 40 30 20 10 0 2005
Chart 14

2006

2007

2008

2009

H1 2010

Sources: Bankscope, BNP Paribas calculations

Net interest margin in 2009

%, net interest income to productive assets

3.0 2.5 2.0 1.5 1.0 0.5 0.0

ga l

Chart 15

balance sheet structure. The share of customer deposits accounted for only 29.5% of the balance sheets of financial and monetary institutions in November 2010, whereas banking systems with more comfortable margins, such as Spain and Italy, traditionally have a broader deposit base (48.8% and 36.4% at the same date). Yet this factor does not explain the decline in margins because deposits as a share of total assets have not changed much since the beginning of the decade, which was still characterised by high margins. The reason for the erosion of margins has more to do with the interest rate environment. The relative weakness of long-term rates (in correlation with the American conundrum) strained the return on assets. Monetary policy tightening in summer 2006 and especially the liquidity crisis in 2007 and 2008 significantly increased the cost of resources. The inversion of the yield curve between mid-2004 and late 2008 also significantly squeezed margins. Lastly, although the arrival of banking and non-banking players (see below) has not called into question the
Conjoncture 9

G er m an y

Be lg iu m

Po rtu

Fr

Source: Bankscope

Ire la nd

Ita ly

Sp ai n

an ce

U K

Aggregated income statement for the largest UK banks

In billions of pounds sterling Net banking income Of which: net interest income Of which: net fees and commissions Of which: other net operating income Operating expenses Of which: staff expenses Of which: other operating expenses Gross operating income Cost of risk Profit before exceptional items and taxes Non recurring income and exceptional items Tax expenses Minority interests Net income attributable to equity holders Table 2005 99.3 51.4 23.1 24.9 52.7 28.2 24.5 46.6 10.9 35.6 -0.1 7.0 1.0 27.6 2006 107.5 53.0 25.7 28.8 56.2 31.2 25.0 51.3 13.0 38.3 0.8 10.0 1.5 27.7 2007 117.0 58.0 30,1 29.0 62.6 34.4 28.2 54.5 17.1 37.3 3.2 10.8 1.7 28.1 2008 120.3 80.8 33.4 6.1 79.6 41.0 38.5 40.7 43.7 -3.0 -33.2 8.5 -8.6 -36.0 2009 136.8 67.5 31.2 38.2 82.5 42.8 39.6 54.3 55.0 -0.7 11.3 0.9 2.9 6.8 H1 2009 79.7 38.8 17.8 23.1 46.3 24.7 21.7 33.4 34.1 -0.7 16.3 0.2 2.2 13.2 H1 2010 88.8 44.5 19.2 25.1 48.7 26.4 22.3 40.1 23.4 16.8 1.9 7.1 0.5 11.0

Source: Bankscope Calculation: BNP Paribas

Sample 2005 2008 : HSBC, RBS, Lloyds, Barclays, HBOS, Standard Chartered Sample 2009, 1st semester 2009 and 1st semester 2010 : HSBC, RBS, Lloyds, Barclays, Standard Chartered

predominance of the incumbent players in the short term, it has stepped up competitive intensity, making it harder for the big banking groups to extract margins from the domestic market. Despite the monetary status quo, net margins probably tightened in 2010 due to fiercer competition. The expected tightening of monetary policy in late 2011 will also squeeze margins further, even though the yield curve should remain positive. This trend, combined with a decline in credit volumes (debt reduction in the private sector), would limit the growth of net interest income. Restructuring strains cost-income ratios The average cost-income ratio for the banks in our selection (see chart 16) increased sharply from 53.5% in 2007 to 66.1% in 2008, mainly due to a 27.1% increase in administrative expenses. The ratio remained high at 60.3% in 2009 and at 54.8% in H1 2010. The increase in charges can be attributed to
February 2011

the M&A movement in the banking sector following the financial crisis, while potential synergies from these operations will only be realised over the long term. For example, the Royal Bank of Scotland acquired part of ABN-Amro's business in 2007. Barclays purchased some of the activities of Lehman Brothers after its collapse. And Lloyds, encouraged by both the government and the Financial Service Authority, purchased HBOS for 12.2bn in 2008 9 even though it was highly dependent on the liquidity market and had significant exposure to the real estate market. This acquisition even required first amending the competition regulations. Some risks persist The financial crisis highlighted the limits of a business model based on excessive debt. Initially private, this debt was eventually transferred to the public sector via bank rescue packages. Although the
Conjoncture 10

Cost/income ratio (% of NBI)

70

UK loans to the private sector (y-o-y % change)

