What Happens When You Make U.K. Banks Safer?
The latest test of the U.K. financial sector's resilience delivers a clean bill of health to seven of the nation's eight biggest banks, with only the ailing Co-Operative Bank deemed deficient. Forcing banks to shrink their balance sheets and hold more capital, however, is somewhat self-defeating if improved health doesn't lead them to boost lending to the real economy.
The Bank of England's stress-test results, announced today, are supposed to assess how the banking industry would cope with economic shocks, including a jump in the central bank lending rate to 4 percent from 0.5 percent currently, a doubling of the unemployment rate to 12 percent, and a decline by more than a third in house prices.
Regulators, though, may be making banks safer while also making them less useful to the broader economy. Here's a chart based on Bank of England data that shows how U.K. companies are being starved of capital as loans shrink:
It's impossible to know for sure how much of the shrinkage is due to a lack of bank appetite for taking on more risk, or if a lack of demand for capital investment means companies aren't asking for money. Both, though, are probably contributing.
The Bank of England warned in today's Financial Stability Report that banks are also scaling back their trading activities, which may make securities prices more volatile during a market rout. The four biggest U.K. banks have cut their trading activities by about 10 percent in the last year, the central bank said. This could be a mixed blessing:
That should reduce banks’ direct exposures to financial market shocks, but may also reduce their ability to intermediate between investors. According to market contacts, some dealers were less willing than in the past to intermediate in financial markets during the period of market volatility in October. As a consequence, indirect risks to banks and other investors from a shock to financial markets may have risen.
The unintended consequences of trying to make finance safer are showing up in both a contraction in lending to companies and in reduced liquidity in financial markets. Regulators need to be mindful that while the safest bank in the world would be one that did no trading and made no loans, it wouldn't really be a bank in any useful sense of the term.
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