UK three years after the financial crisis Laurent Nahmias

K banks are gradually recovering from the global Misleading balance sheet growth financial shock of 2007. The least diversified The total assets of the banks in our selection banks are still highly dependent on national U virtually doubled as a share of GDP, from 273% in 2005 economic prospects. After six quarters of contracting to 506% in 2008 (see chart 1). This trend was reversed GDP, the UK economy finally pulled out of recession in in 2009, and total assets returned roughly to 2007 Q4 2009. Yet budget consolidation measures levels. announced last fall will probably continue to strain The growth of balance sheets in 2008 was not due activity. Assuming that real GDP growth is limited to the dynamic momentum of traditional intermediation to 1.7% in 2010 and 1.2% in 2011, economic activity activities as much as to valuation effects pertaining to in volume is unlikely to return to 2008 levels before the interest rate environment and the reintegration of off 2013. balance sheet commitments. The financial crisis hit the big UK banks to differing As the same time, in a tight interbanking market, UK degrees. Only two reported full-year losses in 2008 and banks increased their holdings of liquid assets between 2009, but they were so great that it was necessary to 2007 and 2009 (low risk short-term securities or central inject public funds. Although the banks in our selection1 assets), which rose from less than 1% of the total strengthened their solvency and were profitable as a bank assets of our selection in 2007 to 4% in 2009. whole in 2010, they still face with the risk of a Off balance sheet commitments, which include the deterioration in the quality of their banking books and liquidity lines or "back up" granted as part of high direct exposure to the peripheral countries of the securitisation activities 2 , increased at a much faster euro zone. pace than banking assets between 2005 and 2007. On average, they rose from 427.6% of total assets in 2005 to 830.7% in 2007 (see chart 3). They abruptly fell back The authorities come to the rescue to 27.1% of assets in 2008 before rising again to 93.6% in 2009. In the wake of the home loan crisis, of ailing UK banks securitisation activities contracted sharply in Q3 and Q4 2007 before recovering strongly in 2008 and collapsing again in 2009 (see chart 4). Several banks encountered troubles that led to Part of their off balance sheet commitments have massive interventions by the Bank of England and the been reintegrated on bank balance sheets since 2009 government. either for legal reasons or to boast the banks reputation. European Union regulations also provided a more The financial crisis shakes the banking sector restrictive framework for the size of off balance sheet commitments. To preserve the quality of risk monitoring, The financial crisis reached its peak in Q4 2008 in April 2009 the European Commission proposed to following the collapse of . Banks had to amend existing banking regulations by requiring banks partially reintegrate their off balance sheet to hold 5% of the underlying loans on their balance commitments, which had swollen rapidly through 2007, sheets. The Capital Requirement Directive II (CRDII) due notably to a major surge in securitisation. adopted by the European Parliament in September 2009

February 2011 Conjoncture 3 Total assets for the largest UK banks Drop-off in off balance sheet items (% of GDP) (% of total assets) 600 900

500 800 700 400 600

300 500 400 200 300 200 100 100 0 0 2005 2006 2007 2008 2009 2005 2006 2007 2008 2009

Chart 1 Sources: Bankscope & OECD, BNP Paribas calculations Chart 3 Source: Bankscope, BNP Paribas calculations

Financial resources for the largest UK banks Drop-off in securitisation since 2009 (% of total) (EUR bn) Debt with customers Debt with credit institutions and central banks 120 Short-term financing Long-term financing 100 45 Derivatives Financial instruments (market value) 40 80 35 60 30 25 40 20 15 20 10 5 0 0 12341234123412341234123 2005 2006 2007 2008 2009 2005 2006 2007 2008 2009 2010

Chart 2 Source: Bankscope, BNP Paribas calculations Chart 4 Source: European Securitisation Forum has been applicable to EU member countries since banking systems on the one hand (whose figures were 31 December 20103. two thirds and half as high, respectively) and on the other, the American system (5.1%) (see chart 7). Substantial losses and writedowns in 2008 In 2008, aggregated net banking income for the banks in our selection rose 2.8%, a Even as losses and asset writedowns eroded their resilient performance at a time of stagnant real GDP solvency, the banks were also faced with the scarcity of growth (-0.1% vs. +2.7% in 2007), despite the losses interbank liquidity due to the mutual mistrust among reported in their trading business (£13.9bn loss after a credit institutions. net gain of £15.3bn in 2007). 4 Cumulative losses and asset writedowns since the Despite the strength of NBI and an aggregate profit of bursting of the financial crisis amounted to £125.4bn in nearly £30bn in 2007, which provided a comfortable January 2011, of which nearly £44bn was concentrated safety mattress, the big UK banks failed to avoid an in Q4 2008 (see chart 5). Asset writedowns alone overall loss of £36bn in 2008 due to the upsurge in the (excluding losses on loan portfolios) were mainly due to cost of risk, which rose 156% to £43.7bn (see chart 8), losses on asset-backed securities (ABS), the and £33.2bn in net exceptional charges, mainly due to deterioration of monoline guarantees and collateralised the impairment of goodwill and intangible assets by debt obligations (CDOs). Together, Royal Bank of RBS. Scotland (30.6% of total losses), HSBC (27.8%), (21.5%) and HBOS (14.2%) accounted for The three key components of rescue plans nearly 95% of reported losses and asset writedowns (see chart 6). Measured as a percent of total banking The immediate responses to the financial crisis by assets (1.6%), the UK banking system ranks in an the UK government and the monetary authorities can be intermediary position between the French and German divided into three components. The first line of attack

