The plunge in the exchange rate has worsened the credit crunch by damaging banks’ capital ratios.

In its October Financial Stability Report, the Bank of England estimated that the tier 1 ratios of Barclays, Lloyds TSB and HBOS would stand at over 11%, 12.1% and 12.0% respectively after last autumn’s capital-raising. However, Barclays recently reported a ratio of only 9.7% at the end of 2008 while Lloyds HBOS has indicated a group outturn “in excess of 9%”. These levels are well above the Financial Services Authority’s minimum of 6-7% but imply a much smaller cushion than previously thought.

The declines appear to be due less to losses than strong growth in risk-weighted assets – the denominator of the tier 1 ratio. This growth in turn reflects both higher risk weightings – caused by the unhelpful pro-cyclicality of Basel Accord rules – and the decline in the exchange rate, which has boosted the sterling value of foreign-currency assets. (The sensitivity of capital ratios to currency movements reflects a mismatch between capital – held mostly in sterling – and assets, which contain a large foreign element.)

Current UK exchange rate policy is reminiscent of Japan in the late 1990s. With US approval, the Japanese authorities engineered a large fall in the yen in an effort to reflate the economy via net exports. However, this worsened a credit crunch by forcing capital-constrained banks to cut back domestic lending to compensate for a higher yen value of their foreign assets. The policy even failed to stimulate trade – the yen’s depreciation helped to topple other Asian currencies and resulting deep recessions damaged Japanese exports.