50

60 50 40 30 20 10 0 2005
Chart 16

40 30 20 10 0 -10 -20 -30

2006 2007 2008 2009 H1 2010

Total non-financial agents Non-financial firms Households

-40 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Chart 18 Source: ECB

Source: Bankscope

Debt ratio of non-financial agents (% of GDP), annual average

100 90 80 70 60 50 40 30 20 10 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Chart 17 Sources: BoE, ONS, BNP Paribas calculations

The correction in real estate prices is not over yet in the UK (Ratio house prices/rent, 100 = H1 1999)
France

Households Non-financial firms General Government

* ratio of house prices to gross household disposable income

200 180 160 140 120 100

Spain Euro Zone Germany USA S&P* UK Halifax*

80 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Chart 19 Sources: Eurostat, ECB, CGPC, BNP Paribas calculations

solidity of the banking sector has been reinforced, there are still several major risks. Credit risk is still significant With the downturn in economic and housing market cycles, this dynamic debt momentum (see chart 17), and in particular, high exposure to the home mortgage market (see chart 18), triggered a deterioration in the quality of bank assets. The boom in securitisation also resulted in a much broader distribution of risks within financial establishments. Three years after the outbreak of the crisis, the combined efforts of the authorities (government support packages and monetary policy) and the banks (drastic cost cutbacks) have unquestionably enabled the sector to weather the crisis with as little damage as possible. Yet, caution is advised in the future for several reasons. So far, the domestic real estate market has not seen any corrections as severe as the ones in the United States (see chart 19). Persistently high real estate valuations suggest that another correction cannot be ruled out. With the economy
February 2011

still displaying a weak recovery (unemployment rate of 7.7% in Q3 2010), the banks could be hit by an increase in the default rate, notably those with the highest exposure to the domestic market (Lloyds and RBS). On the contrary, more geographically diversified banks should be able to continue benefiting from powerful sources of international growth, even though some emerging countries risk overheating. Although the banking sector managed to swing back into earnings in 2009 despite a sluggish economy, current debt reduction efforts by nonfinancial agents and budget reform measures10 will increase uncertainty over the recovery of economic growth and the bank profitability. Further constraints could also be imposed by a tighter regulatory framework, in the wake of new national and Basel requirements (see box 2) and from a Bank Tax based on assets 11 . Lastly, the relative consensus among analysts' estimates suggests that new Basel liquidity requirements (LCR and NSFR) could imply significant adjustment measures, a characteristic nonetheless shared by most of the major banking systems. Yet
Conjoncture 11

Box 2: the new Basel III regulations

Following G20 meetings in Pittsburgh and London, the governments of the world's main economic powers expressed the desire to strengthen banking regulatory standards12. The Basel Committee on Banking Supervision (BCBS) reviewed the main principles of the proposals by the G20 countries and systematised key points to deploy a stronger regulatory framework. In December 2009, the Basel Committee made a series of proposals on capital adequacy requirements and standardized monitoring of liquidity risks which were presented to the public in a consultative document (closed 16 April 2010). Two impact studies were also conducted. Last September, the Basel Committee revealed the new regulatory framework that will be applicable to banks as of 2013 13 , although the application timetable will extend through 2019. Capital adequacy requirements will be tightened as of 2013. They reflect a stricter definition of regulatory capital (non-eligibility of certain hybrid securities, additional deductions, etc.), set up capital conservation and contra-cyclical buffers, which in a macro-prudential framework take into account the macroeconomic risks associated with excessive lending (bank indebtedness and debt securities), and lastly, introduce stricter criteria that will increase weighted risks. In the end, common equity Tier 1 capital requirements will be raised to 7% of risk weighted assets by the end of the application timetable on 1 January 2019. Lastly, systemic establishments, i.e. banks that are "too big to fail" without disrupting stability of the financial system, could be required to provide an additional capital buffer depending on the applicable terms (size, interdependence and absence of a substitute) which must be specified by the Basel Committee by mid 2011. In addition to strengthening equity capital requirements, the Basel Committee also introduced new bank liquidity requirements, a short-term one, the Liquidity Coverage Ratio, which requires banks to hold sufficient liquid assets to cover 30 days of net cash flows, and a medium-term one, the Net Stable Funding Ratio, which requires banks to mobilise long-term or stable resources to finance their medium-term applications. Lastly, a leverage ratio was also introduced (equity capital/ total assets). Yet, since this ratio does not take into account risks and depends closely on accounting practices, it would be preferable if it were simply "an additional supervision indicator for the national regulator and, as such, appear in Pillar 2".14 the situation of individual banks seems to be very mixed. Unless they can obtain the long-term or stable resources required by the new regulations, certain banks could be forced to undergo strategic hedging to reduce the size of their balance sheets. Lastly, there is still significant credit risk. Bank of England statistics show that although losses on loans by banks, investment companies and building societies certainly declined to 3.6bn in Q3 2010 from 5.2bn in Q4 2009, they are still higher than precrisis levels (which averaged about 2bn over the period 2005-2006). Nonetheless, the relative improvement in economic prospects should limit the cost of risk in 2011 (see chart 8). Direct exposure to the peripheral countries is still rather high The existence of a major colonial empire until the mid-20th century and the long tradition of international trade that this engendered still explains the openness of the UK banking sector to the rest of the world. The high degree of internationalisation can
February 2011