February 2011 Conjoncture 4 UK bank losses and depreciations Bank losses and depreciations by country (£ bn) (% of assets)

6 50 45 5 40 35 4 30 25 3 20 15 2 10 5 1 0 34123412341234 0 2007 2008 2009 2010 USA UK France Spain

Chart 5 Source: Bloomberg at 17/01/2011 Chart 7 Sources: Bloomberg, ECB & FDIC

Breakdown of cumulative losses and depreciations Cost of risk Ratio and GDP growth rate (% of total)

Alliance & Bradford & % Cost of risk ratio (provisions/NBI) Inverted scale, % Leicester Bingley Standard 45 -5 chartered GDP growth rate Nothern Rock 40 -4 Lloyds 35 -3 RBS 30 -2 HBOS 25 -1 20 0 15 1 10 2 Barclays 5 3 0 4 HSBC 2005 2006 2007 2008 2009 S1 2010 2011 (f)

Chart 6 Source: Bloomberg at 17/01/2011 Chart 8 Sources: Bankscope, Datastream, BNP Paribas forecasts was to boost liquidity through monetary easing and to At the same time, the monetary authorities set up a system of public guarantees for bank debt. The broadened the refinancing base by extending the second was to strengthen the equity of banks by maturities of refinancing instruments, extending the injecting public funds into their capital. The last solution range of eligible collateral and by setting up the Asset was to set up a bad bank, largely inspired by measures Purchase Facility in January 2009 to purchase gilt- to handle banking crises in the 1990s, although a less edged securities. radical approach was used since partial guarantees were granted instead of traditional asset transfers.

Boosting liquidity: restoring confidence in the Interest rates in UK interbanking market 12 % 10-year governement bonds - 3-month LIBOR Easing monetary policy was the first leverage used 11 Base rate 10 SONIA to restore the banks' access to liquidity and to facilitate 9 3-month LIBOR 8 10-year governement bonds their short-term refinancing. Before the crisis, faced with 7 6 the risks of overheating, the Bank of England adopted a 5 4 more restrictive bias in summer 2006. Inversely, the 3 2 central bank gradually began to ease the base rate in 1 0 25bp increments from 5.50% in December 2007 to 5% -1 -2 in April 2008, and then more energetically after the -3 collapse of Lehman Brothers, from 5% in September 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2008 to 0.5% in March 2009 (see chart 9). Chart 9 Sources: BoE & Datastream

February 2011 Conjoncture 5 They played the role of lender of last resort by largely Equity/Total assets stepping in for the interbanking market, which had suddenly dried up. The Bank of England's balance sheet % 01234567 31/12/06 almost tripled from £93.7bn in August 2008 to £244.1bn Barclays in October 2010, with most of the increase occurring by 31/12/08 RBS January 2009 (£225.9bn) (see chart 10). 30/06/10 HSBC Bank of England assets (£ bn) Standard Chartered 300 Other assets 280 Lloyds 260 Bonds and other securities acquired 240 via market transactions 220 HBOS Treasury advances 200 180 Chart 11 Source: Bloomberg 160 Long-term reverse repo operations 140 120 Short-term open-market operations 100 Tier 1 Ratio 80 60 40 20 % RWA 02468101214 0 31/12/06 2006 2007 2008 2009 2010 Barclays Chart 10 Source: BoE 31/12/08 RBS 30/06/10 In addition to the intended effect on the real HSBC economy, the Bank of England's successive key rate cuts helped boost intermediation margins, which had Standard Chartered eroded under four consecutive years of an inverted yield Lloyds curve (2004-2008). HBOS The second leverage was to strengthen existing public guarantee mechanisms on client deposits and to Chart 12 Source: Bloomberg introduce new ones on newly issued bank debt. To limit the risk of bank runs, the Financial Services The government's capital injections mainly took the Authority (FSA) raised the ceiling on deposit guarantees form of ordinary shares (£70.56bn, or 94.6% of injected from £35,000 to £50,000 in October 2008. In compliance capital), which is the highest quality of equity capital with European legislation, the ceiling was raised again (Core Tier 1) and thus eligible under Basel 3. Three to the equivalent in sterling of €100,000 on institutions benefited from over 90% of the government's 31 December 20105. The government did not create an purchases of ordinary shares: RBS (£45.5bn), Lloyds ex nihilo bank refinancing structure (like the French (£10.3bn) and HBOS (£8.5bn)6. In November 2008, a SFEF, for example), but in fall 2008 rolled out a simpler public entity, UK Financial Investments LTD (UKFI), was mechanism of government guarantees on new bank created to manage these banking stakes. After these debt issues. initial equity purchases, the government held 70% of RBS and 43% of Lloyds. The smaller-sized Northern Boosting solvency: public capital injections and Rock and Bradford & Bingley were fully nationalised. On nationalisations 3 November 2009, the government increased its stake in RBS to 84%. In contrast, following a new share issue The government also responded to the financial and the reimbursement of the government's preferred crisis by implementing measures to strengthen the shares, UKFI reduced its stake in Lloyds to 41% in equity capital of banks. February 2010. With the exception of HSBC, Standard The impact of capital injections on the ratio of Chartered and Barclays, which called on little or no equity/total assets was wiped out by the swelling of government assistance (about £1.5bn since the assets in 2008 (see chart 11). In contrast, the average beginning to the financial crisis for Barclays, less than Tier 1 ratio picked up significantly, in keeping with the 8% of the total increase in capital), virtually all the big decline in weighted assets (see chart 12). UK banks benefited from the injection of public capital

