The UK banking sector has undergone significant structural changes since the global financial crisis of 2007-09. So if coronavirus has a similar impact on banks, how different will the impact be? As individuals, our bank deposits are now much safer than when we queued down the high street to withdraw our savings from Northern Rock. But the position is not so simple for wholesale depositors including large companies and local authorities.
Safer for all
In many ways, banks are now safer for everyone. There has been a big reduction in higher risk activity such as proprietary trading and wholesale funding. And banks are now less connected than before, with a large fall in interbank lending and a massive increase in central clearing of derivatives; this reduces the domino effect where a failure of one bank could tip others over the edge too.
The Bank of England will also tell you that banks are now much better regulated than before. They would say that, of course, but the separation of the old Financial Services Authority into two new regulators, the Prudential Regulation Authority and the Financial Conduct Authority, and the introduction of more intrusive supervision, including the senior management conduct regime, is likely to have made some progress.
Safer for depositors
Some of the changes to the way banks operate has shifted risk away from depositors onto other players. Firstly, banks have issued significant amounts of capital, ensuring that shareholders are on the hook for greater losses; on one measure, banks now have three times the capital they did before.
Controls on senior staff pay, including rules on deferral and clawback of bonuses, have put some of the risk back onto management and traders.
And in direct response to Northern Rock, the Financial Services Compensation Scheme (FSCS) coverage has been increased from 90% of losses up to £35,000 to 100% of losses up to £85,000 or a £1 million for life-changing events. The scheme has also been extended to cover charities and most private sector companies, although not public bodies. The burden of this scheme falls on the wider financial sector, creating peer pressure for better standards.
Risks shifted onto wholesale depositors
But some of the risk is now firmly at the feet of wholesale depositors. The new resolution regime for failing banks includes the bail-in tool which allows liabilities including deposits to be trimmed to restore equity in the bank’s balance sheet following losses on assets. The requirement for banks to have “living wills” explaining their complexities will make bail-in easier to implement. This is of course to protect the taxpayer from having to make another expensive bail-out.
The impact of a bail-in on wholesale depositors is magnified by changes to insolvency law classing retail deposits as preferred creditors. After shareholders have been wiped out, wholesale depositors will be bailed-in by up to 100% before individuals, SMEs or the FSCS lose a penny. This also reverses the position in building societies where retail depositors used to be treated as the shareholders. Cynics would say this change protects voters at the expense of millionaires, even if few local authorities consider themselves to be rich.
And the ringfencing of the UK’s largest banks also has an impact. While the ringfenced banks are now protected from some of the higher risk activities of banks, they are predominantly funded by retail deposits. The burden of losses will therefore fall disproportionately on the few wholesale depositors; the same is true of most building societies and challenger banks.
This time round
Arlingclose clients will shortly receive a credit update explaining our analysis of what might happen to the UK’s banks and building societies if they collectively lose another £80 billion on bad loans, as they did in the last financial crisis. Our house view is that collective losses will be smaller this time, as the timely government action should ensure a stronger and faster economic recovery. But credit risk management is all about planning for the worst outcomes. After all, at today’s base rate, you would need to wait a millennium for interest income to cover the total loss of your principal.