be seen in the commitments of financial and monetary institutions to non-residents as a share of total assets, which is particularly high at 37.3%. The big banks should continue to operate new sources of growth outside of Europe, notably in Asia. According to the statistics of the Bank of International Settlements (BIS), UK bank commitments to non-residents (bank and sovereign risk) amounted to $3,781.7bn on an ultimate-risk basis 15 at 30 June 2010 (15.4% of all international debt recorded by the BIS), which places the UK banking system ahead of the United States (12.6%), Germany (12.2%) and Switzerland (6.5%). It has the highest exposure to Ireland (3.5% of total debt, 6% of GDP and 1.5% of total banking assets) and Spain (2.8% of total debt, 4.8% of GDP and 0.9% of total banking assets) (see chart 20). The UK bank's direct exposure to the "peripheral" countries (Spain, Greece, Ireland and Portugal), currently the focal point of much concern, has declined since December 2008, but is still rather high. At the end of June 2010, they accounted for 7.2% of total

Conjoncture

12

Holding of "peripheral" claims by UK banks

% of total foreign claims, % of GDP & % of total banking assets

UK stock market performance (100 = January 2000)

160 140

18 16 14 12 10 8 6 4 2 0

Spain Ireland
Dec. 2005 Dec. 2006

Greece Portugal
Dec. 2007 Dec. 2008 Dec. 2009 June 2010

120 100 80 60 40 20 FSTE - Total FTSE - Banks Stocks

OF OF OF OF OF OF OF OF OF OF OF OF OF OF OF OF OF OF TOTAL GDP ASSETS TOTAL GDP ASSETS TOTAL GDP ASSETS TOTAL GDP ASSETS TOTAL GDP ASSETS TOTAL GDP ASSETS

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Chart 21 Source: Datastream

Chart 20

Sources: BIS, OECD & Datastream, BNP Paribas calculations

foreign debt held directly ($270.7bn), equivalent to 12.4% of GDP and 2.6% of total assets of UK banks (compared to 16.9% and 2.2%, respectively, in December 2008). The exposure of UK banks to the peripheral countries is slightly less than that of German banks (12.9% of GDP and 4.2% of total banking assets) but much higher than for Swiss banks (6.3% of GDP and 1.2% of total banking assets). In the short term, the risk of a pure default seems relatively unlikely now that a series of collective public actions (successive ECB interventions, IMF assistance and launch of the FESF) have already been deployed. In the longer term, however, we cannot exclude the possibility that debt maturities will be rescheduled. Towards a new banking landscape The government could begin to gradually sell off its equity stakes. At the same time, non-banking players are currently moving into a fast-changing banking environment. Government stakes could be sold off soon After a series of nationalisations in 2008 and 2009, it is now time for the government to gradually sell off its equity stakes in banks. The leaders of RBS, in consultation with the government, have already expressed their determination to begin the privatisation process as of 2011. The European Commission has also imposed disposals on Lloyds and RBS in exchange for the financial support received during the crisis. Condemning the acquisition of ABN-Amro by its predecessors, the new RBS management team has set the bank on the road to a new strategic positioning since 2009,

by selling off several of its activities, for the most part belonging to the former Dutch bank. Northern Rock, the first bank to be nationalised after the outbreak of the financial crisis, is also expected to be privatised again in H1 2011, and talks are underway with the UKFI16. Lifted by renewed optimism in early 2010, the market value of UK bank stocks has picked up (see chart 21), notably in H1 2010, albeit without returning to pre-crisis levels before the end of the year. In the end, the upturn in market prices, which reflects the improvement in earnings, makes it a more opportune movement to sell off public stakes, despite ongoing doubts about the financial solidity of certain banks that have received support from public funds. The precise timetable for selling off public stakes has not been clearly defined yet, but according to the assumptions of the Center for Economic and Business Research (CEBR) in August 2010, the government could post a capital gain of about 19bn if the disposals were gradually made over the next five years. Retail banking: an increasingly contestable market The UK retail banking market is characterised by the growing presence of foreign players. The Spanish group Santander, which paid 1.65bn for 318 branches of Royal Bank of Scotland (RBS) in August 2010, is not entering unchartered waters. Its technological infrastructure, for example, should enable it to realize synergies in the medium term. With the acquisition of Abbey in August 2004, Alliance and Leicester in August 2008 and Bradford & Bingley's retail network and savings division of in September 2008, the Spanish group already has

