RBS RESULTS
With the share price still at first class postage stamp levels and gross gains at the same return as the rise in postage stamp prices, what are our banks' prospects - can they sustain lending to aid economic recovery while deleveraging and can they buy government bonds issuances? RBS shares were 10p in Jan '09 and are now heading for 40p, but in book value terms should be 80p at least.
RBS report for 2009:2009 net attributable loss fell to £3.6bn from £24.3bn in 2008 -in part this is asset price recoveries and debt recoveries. 2009 operating loss narrowed to £6.2bn from £6.9bn in 2008, with loss before tax falling to £1.9bn from £8.3bn in 2008. The cost in fees other aspects of the APS asset repo swap with government played a large part in this, so much of this loss is nominally taxpayer gain to be realised sometime in the near future. RBS swapped £282bn assets and got £128bn RWA saving (but no clear sign of the effect of the Bank of England cheque except a £60bn narrowing of the bank's funding gap? Let's presume another £100bn or so replaced other funders, hence my guess at least a BoE cheque for £160bn left on deposit at BoE, leaving BoE with plenty of net headroom for funding its £198bn QE?)
RBS's pre-impairment profit, adjusted for fair value of own debt, improved to £7.8bn from a loss of £0.7bn in 2008, but £6bn of this was gains on redemption of own debt and pension curtailments! Impairments rose sharply to £13.9bn, rising £6.5bn in the year, from £7.4bn in 2008, with a third taken as losses and over £5bn as goodwill and intangibles loss, but now appear likely to have peaked.
A problem with summarising the balance sheet of such as large bank as RBS is understanding both sides of the accounts, assets (loans) and Liabilities (deposits, borrowing and equity capital) like strawberries and cream it's not advisable to digest one without the other.
The BBC news described impairments as expected irrecoverable loss, which is simply out of whack with where the main gains and losses appear and strictly incorrect anyway since recoveries medium term should normally be 30-55% of impairments. Fourth quarter impairments were 5% lower than 3Q09 and risk elements in lending at year end were unchanged compared with end-September at £35.0bn.Total income was up at almost £32bn compared to almost £24bn, half of it non-interest income. Core bank operating profit improved to £8.3bn, compared with £4.4bn in 2008. Exceptional trading results in investment banking led. Net interest margin was 1.76% for the full year, which is very healthy given a normal ratio of 1.5%, if down 32 basis points from 2008 but stable in the second half. Fourth quarter NIM of 1.83% was up 8 basis points compared with 3Q09.
Risk in the balance sheet has been reduced, with total assets cut by £696bn in 2009 in unfunded items i.e. 80% of it in derivatives and the rest in APS with a fall in retail customer lending as customer paid off loans faster than the bank could agree new loans - partly by deleting undrawn overdafts. This is in line with Stephen Hester's commitment a year ago to reduce £500bn in derivatives. More worrying is a planned £500bn reduction in the funded balance sheet in constant currency terms, which is 70% though split between wholesale and retail operations, and half is the APS effect, but I wory that RBS is not doing enough to maintain houshold and business lending levels?
On risk capital side, Core Tier 1 capital ratio improved to 11.0%, following the issue of B shares to the UK Government and accession to the APS Scheme (Risk-weighted assets, or net risk exposures, at year-end was £438bn). There is currently a problem as to exactly how preference shares (as hybrid instruments) absorb loss given their bond nature, not pure equity. This brings us to why banks have to buy government bonds.
LIQUIDITY BUFFER CAPITAL RESERVES
Unlike in the USA where issuance by banks of bonds was almost zero, in the UK in the second half of 2008 there was quit massive securitisations for the BoE SLS and others funding sources. Then in early 2009, the big UK banks slowed issuance of term funding, and also reduced holdings of Govt bonds in Q3 2009. This helped margins for end-year reporting by 5bps. Then through 2009 government issued £170bn in bonds and redeemed about £20bn, then BoE bought in £200bn under QE using its balance sheet net liabilities from SLS and APS. The Government needs to sell £230bn in new bonds roughly in 2010. meanwhile the FSA has issued new very firm rules on liquidity reserves that UK banks must posess and these need to be mainly government bonds. Rejecting objections from banks about the burden of providing themselves with hundreds of £billions in liquidity risk buffer reserves to avoid having ever again to ask the government for massive help in a credit crunch, the FSA is interestingly being very forthright; no compromises.
We can now think about banks' capital funding requirement as a weighted mixture of deposits, equity and long-term wholesale funding that is as important as Tier 1 ratio in the FSA view, with loan to deposit ratios becoming obsolete as a liquidity measure. Current CFR of the UK banking sector is about 60%, and assuming banks target 70% (the level in 2000) the gap is a net £250bn of core funds (about half of bank capital!).
The FSA says the banks have 3 years to get there, during which £250bn SLS and CGS funds will also mature – potentially leaving Barclays, LBG and RBS with the need to raise over £500bn as an LR buffer including some superior long term high quality funding gap financing. Government bond purchases will rise sharply – at least £100-150bn purchases that might make insurers and pension funds feel squeezed out in the auctions. Without change in funding structure, UK banks may need to buy £620bn of additional purchases! The banks will have to withdraw funds from properietary investment trading and apply these to liquidity reserves.
