The Bank of England has shamed U.K. lenders by flagging their potentially weak capital positions. But it has not named them. Back in June, when the Swiss regulator thought Credit Suisse looked undercapitalized, it said so publicly. The ploy worked. On Nov. 29 the BoE said that U.K. bank capital positions might need bolstering too. But it didn't say which of its lenders needed capital, nor how much would be needed, nor when.
The BoE's Financial Policy Committee (FPC) did break new ground, however, in its analysis of why more capital is needed. Since its inception last year, the FPC has consistently badgered banks to raise capital by limiting payouts to shareholders and staff. Its latest Financial Stability Report (FSR) recognizes that the models used to risk-weight bank assets are seriously flawed.
Probabilities of default for the sovereign portfolio of the most conservative bank were seven times higher than that of the most aggressive in 2011, according to the FSR. Now, if the banks' risk-weighted assets had been calculated on more conservative risk weights, U.K. lenders might need as much as £35-billion ($55.7-billion) in extra capital. Throw in two other perpetual bugbears – the cost of atoning for past sins such as mortgage insurance misselling, and underprovisioning against future losses – and the shortfall might be even higher.
So why did U.K. bank investors shrug this off rather than send share prices tumbling, as happened with Credit Suisse? One reason is that the actual capital shortfall may not be as big, because behind closed doors the U.K. regulator makes banks hold so-called "Pillar 2" buffers on top of the capital requirement indicated by risk weights. Capital gaps, meanwhile, may be rectified through asset disposals, or issuance of contingent convertible debt. Dilutive rights issues aren't inevitable.
Investors have also known about the hidden risks lurking in U.K. bank balance sheets for years, which is why the sector still trades at two-thirds of book value. That discount may persist until the appropriate corrective action is actually taken.