February 2011

Conjoncture

13

1,300 branches. This acquisition policy can also be seen as testimony of its optimism in the growth prospects offered by the UK market in terms of margins and profitability. Several retail players have also expressed their interest in making a long-term investment in the retail banking market, gambling on their ability to win over consumers whose confidence has been shaken by the financial crisis. Metro Bank, a subsidiary of the eponymous retail group, opened its first branches at the end of July 2010 and offered an innovative range of services (longer store hours, open seven days a week, and a more rapid handling of operations). Metro Bank has said that it will stay away from the banking branches put up for sale by the incumbent players (RBS in particular), basing its business model instead primarily on organic growth. The Virgin Group, in contrast, seems to prefer an external growth strategy. Virgin purchased the regional bank Church House Trust for 12.3m in December 2009, which it will use as a beachhead to develop its retail banking business. Lastly, the Tesco group, the UK's leading retail chain, wants to impose itself as a key player in retail banking, via growth through acquisitions by its subsidiary Tesco Bank. In the wake of the crisis, numerous establishments were eliminated or lost their independence (through acquisitions or mergers), including listed banks as well as mutual banks. This concentration movement has benefited a small number of groups and attracted greater monitoring by the public authorities. The authorities are encouraging competition and the installation of new players in the retail banking segment. These new arrivals are unlikely to call into question the predominance of the incumbent players, at least not in the short term, although their growing presence could hinder the rebuilding of intermediation margins, which have eroded sharply over the past decade.

The UK banks were hard hit by the brunt of the financial crisis in 2008. The authorities reacted promptly and massively, but their efforts did not prevent the shock wave from spreading to the real sphere, after a lag of a few quarters. UK GDP contracted by an unprecedented 4.9% in volume in 2009. Monetary easing, the injection of public capital and the creation of a virtual "bad bank" nonetheless prevented the collapse of the financial sector. In support of this shock treatment, the situation in the UK banking sector is now returning to normal, although major disparities still exist between banks. Despite sector restructuring, several threats still loom over future profitability, notably the intensification of competition, persistent sources of risk and tighter prudential regulations. At the end of a period characterised by an exceptional surge in bank assets, with virtually a tenfold increase in bank assets as a share of GDP since the beginning of the 1970s, UK banks have one of the highest profitability rates on an international scale. Economic growth and strategies to focus on core business and streamline operations are the main keys to this success. But the crisis will leave a lasting mark, and in the future, UK banks surely will not be able to repeat their past performances. Debt must be reduced in both the private and public sectors, which could strain loan volumes and recurrent banking revenues. The real estate market correction, put on hold through massive injections of liquidity, has clearly not run its course. The economic recovery looks sluggish and the financial environment remains uncertain. Looking beyond the direct impact of the crisis, the tightening of prudential regulations will force the banking sector to strengthen its capital base and limit the transformation of maturities, thereby restraining the size of balance sheets and financing as well as profitability. Completed, 10 February 2011 laurent.nahmias@bnpparibas.com

