The Bank of England’s Financial Stability report could be good news for investors in bank debt

5th July 2016

Twentyfour Asset Management looks at what this weeks Bank of England Financial Stability report and what it means for banks.

The Bank of England Financial Stability report discusses many different factors influencing financial stability in the UK, including financial markets, household debt, the property markets – commercial property in particular – and the UK current account balance.

Many parts of the report are worthy of comment but one area that grabbed our attention was the paper on the resilience of the UK financial system – there is a separate report devoted to the sector.

The interesting news for us was the decision to cut the UK Countercyclical Capital Buffer to zero, from 0.5%, until at least June 2017.  For those of you less familiar with the increasingly complicated capital structures now prevailing at most banks, the regulators decided, following the credit crisis, to build various “buffers” into the capital structure, which could “release” capital to banks in times of stress. This is one such buffer. The idea is simple; force the banks to build additional capital in more benign periods, like that we’ve just had (!), by increasing the Common Equity Tier 1 (CET1) capital requirement, and when the environment is more stressed the regulator can lower this capital requirement thus increasing excess capital over and above the minimum level required.  This has the impact of creating “breathing space” for the banks. The hope for the BoE is that this cushion will incentivise the banks to continue to lend to the real economy; encouraging investment; maintaining credit conditions for those with high household debt, and making a recession less likely.  As the report says; “This means that three quarters of banks, accounting for 90% of the stock of UK economy lending, will, with immediate effect, have greater flexibility to maintain their supply of credit to the real economy.”  The BoE calculates that this move would reduce regulatory capital buffers by £5.7bn – raising the capacity for bank lending by £150bn – not an insignificant amount.

So what does this mean for investors in UK banks?  From an equity point of view, not too much.  If the cut to the buffer does indeed encourage the banks to continue business as normal, rather than cutting back on the availability of credit, that should be positive for ROE, however, the FPC has also encouraged banks not to increase their dividends and they also can’t use the extra capital for dividends, which isn’t such positive news for equity investors.

However, the impact for investors in £ bank debt is much more significant and for £ AT1s, this is unambiguously good news.  The reduction in the CET1 capital burden will certainly ease any issuance pressures that UK banks were feeling, but moreover, it also increases the all important “gap to action” for UK AT1 issuers.  This gap to action is one of the biggest factors for investors when considering AT1s; and £ AT1s just received a 50bps windfall – none of which can be used on dividend payments.

The statement as a whole is very detailed and focuses on the areas that are most at risk from a negative impact from the Brexit vote, but it’s clear that the BoE is very focused on ensuring that the financial sector continues to the support all areas of the economy.  The cut to the Countercyclical Buffer is clear evidence of this, which is good news for the wider economy and comforting news for UK bank debt investors.

Eoin Walsh
Partner, Portfolio Management, TwentyFour Asset Management

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