February 2011 Conjoncture 6 Box 1: Defeasance

Principle

Defeasance consists of regrouping the impaired or "toxic" assets of a bank into a separate special-purpose vehicle in order to restructure the bank's balance sheet and protect it from default. Isolating toxic assets enables a bank to pursue its business while limiting the impact of a downgraded solvency ratio on loan distribution. By setting up a defeasance structure, a bank also gains time to sell off assets, which become illiquid at the height of a crisis due to contracting demand. One of the shortcomings of this system is determining the value of toxic assets.

The classic defeasance mechanism described above is different from the asset protection schema used in the UK, which provides guarantees against risks. Under this configuration, ailing assets remain on bank balance sheets and the government insures the value of the assets in exchange for an annual fee paid to the central bank. If the assets fall in value, the bank must absorb a franchise and a percentage of the loss (10% in the case of the UK). Setting up an insurance-like system with a franchise places a lid on the amount of losses while limiting the risk of .

Implementation and accounting

From a technical perspective, in the American example, assets transferred to the special purpose vehicle are generally debt portfolios or sub-prime financial assets. The defeasance structure can be private, in which case management of assets and liabilities is entrusted to a private trust, which finances debt servicing through the interest received on the assets in the trust. In general, however, a public agency purchases the most risky and/or impaired assets below market value and ensures their management during a transition period.

From an accounting perspective, this operation results in the removal of financial assets from the balance sheet at a disposal price below book value, resulting in a loss on the income statement. In this case, the reported loss is smaller than it would have been if the assets had been sold at rock-bottom prices, and the bank is able to limit the impact of the lack of liquidity in certain markets on its balance sheet and income statements.

Simplified schema of a defeasance structure Bank A Special Purpose Vehicule Assets Liabilities Assets Liabilities

Impaired and/or toxic Impaired and/or toxic Debt assets assets Debt Equity capital Financial markets Other assets Issue of debt Disposal to SPV securities guaranteed Equity capital by shareholders

Interest received on Payment of debt isolated assets servicing

February 2011 Conjoncture 7 (see chart 13). Since the beginning of the financial As in the United States 8 , illiquid and/or highly crisis, the UK banking system has raised about impaired assets following the financial crisis, mainly £151.3bn in equity capital (120.7% of cumulative those of RBS and Lloyds, were isolated within a "bad losses to date), half of which is public funding bank". Yet the UK only set up a virtual bad bank that (£74.6bn). This proportion reached 77% for RBS was not a distinct legal entity. Toxic assets remain on (£45.5bn), 74% for the former HBOS (£11.5bn) and the balance sheets of each of the guaranteed banks, 36% for Lloyds (£11.3bn). in exchange for the payment of a commission, comparable to an insurance premium. Capital injected in UK banks This system, which resembles a pure insurance mechanism more than a classic defeasance £ bn Public funds % structure, nonetheless has the same goals. Both are Private funds 80 Public funds as share of total 100 designed to restore the solvency of banks and to 70 88 allow them to concentrate on their core business 60 75 50 63 while minimising the impact of losses on current 40 50 30 38 operations. The main advantages of the UK 20 25 10 13 mechanism, according to the government, are that it 0 0 can be rolled out relatively rapidly and offer more S s r y ys d e e a y t RB l o HSBC HBOS l ingl L ices B flexible management, because it avoids the question Barc e rd & rd chartered Nothern Rock fo a of valuing toxic assets. nd liance & L a Al Brad St Chart 13 Source: Bloomberg at 17/01/2011 Mixed prospects

