jka on economics UK: Banking in and on recovery

Banks are open to lend, they have to lend, it is a great way of making money. They have to lend, since there is intense political pressure to respond to corporate and private sector need. They have to lend because shareholders have needs.

For some, banks are lending but on blue chip, gilt edged, gold plated, copper bottomed, underwritten, high security, high equity, low LTV projects with increased loan spreads and more than modest fee charges. Yeah, but at least they are lending.

At this stage in the cycle of recovery, the banks are able to pick and choose and be selective about the project types in which they wish to engage. There is a capacity issue relating to demand and supply for capital. The banks are in a strong position.

For existing projects, especially property related, the banks are being extremely accommodating in supporting established positions. In the recession of 1989 -1990, banking relationships were dominated by the dreaded “call” for an updated property valuation. Covenants structured to Loan to Value ratios demanded a valuation review as property prices came under pressure. In the current economic downturn, few calls have been made for an updated PV. In many cases banks don’t need to know and don’t want to know. One valuation can infect the whole loan book.

Indeed, the debt to asset value is of limited concern as long as the debt is being serviced, With base rates at 50 basis points, this is less of an issue than previous slow downs.

Recessions are traditionally central government induced in response to an overheating economy, with manifest inflation, a deteriorating external account, a run on Sterling and a “Balance of Payments Crisis”. Policy response - rate hike and a credit squeeze. This time it is different. Base rates have moved onto Planet ZIRP with a zero interest policy and a process of QE. Rates are low and debts can be more easily serviced. This is no requirement for a PV to trigger a default process.

Some banks have engaged in what is called by some “Lend and Pretend” schemes, ignore LTV’s and covenant breeches, pretend everything is OK and roll over the term debt as long as interest cover can be maintained.

As base rates begin to rise, the bank position will become less accommodating as interest cover diminishes. Furthermore, as property prices recover or are inflated back to health, banks may well become more aggressive or adventurous as the prospects for capital redemption on disposal become more feasible.

The supply side, in terms of banking capacity is limited, compared to the position three years ago. Many of the international banks have “left these shores” obliged to repatriate and restrict activity as domestic balance sheets are constrained.

Basle II requirements have placed greater emphasis on higher capital ratios and the introduction of a risk curve whereby greater investment risk demands higher capital provision. No longer a straight line trade off is made across the portfolio.

Banks have a high wholesale funding requirement to finance the equity or funding gap. According to some estimates, the funding gap some £100 bn ten years ago soared to £800bn in 2008. Normality requires a return to around £300bn - £400 bn at least.

This is a substantial reduction in capacity to restore capital ratios to a reasonable norm, placing additional pressure on liquidity and lending. The short term wholesale funding requirement is significant.

Loan rate spreads are increasing, reflecting cost both wholesale cost of capital and overhead amortisation over a smaller loan book. In addition risk profiles in an uncertain demand horizon have increased placing pressure on pricing premia.

“I used to be able to borrow at 2% over base” is a distant memory for many borrowers with 400 basis point spread more the norm. Well at least it is still on a very low base rate (for now).

In November 2008, Sir James Crosby, in the Crosby report to the Treasury, explained that banks were faced with a massive £160bn of capital redemptions over the following three years. This with little prospect of wholesale funding "will lead to a contraction in loan books".

As Crosby said “The banking sector is shell shocked, most banks will be focussed on strengthening their balance sheets. In such an environment, there are very few banks with the capacity to increase lending.”

At the same time, Mervyn King warned the UK economy would experience a protracted downturn if the commercial banks didn’t resume normal lending level. The fact is then and now they cannot in the short term. The Bank of England had one message to transmit as the Treasury was receiving another.

Funding solutions : The word on the street is “alternative balance sheet reconstruction with non consensual equity for debt provision”. Ouch. It should be a great year ahead for Corporate Finance and Private Equity. JKA

UK Economics news and analysis : no politics, no dogma, no polemics, just facts.