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Bibliography Kodres L. and Narain A. [2010], "Redesigning the contours of the future financial system", IMF Staff Position Note SPN/10/10, August Amenc N. and Sender S. [2008], "Les mesures de recapitalisation et de soutien la liquidit du secteur bancaire europen", December, Edhec Business School: http://www.lesechos.fr/medias/2008/1203//300313840.pdf Bank of England [2010], "Financial Stability Report", Issue N28, December: http://www.bankofengland.co.uk/publications/fsr/2010/fsrfull1012.pdf Choulet C. and Quignon L. [2009], "European banks: support plans to be tested by recession", BNP Paribas Conjoncture, January: http://www.imf.org/external/pubs/ft/spn/2010/spn1010.pdf DArvisenet P. [2011], "The Sovereign Debt Crisis in Europe", BNP Paribas Conjoncture, January Newhouse-Cohen C. [2010], "Worse lies ahead", BNP Paribas Conjoncture, September Nier E.W. [2009], "Financial stability frameworks and the role of central banks: lessons from the crisis", IMF Working Paper WP/09/70, April: http://www.imf.org/external/pubs/ft/wp/2009/wp0970.pdf OECD [2009], "OECD Economic Research: UK", June OECD [2009], "UK Economic Research: 2009" Summary, June: http://browse.oecdbookshop.org/oecd/pdfs/browseit/1009092E4.PDF Quignon L. [2008], "Banks in the financial crisis, Act 2", BNP Paribas Conjoncture, October November Quignon L. [2010], "Basel III: capital requirements not without impact", BNP Paribas EcoWeek 10-37, September Quignon L. [2005], "UK banks at the peak of profitability", BNP Paribas Conjoncture, March tker-Robe I. and Pazarbasioglu C. [2010], "Impact of regulatory reforms on large and complex institutions", IMF Staff Position Note SPN/10/16, November: http://www.imf.org/external/pubs/ft/spn/2010/spn1016.pdf Sabuco P. [2008], "UK banks and the sub-prime crisis", BNP Paribas Conjoncture, July Sabuco P. [2010], "Ireland, the debt legacy", BNP Paribas EcoWeek 10-40, October Sabuco P. [2010], "Irish banks: another look at the Celtic mirage", BNP Paribas Conjoncture, December

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NOTES
1 Our sample comprises the largest credit institutions in terms of Tier 1 capital: - 2005-2008: Barclays, HBOS, HSBC Holdings, Lloyds Banking Group, RBS Group and Standard Chartered - 2009-2010: Barclays, HSBC Holdings, Lloyds Banking Group (including the former HBOS), RBS Group and Standard Chartered. 2Securitisation is a financial technique in which a non-negotiable debt portfolio is made negotiable on the financial markets. In addition to the cash obtained, securitisation operations transfer debt portfolios from bank balance sheets to investors (in general ad hoc structures known as Special Purpose Vehicles), which enable banks to increase the volume of loan distribution without increasing their balance sheets and/or without first having to increase their equity capital. 3 CRDII was transposed into national law in October 2010: http://www.legislation.gov.uk/uksi/2010/2628/introduction/made 4 Gains or losses on derivatives and other securities excluding gains or losses on assets at market value per year. 5 Source: Financial Services Compensation Scheme: http://www.fscs.org.uk/what-we-cover/eligibility-rules/compensationlimits/deposit-limits/ 6 Bloomberg data. 7 Information on the status and functioning of this government agency is available on the UK Treasury website: http://www.hmtreasury.gov.uk/apa.htm 8 The Paulson Plan, also known as the Troubled Asset Relief Program or TARP, consisted of creating a structure pooling together the toxic assets of financial institutions. 9 Due to legal constraints, the operation was not finalised until 2009. 10 In October 2010, the UK government announced an unprecedented austerity plan that aims to reduce spending by 81bn by 2015 in order to reduce the public deficit from 10.1% in 2010-2011 to 2.1% in 2014-2015. The measures announced by George Osborne, Chancellor of the Exchequer, include the elimination of nearly 500,000 public sector jobs, postponing the retirement age from 65 to 66 by 2020 and budget cutbacks that could reach as high as 20% over 4 years in some ministries. 11 The Bank Tax could bring in about 2.5bn net per year. This measure would consist of taxing financing of less than one year at 0.07% and longer term debt at 0.035%. 12 See the G20 press release, "Declaration on strengthening the financial system London, 2 April 2009": http://www.g20.org/Documents/Fin_Deps_Fin_Reg_Annex_020409_-_1615_final.pdf 13 See EcoWeek of 17 September 2010 by Laurent Quignon for a detailed presentation of the new capital adequacy requirements. See also the BIS press release of 12 September 2010, "Group of Governors and Heads of Supervision announces higher global minimum": http://www.bis.org/press/p100912.pdf 14 Press release by the French Banking Federation (FBF), 20 April 2010: http://www.fbf.fr/web/Internet2010/Content.nsf/DocumentsByIDWeb/87MDV6?OpenDocument 15 According to the BIS definition, on an ultimate-risk basis, the geographic classification of a foreign claim is the residence of the guarantor of the financial claim or the country where the head office is legally located, and not the immediate borrower's country. The debtor bank can be legally tied to a guarantor whose place of residence is different from that of the immediate borrower. Foreign debt includes claims granted to foreigners and the financial assets held on behalf of foreign entities (debt securities and capital). 16 Northern Rock was split into two entities, a bad bank pooling together its real estate loan activities and a healthy entity comprised of the group's retail banking business, which could be reprivatised at an estimated minimum of 1.4 bn.

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