The ranking of recapitalisation efforts by country Bolstered by support measures and despite an can be correlated with the size of losses. Public and unprecedented economic contraction, our sample of private capital injections amounted to 1.9% in the UK, banks as a whole swung back into positive territory in behind the United States (3.7%), but far ahead of 2009. Eventually, the government gradual withdrawal Germany (0.9%) and France (0.5%). from the capital of the big banks and the growing importance of non-banking players should lead to a The creation of a virtual "bad bank" reshuffling of the banking sector. In December 2009 the UK government set up a Disparate results in 2009 system of guarantees designed to contain highly impaired bank assets and to authorize their The overall 2009 results of our selection must be autonomous management. Open to resident credit interpreted carefully because they mask wide institutions and to a lesser extent, foreign disparities between banks. Neither of the two loss- subsidiaries, this system was placed under the making groups in 2008 (HBOS and RBS) have responsibility of a government agency, the Asset swung back into profits. In its new configuration, the Protection Agency (APA) 7 . At the Treasury's Lloyds group managed to report a £2.9bn profit in discretion, as part of bilateral discussions with each 2009 thanks solely to an exceptional gain of £11bn bank and after examination by an ad-hoc on the acquisition of HBOS. Barclays also reported commission, all sub-prime loan portfolios and major capital gains on the disposal of assets to the portfolios of asset-backed securities (CDO, CDS, BlackRock investment fund. ABS, MBS, etc.) were eligible for guarantees, above Net banking income, half of which is comprised of a franchise for the first losses. At 31 March 2010, net interest income (see chart 14), increased 13.7% APA covered £230.9bn of the toxic assets held by between 2008 and 2009, buoyed by a slight upturn in RBS, which is 84% state owned, in exchange for a the net interest margin (to 1.3% in 2009 from 1.1% in franchise of £60bn. 2007 and 2008) and from an increase in other Above this franchise, the government would revenue. In 2008, the structure of net banking income cover 90% of any losses and RBS, 10%. was distorted by the collapse of other revenues, but

February 2011 Conjoncture 8 has since returned virtually to normal (see chart 13). Structural net banking income Nonetheless, higher administrative expenses (+3.6%) Largest UK banks of our sample and the cost of risk (+25.7%) weighed down Net interest income Net commissions Other net operating income current income before tax, which was negative both 100 years (£2,991m loss in 2008 and £700m loss in 90 80 2009). 70 In H1 2010, the big banks in our selection all 60 50 reported earnings. Compared to H1 2009, net income 40 of the five largest UK banks declined 16.7% after the 30 20 elimination of exceptional items, which had a positive 10 impact in 2009 (acquisition gain for Lloyds, loss on 0 2005 2006 2007 2008 2009 H1 2010 the buyback of debt for Barclays). Net banking Chart 14 Sources: Bankscope, BNP Paribas calculations income and operating income continued to rise 11.4% and 20.1%, respectively. The cost of risk fell Net interest margin in 2009 significantly (-31.4%). Banks like HSBC and Barclays benefited from %, net interest income to productive assets major gains on their own debt following the widening 3.0 of their credit spread. 2.5 Only two banks have released their Q3 2010 2.0 figures, but they offer a few indications. Unlike in 1.5 2009, Barclays and RBS reported losses on their own 1.0 debt. RBS also reported a charge following a decline 0.5 in the fair value of the Asset Protection Scheme CDS, 0.0 l ly a e K the valuation of which benefited from tighter spreads. g Ita ium U Spain lg ranc ortu e F rmany Ireland RBS reported a Q3 loss of £1,146m after a small H1 P B Ge profit of £133m. Barclays barely managed to remain Chart 15 Source: Bankscope in positive territory with a profit of £49m, after comfortable performances of £1,067m in Q1 and £1,364m in Q2. HSBC simply announced that its Q3 balance sheet structure. The share of customer pretax results would be lower than in Q1 and Q2 deposits accounted for only 29.5% of the balance 2010. sheets of financial and monetary institutions in November 2010, whereas banking systems with Short-term operating conditions remain tough more comfortable margins, such as Spain and , traditionally have a broader deposit base (48.8% and The UK banking sector's capacity to generate 36.4% at the same date). Yet this factor does not recurrent revenues will continue to be restricted in explain the decline in margins because deposits as a 2011 by a squeeze on margins. The cost-income share of total assets have not changed much since ratio will also remain relatively high. the beginning of the decade, which was still characterised by high margins. Greater pressure on margins in 2011 The reason for the erosion of margins has more A preliminary analysis of UK banks shows that to do with the interest rate environment. The relative the average net margin in 2009 had nearly returned weakness of long-term rates (in correlation with the to pre-crisis levels (1.3% in 2009) but was sharply American conundrum) strained the return on assets. lower than at the beginning of the decade. Between Monetary policy tightening in summer 2006 and 2008 and 2009, the improvement was due to a faster especially the liquidity crisis in 2007 and 2008 reduction in interest paid on productive assets significantly increased the cost of resources. The (+1.2% in 2009 down from +1.7% in 2008) than in inversion of the yield curve between mid-2004 and interest received (+2.4% down from +2.8%). It is late 2008 also significantly squeezed margins. Lastly, tempting to link the relative weakness of UK banking although the arrival of banking and non-banking margins (see chart 15) to their rather unfavourable players (see below) has not called into question the

