UK banks in “fragile state” as Covid crisis beckons, says new IEA research

31 Jul 2020 10:11 AM

The Bank of England’s stewardship of the banking system has “turned out to be a disaster, again” say Kevin Dowd and Dean Buckner

The Bank of England’s claims, that UK banks are so strongly capitalised after the Global Financial Crisis they could go through an even worse event and still emerge in good shape, do not hold water. A new briefing paper from the Institute of Economic Affairs argues that evidence from share prices and market values suggest quite the opposite.

In reality, the Bank of England has failed to ensure banks have strong capital buffers ahead of the Covid-induced downturn. “How Strong Are British Banks?” – co-authored by Kevin Dowd, Professor of Finance and Economics at Durham University and Dean Buckner from The Eumaeus Project – says that British banks are in a more fragile state than they were in 2007.

First, banks’ average market capital ratios have fallen from 11.2 per cent prior to the financial crisis to 2.3 per cent now, a fall of 80 per cent. The implication is a loss of 2.3 per cent of their assets would be enough to wipe out the market capital of the banking system.

Second, a healthy bank should have a price-to-book ratio in excess of 100%. The average price-to-book ratio for the Big Five banks in the UK is 38.4%. The banks’ low price-to-book ratios show the market clearly believes that there is something wrong with the banks, contrary to the Bank of England’s claims.

Naturally, it would be unfair to criticise the Bank for failing to anticipate the Covid-19 crisis. But it is reasonable to criticise the regulator for leaving the banking system frail when its mandate is to ensure that capital standards are high enough to make the system resilient. A “more serious regulatory failure is difficult to imagine,” say the report’s authors.

The Bank of England’s failure is all the more regrettable because it could have ensured that banks had built strong capital buffers at no cost to the economy. The Bank’s stewardship of the banking system has turned out to be a disaster, again.

There is a solution to this problem, but it isn’t a regulatory one. The standard response – another regulatory reform – will fail for the same reason that such reforms have always failed in the past: the regulatory system gets captured by the firms it seeks to regulate, which then manipulate the system to their advantage.

“How Strong Are British Banks?” suggests we do away with the regulator, make bankers personally liable for their losses, and the banks will soon sort themselves out.

Kevin Dowd, Professor of Finance and Economics at Durham University and co-author of How Strong are British Banks?, said:

“For years the Bank of England has been telling us that UK banks are sufficiently capitalised that they could withstand a worse financial crisis than the last one and still be in good shape. That’s hogwash.

“The regulation of UK banks’ capital adequacy has more holes than a piece of Swiss cheese. On paper, according to the Bank’s preferred metrics, UK banks look to be in great shape, but those metrics are unreliable and the banks have been gaming them to perfection.

“Bank of England stewardship of the banking system has failed us again and again. If we are ever to establish a system in which the banks work for us and not the other way round, then we need to fire the steward and make bankers personally liable for the decisions they make.

“The key to good governance in banking is not more regulation, but more personal liability. It’s as simple as that.”

How strong are British banks?