Northern Rock 10 years on – are our banks any stronger?
A British bank is run with precision
A British home requires nothing less
Tradition, discipline and rules must be the tools
Without them – disorder, chaos, moral disintegration
In short, you have a ghastly mess!
These prophetic words, sung by Mr Banks, prefaced a comical scene in the film Mary Poppins when a misunderstanding over his children’s tuppence pocket money caused a run on the Fidelity Fiduciary bank. It mirrored a real-life run on the Westminster Bank in 1910 – when the film was set.
Most modern viewers might have assumed bank runs like this, with people banging on counters, clamouring for their money, had been confined to pre-war history. But in September 2007 news broke that Northern Rock was in crisis. The next day queues formed around cashpoints and at cashier desks as anxious savers tried to withdraw their savings. Demand from online customers caused the bank’s website to crash and the shares tumbled. The Bank of England was forced to step in as a lender of last resort with over £26bn in bailouts.
On 21st Feb 2008 the Banking (Special Provisions) Act 2008, giving the Treasury power to take ownership of struggling UK banks and building societies, was passed and the next day the Treasury announced that it had acquired all the shares in Northern Rock. It was nationalised.
How did it come to this and, a decade on, are the banks any stronger?
Banks have always been risk takers – it is their job. Without this willingness to risk savers’ money, lending to entrepreneurs and would-be house buyers, businesses would struggle to invest and grow and few of us would own a home. However, at the turn of the millennium banks around the world were taking on unprecedented levels of risk. Northern Rock was particularly aggressive. Whereas most banks traditionally lent money deposited by their savers, Northern Rock went much further, borrowing money from the short-term wholesale markets – from other financial institutions – to increase its lending capacity. It then securitised these loans, bundling them up within complex packages and selling them on again.
As the US prime mortgage crisis broke confidence collapsed in the quality of these securitised loan packages and the international wholesale market dried up. Northern Rock – now Britain’s fourth-biggest lender – was left marooned. It had been using those securitisations to pay off interest on its borrowings and now the plan was imploding.
As Mr Banks predicted, disorder and chaos ensued. Many would argue we witnessed moral disintegration too. The troubles were not confined to Northern Rock. A few months later Royal Bank of Scotland – one of the world’s biggest banks – was also bailed out, with the government taking a 58% share and injecting £37bn. RBS’s CEO, Fred Goodwin, became synonymous with the image of the reckless banker who lived extravagantly, prospered personally but brought the global economy to the brink.
A decade on a lot has changed.
Financial regulators around the world have exerted a strong grip on the banks, limiting their reliance on wholesale funding and imposing constraints on how far they can stretch themselves. One common gauge of this is the “Tier 1 ratio”, which measures a bank’s core equity capital (for instance, common stock and retained earnings) as a proportion of its total assets. These capital buffers are there to prevent the banks’ failure in periods of crisis.
Banks headed into the downturn with Tier 1 equity ratios at half the level they are today. The Capital Requirements Directive targets a 13% Tier 1 equity ratio (it started at 10% and has been ratcheted upwards over the decade). Most UK banks are now at 13.5%. However, getting to this point has hampered their ability to grow or return capital to shareholders in the form of dividends.
There is much better liquidity in the banking system – RBS had just six weeks of liquidity in 2007; now it has two years’ worth. Long-term incentives plans for senior management are also now much more aligned with the interests of shareholders. They are tied to things like total shareholder return, economic profit above the cost of capital and cost-income ratios – measures of how efficient a bank is.
In creating institutions that will not require a bailout from the taxpayer, the regulators have reduced their capacity to take risk, making them more like facilitators to the wider economy, akin to a nationalised railway line rather than a profit-maximising entity. Many would applaud that in the wake of the crisis they largely created.
So does that make banks a good investment now? In some ways it does. Given that capital ratios are now in line with regulatory requirements, it means there is more opportunity for banks to reinvest to grow, as well as to return more capital to shareholders in the form of dividends. Some estimates forecast the major UK banks to yield in aggregate around 5% through to 2021.* Furthermore, an environment of rising interest rates is typically beneficial to bank profitability as they are able to increase their loan rates by more than their savings rates. Finally, with undemanding price-to-book ratios relative to their forecast returns, this stable and gradually improving earnings and dividend profile could lead to higher valuation multiples in time.
We have seen businesses coming in offering peer-to-peer lending and the rise of challenger banks. Open banking may change the landscape too, making it easier for people to switch banks with confidence. For now, consumers generally remain very loyal to their banks, but any regulatory pressure to lower the barriers to switching is another incremental headwind.
Fintech and blockchain are not just a threat – they may also offer opportunities, helping traditional banks to reduce costs evolve their online propositions and gradually reduce the physical network of branches. Equally, with their scale and improving capital positions, the banks will be able invest or acquire to overcome any emerging competition.
For now, I think banks are on the watch list.
* Exane BNP Paribas, Jan 2018
Posted 28 February 2018
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