February 2011 Conjoncture 9 Aggregated income statement for the largest UK banks 2005 2006 2007 2008 2009 H1 2009 H1 2010 In billions of pounds sterling Net banking income 99.3 107.5 117.0 120.3 136.8 79.7 88.8 Of which: net interest income 51.4 53.0 58.0 80.8 67.5 38.8 44.5 Of which: net fees and commissions 23.1 25.7 30,1 33.4 31.2 17.8 19.2 Of which: other net operating income 24.9 28.8 29.0 6.1 38.2 23.1 25.1 Operating expenses 52.7 56.2 62.6 79.6 82.5 46.3 48.7 Of which: staff expenses 28.2 31.2 34.4 41.0 42.8 24.7 26.4 Of which: other operating expenses 24.5 25.0 28.2 38.5 39.6 21.7 22.3 Gross operating income 46.6 51.3 54.5 40.7 54.3 33.4 40.1 Cost of risk 10.9 13.0 17.1 43.7 55.0 34.1 23.4 Profit before exceptional items and taxes 35.6 38.3 37.3 -3.0 -0.7 -0.7 16.8 Non recurring income and exceptional items -0.1 0.8 3.2 -33.2 11.3 16.3 1.9 Tax expenses 7.0 10.0 10.8 8.5 0.9 0.2 7.1 Minority interests 1.0 1.5 1.7 -8.6 2.9 2.2 0.5 Net income attributable to equity holders 27.6 27.7 28.1 -36.0 6.8 13.2 11.0 Table Source: Bankscope – Calculation: BNP Paribas

Sample 2005 – 2008 : HSBC, RBS, Lloyds, Barclays, HBOS, Standard Chartered Sample 2009, 1st semester 2009 and 1st semester 2010 : HSBC, RBS, Lloyds, Barclays, Standard Chartered

predominance of the incumbent players in the short the M&A movement in the banking sector following term, it has stepped up competitive intensity, making the financial crisis, while potential synergies from it harder for the big banking groups to extract margins these operations will only be realised over the long from the domestic market. term. Despite the monetary status quo, net margins For example, the probably tightened in 2010 due to fiercer competition. acquired part of ABN-Amro's business in 2007. The expected tightening of monetary policy in late Barclays purchased some of the activities of Lehman 2011 will also squeeze margins further, even though Brothers after its collapse. And Lloyds, encouraged the yield curve should remain positive. This trend, by both the government and the Financial Service combined with a decline in credit volumes (debt Authority, purchased HBOS for £12.2bn in 2008 9 reduction in the private sector), would limit the growth even though it was highly dependent on the liquidity of net interest income. market and had significant exposure to the real estate market. This acquisition even required first Restructuring strains cost-income ratios amending the competition regulations. The average cost-income ratio for the banks in Some risks persist our selection (see chart 16) increased sharply from 53.5% in 2007 to 66.1% in 2008, mainly due to a The financial crisis highlighted the limits of a 27.1% increase in administrative expenses. The ratio business model based on excessive debt. Initially remained high at 60.3% in 2009 and at 54.8% in H1 private, this debt was eventually transferred to the 2010. The increase in charges can be attributed to public sector via bank rescue packages. Although the

February 2011 Conjoncture 10 Cost/income ratio UK loans to the private sector (% of NBI) (y-o-y % change) 70 50 Total non-financial agents 60 40 Non-financial firms Households 50 30 20 40 10 30 0 -10 20 -20 10 -30 0 -40 2005 2006 2007 2008 2009 H1 2010 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Chart 16 Source: Bankscope Chart 18 Source: ECB

Debt ratio of non-financial agents The correction in real estate prices is not over yet (% of GDP), annual average in the UK (Ratio house prices/rent, 100 = H1 1999)

100 Households France * ratio of house prices to gross household Non-financial firms disposable income 90 General Government 200 Spain 80 Euro Zone 70 180 Germany 60 160 50 USA S&P* 140 40 UK Halifax* 30 120 20 100 10 0 80 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Chart 17 Sources: BoE, ONS, BNP Paribas calculations Chart 19 Sources: Eurostat, ECB, CGPC, BNP Paribas calculations solidity of the banking sector has been reinforced, still displaying a weak recovery (unemployment rate there are still several major risks. of 7.7% in Q3 2010), the banks could be hit by an increase in the default rate, notably those with the Credit risk is still significant highest exposure to the domestic market (Lloyds With the downturn in economic and housing and RBS). On the contrary, more geographically market cycles, this dynamic debt momentum (see diversified banks should be able to continue chart 17), and in particular, high exposure to the benefiting from powerful sources of international home mortgage market (see chart 18), triggered a growth, even though some emerging countries risk deterioration in the quality of bank assets. The boom overheating. in securitisation also resulted in a much broader Although the banking sector managed to swing distribution of risks within financial establishments. back into earnings in 2009 despite a sluggish Three years after the outbreak of the crisis, the economy, current debt reduction efforts by non- combined efforts of the authorities (government financial agents and budget reform measures10 will support packages and monetary policy) and the increase uncertainty over the recovery of economic banks (drastic cost cutbacks) have unquestionably growth and the bank profitability. Further constraints enabled the sector to weather the crisis with as little could also be imposed by a tighter regulatory damage as possible. framework, in the wake of new national and Basel Yet, caution is advised in the future for several requirements (see box 2) and from a Bank Tax based reasons. So far, the domestic real estate market on assets11. Lastly, the relative consensus among has not seen any corrections as severe as the ones analysts' estimates suggests that new Basel liquidity in the United States (see chart 19). Persistently high requirements (LCR and NSFR) could imply significant real estate valuations suggest that another adjustment measures, a characteristic nonetheless correction cannot be ruled out. With the economy shared by most of the major banking systems. Yet

