The Elephant in the Room or ‘has anyone seen my prop?’

So where do we go next?

The analogy I’ve started using is the one about the building that had subsidence and was propped up with Acrow props. For building read the banks and financial system and for Acrow props read Special Liquidity Scheme (SLS), Credit Guarantee Scheme (CGS) and Quantitive Easing among others.

The trouble is that these ‘props’ start to be removed next year and the Bank of England is adamant that they won’t be replaced. But I’m afraid that it doesn’t stop there. According to the Bank of England Financial Stability Report published in June, there is a total of £165bn of repayments due under the SLS and £120bn of guarantees under the CGS by the end of 2012. These are the props of course. In addition, by the end of 2012, the Bank of England forecast around £480bn of unsecured senior debt, subordinated debt, covered bonds and securitisations maturing or callable over the period. That’s an eye watering £765bn for the market to find by the end of 2012 which equates to an average of £25bn a month. With the debt crisis in Greece we have nowhere near achieved this year to date. The building is looking a little shaky at this point!

The Bank is clearly well focussed on this but has also made it very clear that they expect the industry to find this money themselves and that there will be no further Government or Bank of England bail-outs. So can they? Frankly I doubt it. If they can’t and there’s no assistance then have no doubts, with the props taken away the system will crash again.

Banks globally have continued to de-leverage since the onset of the credit crisis and in the UK this has meant that banks have assets of around 19 times their capital rather than the 30 times we saw at the end of 2008. This has manifested itself in declining asset classes including not only those esoteric types of asset, the derivative, but also in the tangible loans made to other banks, corporates and individuals. This is one of the reasons that Vince Cable has been urging banks to lend more. The banks are saying they are lending as much the market currently demands. This may or may not be true in the SME sector, I’m not an expert, but it doesn’t sound right to me in relation to mortgages. Residential mortgage loans represent the largest single asset class in the UK at around £1.2tn. It is mind-blowingly massive. To fund this, banks and building societies are having to use retail deposits and wholesale markets. Although retail deposits are growing overall they are simply not sufficient in scale to meet the problem. As competition hots up in this sector, they will become less useful as a funding mechanism due to increased expense and volatility as they change hands between deposit takers more rapidly. Not only that, mortgages are inherently medium to long-term assets and funding them solely from demand to one year maturity deposits simply doesn’t work if you want a stable market. Ask any Treasurer. If you are still in doubt about the over-reliance on short term debt to fund longer term assets then look at Northern Rock and remember the queues. The Bank of England recognises this and is exhorting banks and building societies to lengthen maturities of funding saying that an increasing reliance on short-term funding is undesirable and would perpetuate the structural fragilities in funding profiles that have caused disruption in the last three years (so we agree on this). The stability the Bank of England is looking for can only be achieved by issuing term maturity debt instruments and in particular Covered Bonds and Mortgage Backed Securities.  

Building Societies get a special mention where some £22bn of maturing fixed rate bonds will need refinancing in 2010. With highly competitive retail deposit markets building societies will have to either cut back further on lending activities or look to other sources of funding such as pooled securitisation ideas and strengthening core Tier I capital. Looking at Kent Reliance and their deal with JC Flowers we can see they have already gone down this route. Further consolidation in this sector looks inevitable from where I’m standing. Amazingly, the Bank of England is suggesting that the relevant provisions of the Building Societies (Funding) and Mutual (Transfers) Act 2007 are implemented to eradicate the preferential status that wholesale lenders achieve when lending to Building Societies.  In other words they want banks lending to Building Societies to carry more risk than at present so as to encourage them to take a more rigorous approach to assessing risk and controls over the Building Society sector. Isn’t that what the FSA should be doing rather then getting banks to do it? My fear is that this will just make it much harder for Building Societies to borrow from banks and hasten their sector’s demise.

So the banking reporting season is under way and the results by and large seem positive and encouraging. Sadly I’m not so sanguine. It seems to me that we have a massive elephant in the room that no one is talking about. I don’t think the banks and building societies can refinance £750bn through the markets alone and if they can’t then without Government support the market and the economy has a very big problem.  Slowing of lending activity will slam the brakes on recovery. If the props are removed too soon then the whole edifice is in danger of falling down!