Can UK banks recover from shares slump?

15th December 2011

Lloyds Banking Group is down from around 600p to 25p while RBS is down from 650p to 20p. The results for those outside taxpayer ownership are more encouraging but hardly earthshattering – Barclays is down from 750p to 173p while HSBC has only halved from 950p to 481p.

Will there ever be a recovery? Maybe one day but some preconditions will apply beforehand.

The banks have got to decide how to manage their capital ratios. The reason they are in the present mess – share price, reputation –  has as much to do with inadequate balance sheet strength as with the wider anti-bank sentiment among investors.

But as Robert Jenkins, an external member of the interim Financial Policy Committee of the Bank of England, wrote in The Times (in a private capacity), the banks have got to think carefully before they do anything.

Banks, in common with all companies, start off with a limited pool of capital. But how they divide it up causes particular problems for this sector compared with other companies.  Financials are unique in having regulators pore all over their balance sheets – because they are also unique in their market power and their lack of tangible assets such as property or machinery.

There are conflicts everywhere you look. In an opinion piece entitled "Why banks must think carefully before they shrink their assets", Jenkins goes through the options; and they are not easy.

EU regulators want banks to raise capital as a ratio to risk-weighted assets to cushion bad times by next June. They have two ways to push up the number – the positive or the negative.

Here's an easy example. They can increase capital from 100 to 200 while keeping the asset base at 100 to double the percentage, increasing the numerator. Alternatively, they could leave the capital unchanged at 100 but halve the asset base (essentially the loan book) to 50, decreasing the denominator. In both cases, the result is doubled.

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