February 2011 Conjoncture 11 Box 2: the new Basel III regulations

Following G20 meetings in Pittsburgh and , the governments of the world's main economic powers expressed the desire to strengthen banking regulatory standards12. The Basel Committee on Banking Supervision (BCBS) reviewed the main principles of the proposals by the G20 countries and systematised key points to deploy a stronger regulatory framework. In December 2009, the Basel Committee made a series of proposals on capital adequacy requirements and standardized monitoring of liquidity risks which were presented to the public in a consultative document (closed 16 April 2010). Two impact studies were also conducted. Last September, the Basel Committee revealed the new regulatory framework that will be applicable to banks as of 201313 , although the application timetable will extend through 2019. Capital adequacy requirements will be tightened as of 2013. They reflect a stricter definition of regulatory capital (non-eligibility of certain hybrid securities, additional deductions, etc.), set up capital conservation and contra-cyclical buffers, which in a macro-prudential framework take into account the macroeconomic risks associated with excessive lending (bank indebtedness and debt securities), and lastly, introduce stricter criteria that will increase weighted risks. In the end, common equity Tier 1 capital requirements will be raised to 7% of risk weighted assets by the end of the application timetable on 1 January 2019. Lastly, systemic establishments, i.e. banks that are "too big to fail" without disrupting stability of the financial system, could be required to provide an additional capital buffer depending on the applicable terms (size, interdependence and absence of a substitute) which must be specified by the Basel Committee by mid 2011. In addition to strengthening equity capital requirements, the Basel Committee also introduced new bank liquidity requirements, a short-term one, the Liquidity Coverage Ratio, which requires banks to hold sufficient liquid assets to cover 30 days of net cash flows, and a medium-term one, the Net Stable Funding Ratio, which requires banks to mobilise long-term or stable resources to finance their medium-term applications. Lastly, a leverage ratio was also introduced (equity capital/ total assets). Yet, since this ratio does not take into account risks and depends closely on accounting practices, it would be preferable if it were simply "an additional supervision indicator for the national regulator and, as such, appear in Pillar 2".14 the situation of individual banks seems to be very be seen in the commitments of financial and mixed. Unless they can obtain the long-term or stable monetary institutions to non-residents as a share of resources required by the new regulations, certain total assets, which is particularly high at 37.3%. The banks could be forced to undergo strategic hedging big banks should continue to operate new sources of to reduce the size of their balance sheets. growth outside of Europe, notably in Asia. Lastly, there is still significant credit risk. Bank of According to the statistics of the Bank of England statistics show that although losses on loans International Settlements (BIS), UK bank by banks, investment companies and building commitments to non-residents (bank and sovereign societies certainly declined to £3.6bn in Q3 2010 risk) amounted to $3,781.7bn on an ultimate-risk from £5.2bn in Q4 2009, they are still higher than pre- basis15 at 30 June 2010 (15.4% of all international crisis levels (which averaged about £2bn over the debt recorded by the BIS), which places the UK period 2005-2006). Nonetheless, the relative banking system ahead of the United States (12.6%), improvement in economic prospects should limit the Germany (12.2%) and Switzerland (6.5%). It has the cost of risk in 2011 (see chart 8). highest exposure to Ireland (3.5% of total debt, 6% of GDP and 1.5% of total banking assets) and Spain Direct exposure to the peripheral countries is still (2.8% of total debt, 4.8% of GDP and 0.9% of total rather high banking assets) (see chart 20). The existence of a major colonial empire until the The UK bank's direct exposure to the "peripheral" mid-20th century and the long tradition of countries (Spain, , Ireland and Portugal), international trade that this engendered still explains currently the focal point of much concern, has declined the openness of the UK banking sector to the rest of since December 2008, but is still rather high. At the the world. The high degree of internationalisation can end of June 2010, they accounted for 7.2% of total

February 2011 Conjoncture 12 Holding of "peripheral" claims by UK banks UK stock market performance (100 = January 2000)

