The Bank of England has estimated that the five largest UK banks and Nationwide would sustain aggregate credit losses over five years of £115-130 billion in a “severe but plausible macroeconomic risk scenario” (see the October Financial Stability Report, pp.28-9). As explained below, an examination of credit impairment suffered by major high-street banks in the aftermath of the recessions of the early 1980s and early 1990s suggests a larger five-year loss, of £190-240 billion. Even this amount, however, could be absorbed by existing capital resources and future profits, implying additional government financial support may be unnecessary.
Credit losses suffered by British banks in the 1980s reflected both a severe domestic recession at the start of the decade and the Latin American debt crisis, initiated by Mexico’s default in 1982. Banks had stepped up their lending to developing-country governments in the late 1970s as they sought to recycle surplus oil funds – comparable perhaps with their recent disastrous foray into US subprime mortgages.
International losses were less important in the early 1990s but domestic default experience was worse than in the 1980s, despite a less serious recession, probably because of punishingly high real interest rates necessitated by sterling’s membership, until September 1992, of the exchange rate mechanism. By contrast, current low nominal and real interest rates will enable some default-prone borrowers to continue to service their loans.
On this basis, it is defensible to assume that current credit losses will be similar to but no greater than those suffered in the 1980s and 1990s downturns. One difference from these earlier episodes is that a much greater portion of banks’ credit exposure now resides in their securities portfolios rather than the traditional loan book. So it is appropriate to compare loan losses in the earlier recessions with total losses – both loan impairments and writedowns of securities – in the current cycle.
The chart shows high-street banks’ annual “impairment and other provisions (net)”, as reported by the British Bankers’ Association (BBA), expressed as percentage of their “assets at risk”, defined here as total assets minus cash held at the Bank of England, UK interbank lending and advances under sale and repurchase agreements. Two series are plotted, including and excluding “problem-country debt” (PCD) provisions. (The PCD figures were sourced from Bank of England Working Paper no. 177 The provisioning experience of the major UK banks: a small panel investigation by Darren Pain.)
In the five years from 1982 to 1986, provisions as a percentage of assets at risk totalled 4.7%. However, this understates credit impairment over the period because banks delayed taking charges for problem-country debt until 1987 and 1989. If these PCD charges are included, the 1982-86 total rises to 8.9%.
Provisions were made on a more timely basis in the early 1990s downturn and totalled 7.1% of assets at risk over 1989-93.
Based on 2008 assets at risk of £2.7 trillion, the five-year provision rates of 7.1% in the 1990s and 8.9% in the 1980s would imply aggregate credit losses for the major high-street banks of £190 billion and £240 billion respectively over 2008-12.
Such numbers are considerably larger than the Bank of England’s October estimate of £115-130 billion but this does not imply that banks require additional government financial support, for the following reasons:
1. Banks raised over £70 billion of new capital during 2008 to cover credit impairment, including £37 billion from the government.
2. The Financial Services Authority last week stated it would allow tier 1 ratios to fall to 6-7% as credit losses materialise. The average tier 1 ratio of major banks rose to more than 11% after last year’s capital-raising, implying a buffer of about £100 billion.
3. High-street banks’ net income before provisions and tax averaged £35 billion pa over 2003-07, according to the BBA. Assuming a similar run-rate before losses over 2008-12, about £175 billion will be available to shore up balance sheets and / or pay dividends. (Tax payments will be modest given credit losses.)
4. Banks’ net interest income fell to a record low 0.8% of assets in 2007, according to the BBA, versus an average of 1.3% over the previous five years. If the interest margin were restored to 1.3%, pre-tax profits would rise by about £25 billion pa or £125 billion over five years.
On reasonable assumptions, therefore, £400 billion of capital reserves and future profits could be available to set against credit losses of £190-240 billion over 2008-12. This would be sufficient to allow banks to expand their lending and even resume normal dividend distributions. Such a scenario, however, depends on the authorities affording them the flexibility to absorb losses over time, as in previous cycles. The alternative of requiring up-front accounting for future losses and further capital-raising on expensive terms is neither necessary nor desirable.
