Bank-to-bank debt’s riskier than thought

Tim Wallace
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COMPLEX risk-weighting calculations make it difficult to assess how well prepared banks are to face a crisis, the Bank of England’s Financial Policy Committee (FPC) warned yesterday.

However, changes are on the way, the FPC’s report said. In particular, lending to financial institutions will be weighted more highly in future, as a result of recent losses.

Lending to households and businesses is currently regarded as significantly more risky than lending to other banks. Large UK banks’ total credit exposure to companies is £3 trillion, according to the report, against which banks must hold £125bn of capital for regulatory purposes.

Meanwhile they hold just £6bn of capital against £360bn of exposure to financial institutions.

However, recent losses will lower this regulatory favour towards intra-bank lending, on the basis that wholesale banking losses between 2007 and 2009 hit 160 per cent of capital requirements allocated to the sector.

Risks from trading will also be amended under the Basel trading book review, though the FPC believes “systemic risk may continue to be undercapitalised.”

This apparent mis-pricing of debt is particularly well-illustrated by the FPC’s report that “banks’ services to the UK real economy have remained among the UK banks’ most profitable and stable business lines.”

More broadly, banks received praise for increasing the size of their capital buffers, making UK banks safer than those in many European countries.

Nonetheless, the FPC did point out that credit default swap premia are above those seen at their 2008 peak.

Part of the reason is that “current strains are being amplified” by structural vulnerabilities in the financial system, as banks are so exposed to those in other countries.

In particular, UK banks are heavily exposed to those in France and Germany, which are in turn particularly heavily exposed to weaker Eurozone economies.

“A continuing deterioration in the euro area would weaken banks’ asset quality and profits,” the report noted.

“That would also increase uncertainty in funding markets, reducing the availability, or increasing the cost, of term refinancing.”