By 2012, liability and these liquidity risk pressures may reduce net interest income of major UK banks by perhaps over £15bn per annum, or the equivalent to 100bps on the entire stock of non-mortgage loans! Hence, one impact may be flat margins in 2010and 2011, i.e. margins at sub-2008 levels in the medium term. This may hold back ROE to 15 percent or less, when 15% is a typical performance target currently. RBS's current RoE is 13%. Anyway, that's not the economic point; it is that banks to be safer will have to focus more on traditional banking and less on prop trading, and regulatory pressure means a ready market for government bond issues; only right and proper not least because of how much government has done to save the banks.
REGULATION
There are two schools of thought on regulations, on Basel II (& Solvency II), that specify the level of capital that banks (and insurers) in dozens of countries must abide by. There is much talk of Basel III, but this doesn't exist formally; the term Basel III only means refinements and additions to Basel II, mainly to get banks at last to fully work through how to implement Pilar II of Basel II, especially the economics modeling.
Supporters say the rules’ risk-based approach to capital requirements stops many banks from suffering a worse fate in the financial crisis, that the alternative, US, norm of restricting leverage, or relative indebtedness, of a bank’s balance sheet is useless because banks simply shift risky investments off the balance sheet.
Basel II’s critics, on the other hand, say the rules exacerbated the crisis because they allowed banks prepared to follow the letter, not the spirit, of the rules to increase leverage in their balance sheets enormously, investing in assets that were nominally safe, yet in reality were anything but. This is mistaken. The filure was in the derivatives of the securitised assets and allowing people to buy them as tradeable investments with highly leveraged funds and not ensure they were held to maturity suitable credit enhanced insured with standby liquidity etc.
And, it is argued, one of the principles of Basel II – that a bank’s capital should be based on the riskiness of its assets – was undermined when measures of riskiness, such as many credit ratings, were discredited during the crisis - that as triple A rated investments turned sour, a disastrous unravelling of bank balance sheets ensued. This is not quite accurate. The ratings agencies models had serious bugs as so securities that should not have been triple-A were rated as such. The weight of the rating in respect of the market value of the instruments had to focus on the instrument's collateral while the underlying collateral was taken for granted and falsely rated. It turned out that the instrument collateral could not be relied on an the market value of the bonds behaved independently of underlying credit risks.
The question, then, is whether Basel II should now be ditched, to be replaced, perhaps, by Basel III, is too simplistic? What is happening is an improvment on Basel II to provide more details and more enforceable advice in Pillar II requirements such as in liquidity risk and economic stress-testing.
Basel II is evolving. It was not a contributory factor to the crisis. There is no correlation between where the crisis struck and the adoption of Basel II.
Basel II was not just regulation but also it’s implementation. banks all failed to implement it in time fully. criticising regulations is an oversimplified.
One focus now is central banks building models to understand how banks are networked and cause systemic risk, and to decide who are the systematically most important institutions should be subject to extra scrutiny in regulation and capital requirements.
Systemically important institutions are not the same as too big to fail. That should be solved through resolution frameworks. And, of course, more capital will help.
Central banks want to get rid of the problem of too big to fail. But, simply put it is recognised that biggest institutions need closer oversight. Whether that means additional capital, that is what needs to be decided.
Insufficient liquidity has been recognised as a fatal flaw of the banking system when the crisis came, must also be addressed. But, this is where the intuitive argument goes wrong. Banks nominally (in USA and UK) lost all of their capital in the credit crunch and the same again in the recssion. For example, the IMF predicts banks will have nominal losses of at least $1.5 trillion in only 2010.
In my opinion the idea of looking for points of failure as if a credit crunch is triggered by failures of certain banks only (i.e. micro-prudential failures) is wrong. The centrak banks should be building macro-economic models integrated with macro-financial models, but this is currently intellectually to big for them to attempt - they prefer games-theory models using micro-economics of networked risks.
The regulators are therefore imposing high liquidity ratios that go beyond the guidance they first gave on liquidity management. There will be a global standard for funding liquidity – there will be a stress liquidity for short term shocks and a long-term structural liquidity ratio.
Banks could find their lending capacity limited more closely to their volume of deposits, and if so that will be a huge culture change - but I don't believe such huge changes are likely.
By the end of Q1 2010 is a very significant milestone for financial institutions operating in the UK. The FSA, which by then may be a sub-division of the Bank of England, should have in place the new regime for measuring and managing liquidity risk, a comprehensive framework that is a strategic part of bank strategies. By Q1 2010 banks must have processed large volumes of liquidity data, built stress scenarios and have the ability to drill down to the lowest level to identify the sources of risk and potentially deliver this information continuously!
Multiple decision-makers, business units and systems have created enormous complexity. The experience will be educational for bankers who for years have ignored the liabilities side of their balance sheet and taken liquidity for granted.
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