% of total foreign claims, % of GDP & % of total banking assets 18 160 Spain Greece 16 Ireland Portugal 140 14 Dec. Dec. Dec. Dec. Dec. June 120 12 2005 2006 2007 2008 2009 2010 100 10 8 80 6 60 4 40 FSTE - Total 2 20 FTSE - Banks Stocks 0 % % % % % % % % % % % % % % % % % % 0 OF OF OF OF OF OF OF OF OF OF OF OF OF OF OF OF OF OF TOTAL GDP ASSETS TOTAL GDP ASSETS TOTAL GDP ASSETS TOTAL GDP ASSETS TOTAL GDP ASSETS TOTAL GDP ASSETS 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Chart 20 Sources: BIS, OECD & Datastream, BNP Paribas calculations Chart 21 Source: Datastream foreign debt held directly ($270.7bn), equivalent to by selling off several of its activities, for the most 12.4% of GDP and 2.6% of total assets of UK banks part belonging to the former Dutch bank. Northern (compared to 16.9% and 2.2%, respectively, in Rock, the first bank to be nationalised after the December 2008). The exposure of UK banks to the outbreak of the financial crisis, is also expected to peripheral countries is slightly less than that of German be privatised again in H1 2011, and talks are banks (12.9% of GDP and 4.2% of total banking underway with the UKFI16. assets) but much higher than for Swiss banks (6.3% of Lifted by renewed optimism in early 2010, the GDP and 1.2% of total banking assets). market value of UK bank stocks has picked up (see In the short term, the risk of a pure default seems chart 21), notably in H1 2010, albeit without returning relatively unlikely now that a series of collective to pre-crisis levels before the end of the year. In the public actions (successive ECB interventions, IMF end, the upturn in market prices, which reflects the assistance and launch of the FESF) have already improvement in earnings, makes it a more opportune been deployed. In the longer term, however, we movement to sell off public stakes, despite ongoing cannot exclude the possibility that debt maturities will doubts about the financial solidity of certain banks be rescheduled. that have received support from public funds. The precise timetable for selling off public stakes has not Towards a new banking landscape been clearly defined yet, but according to the assumptions of the Center for Economic and The government could begin to gradually sell off Business Research (CEBR) in August 2010, the its equity stakes. At the same time, non-banking government could post a capital gain of about £19bn players are currently moving into a fast-changing if the disposals were gradually made over the next banking environment. five years.

Government stakes could be sold off soon Retail banking: an increasingly contestable After a series of nationalisations in 2008 and market 2009, it is now time for the government to gradually The UK retail banking market is characterised by sell off its equity stakes in banks. The leaders of the growing presence of foreign players. The Spanish RBS, in consultation with the government, have group Santander, which paid £1.65bn for 318 already expressed their determination to begin the branches of Royal Bank of Scotland (RBS) in August privatisation process as of 2011. The European 2010, is not entering unchartered waters. Its Commission has also imposed disposals on Lloyds technological infrastructure, for example, should and RBS in exchange for the financial support enable it to realize synergies in the medium term. received during the crisis. Condemning the With the acquisition of Abbey in August 2004, acquisition of ABN-Amro by its predecessors, the Alliance and Leicester in August 2008 and Bradford & new RBS management team has set the bank on Bingley's retail network and savings division of in the road to a new strategic positioning since 2009, September 2008, the Spanish group already has

February 2011 Conjoncture 13 1,300 branches. This acquisition policy can also be The UK banks were hard hit by the brunt of the seen as testimony of its optimism in the growth financial crisis in 2008. The authorities reacted prospects offered by the UK market in terms of promptly and massively, but their efforts did not margins and profitability. prevent the shock wave from spreading to the real Several retail players have also expressed their sphere, after a lag of a few quarters. UK GDP interest in making a long-term investment in the retail contracted by an unprecedented 4.9% in volume in banking market, gambling on their ability to win over 2009. Monetary easing, the injection of public capital consumers whose confidence has been shaken by the and the creation of a virtual "bad bank" nonetheless financial crisis. prevented the collapse of the financial sector. In Metro Bank, a subsidiary of the eponymous retail support of this shock treatment, the situation in the group, opened its first branches at the end of July 2010 UK banking sector is now returning to normal, and offered an innovative range of services (longer store although major disparities still exist between banks. hours, open seven days a week, and a more rapid Despite sector restructuring, several threats still loom handling of operations). Metro Bank has said that it will over future profitability, notably the intensification of stay away from the banking branches put up for sale by competition, persistent sources of risk and tighter the incumbent players (RBS in particular), basing its prudential regulations. business model instead primarily on organic growth. The At the end of a period characterised by an Virgin Group, in contrast, seems to prefer an external exceptional surge in bank assets, with virtually a growth strategy. Virgin purchased the regional bank tenfold increase in bank assets as a share of GDP Church House Trust for £12.3m in December 2009, since the beginning of the 1970s, UK banks have one which it will use as a beachhead to develop its retail of the highest profitability rates on an international banking business. Lastly, the Tesco group, the UK's scale. Economic growth and strategies to focus on leading retail chain, wants to impose itself as a key core business and streamline operations are the player in retail banking, via growth through acquisitions main keys to this success. But the crisis will leave a by its subsidiary Tesco Bank. lasting mark, and in the future, UK banks surely will In the wake of the crisis, numerous establishments not be able to repeat their past performances. Debt were eliminated or lost their independence (through must be reduced in both the private and public acquisitions or mergers), including listed banks as sectors, which could strain loan volumes and well as mutual banks. This concentration movement recurrent banking revenues. The real estate market has benefited a small number of groups and attracted correction, put on hold through massive injections of greater monitoring by the public authorities. The liquidity, has clearly not run its course. The economic authorities are encouraging competition and the recovery looks sluggish and the financial environment installation of new players in the retail banking remains uncertain. Looking beyond the direct impact segment. These new arrivals are unlikely to call into of the crisis, the tightening of prudential regulations question the predominance of the incumbent players, will force the banking sector to strengthen its capital at least not in the short term, although their growing base and limit the transformation of maturities, presence could hinder the rebuilding of thereby restraining the size of balance sheets and intermediation margins, which have eroded sharply financing as well as profitability. over the past decade. Completed, 10 February 2011 [email protected]

