Fixing the Financial Sector: A Change the UK Must Bank On

IMF Blog, July 17, 2013

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Growth has been flat for more than two years.
Per capita income is about 7 percent below its pre-crisis peak.
Unemployment is 7.8 percent; youth unemployment is 21 percent.
Credit to the economy remains severely constrained.
Recent data are encouraging; policies should capitalize on nascent signs of recovery to secure strong growth and rebalance the economy.
Fixing the financial sector, including by addressing banks’ asset quality, is a pre-requisite for a durable UK recovery.

Fiscal: Fiscal consolidation has been a brake on growth; policy should aim to offset the drag from planned near-term tightening, notably by bringing forward capital investment.
Structural: Accelerate structural reforms such as expanding vocational training, adopting new technologies, and attracting qualified workers from abroad to improve skills and competitiveness.
Monetary: Monetary policy should remain accommodative.
Complementarity: Financial sector repair must proceed urgently to normalize credit intermediation, improve the effectiveness of monetary policy, and ensure a durable exit from the crisis.

Progress noted:
- Banks’ funding costs have come down.
- Reliance on wholesale funding has declined.
- Noncore deleveraging of bank balance sheets has progressed.
- Regulatory capital ratios have edged up.
- Profitability has improved recently, albeit modestly.
Key concerns:
- The share of non-performing and delinquent loans is still high (estimated to average over 10 percent for Royal Bank of Scotland (RBS), Lloyds Banking Group (LBG), and Barclays).
- Lender forbearance remains a concern.
- Net bank lending to households and firms has not picked up since June 2012, notwithstanding a sharp decline in bank funding costs since then.
- Credit to businesses has declined continuously since September 2008 (cumulatively by 12 percent).
- Slowdown since 2009 in the build-up of provisions against expected losses, and of tangible capital buffers to meet unexpected losses, across major banks.
Implication: Weak bank balance sheets and inadequate capital buffers are constraining credit and recovery.

U.S. approach emphasized building tangible capital and conducting credible stress tests backed by supervisor-approved capital plans.
Tangible capital (as a share of tangible assets) has risen by about twice as much since 2008 for major banks in the U.S. as for those in the UK.
Vigorous capital-building helped break the vicious circle between bank health and lending.
Credit recovery in the U.S. has been strong: lending to businesses increased by 30 percent since the trough in 2010.

1) Asset Quality Review follow-up:
- The Prudential Regulation Authority (PRA) should ensure that individual financial institutions take the necessary measures to meet without delay the capital shortfalls identified by the Asset Quality Review (AQR).
2) Comprehensive stress testing:
- The system-wide stress tests planned for 2014 should cover a broad range of risks, employ sufficiently stringent scenarios, and aim for commensurately ambitious capital buffers.
- Transparency over methodology, results and supervisor-approved bank-by-bank capital plans would significantly enhance the credibility of the stress tests.
3) Measures to boost lending while building capital:
- Capital building efforts should be based on a combination of new equity issuance, reduction of dividend payments, restrained remuneration, and balance sheet restructuring that does not reduce net lending.

Objectives:
- Return the banks to good health and eventually to private ownership.
- Maximize taxpayer value, safeguard financial stability, strengthen confidence and competition in the sector, and minimize outward spillovers.
Importance:
- Together, RBS and LBG account for almost two-fifths of the stock of UK net lending to the non-financial private sector.
Implementation notes:
- Both banks have made progress in repairing their balance sheets and improving profitability, but significant challenges remain, particularly for RBS.
- A sovereign backstop—if required—should be provided to meet a capital shortfall, as it would result in a boost to growth far offsetting its cost.

Source: Krishna Srinivasan, July 17, 2013