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February 2011 Conjoncture 14 Bibliography

Kodres L. and Narain A. [2010], "Redesigning the contours of the future financial system", IMF Staff Position Note SPN/10/10, August Amenc N. and Sender S. [2008], "Les mesures de recapitalisation et de soutien à la liquidité du secteur bancaire européen", December, Edhec Business School: http://www.lesechos.fr/medias/2008/1203//300313840.pdf Bank of England [2010], "Financial Stability Report", Issue N°28, December: http://www.bankofengland.co.uk/publications/fsr/2010/fsrfull1012.pdf Choulet C. and Quignon L. [2009], "European banks: support plans to be tested by recession", BNP – Paribas Conjoncture, January: http://www.imf.org/external/pubs/ft/spn/2010/spn1010.pdf D’Arvisenet P. [2011], "The Sovereign Debt Crisis in Europe", BNP – Paribas Conjoncture, January Newhouse-Cohen C. [2010], "Worse lies ahead", BNP – Paribas Conjoncture, September Nier E.W. [2009], "Financial stability frameworks and the role of central banks: lessons from the crisis", IMF Working Paper WP/09/70, April: http://www.imf.org/external/pubs/ft/wp/2009/wp0970.pdf OECD [2009], "OECD Economic Research: UK", June OECD [2009], "UK Economic Research: 2009" Summary, June: http://browse.oecdbookshop.org/oecd/pdfs/browseit/1009092E4.PDF Quignon L. [2008], "Banks in the financial crisis, Act 2", BNP – Paribas Conjoncture, October – November Quignon L. [2010], "Basel III: capital requirements not without impact", BNP – Paribas EcoWeek 10-37, September Quignon L. [2005], "UK banks at the peak of profitability", BNP – Paribas Conjoncture, March Ötker-Robe I. and Pazarbasioglu C. [2010], "Impact of regulatory reforms on large and complex institutions", IMF Staff Position Note SPN/10/16, November: http://www.imf.org/external/pubs/ft/spn/2010/spn1016.pdf Sabuco P. [2008], "UK banks and the sub-prime crisis", BNP – Paribas Conjoncture, July Sabuco P. [2010], "Ireland, the debt legacy", BNP – Paribas EcoWeek 10-40, October Sabuco P. [2010], "Irish banks: another look at the Celtic mirage", BNP – Paribas Conjoncture, December

February 2011 Conjoncture 15 NOTES

1 Our sample comprises the largest credit institutions in terms of Tier 1 capital: - 2005-2008: Barclays, HBOS, HSBC Holdings, Lloyds Banking Group, RBS Group and Standard Chartered - 2009-2010: Barclays, HSBC Holdings, Lloyds Banking Group (including the former HBOS), RBS Group and Standard Chartered. 2Securitisation is a financial technique in which a non-negotiable debt portfolio is made negotiable on the financial markets. In addition to the cash obtained, securitisation operations transfer debt portfolios from bank balance sheets to investors (in general ad hoc structures known as Special Purpose Vehicles), which enable banks to increase the volume of loan distribution without increasing their balance sheets and/or without first having to increase their equity capital. 3 CRDII was transposed into national law in October 2010: http://www.legislation.gov.uk/uksi/2010/2628/introduction/made 4 Gains or losses on derivatives and other securities excluding gains or losses on assets at market value per year. 5 Source: Financial Services Compensation Scheme: http://www.fscs.org.uk/what-we-cover/eligibility-rules/compensation- limits/deposit-limits/ 6 Bloomberg data. 7 Information on the status and functioning of this government agency is available on the UK Treasury website: http://www.hm- treasury.gov.uk/apa.htm 8 The Paulson Plan, also known as the Troubled Asset Relief Program or TARP, consisted of creating a structure pooling together the toxic assets of financial institutions. 9 Due to legal constraints, the operation was not finalised until 2009. 10 In October 2010, the UK government announced an unprecedented austerity plan that aims to reduce spending by £81bn by 2015 in order to reduce the public deficit from 10.1% in 2010-2011 to 2.1% in 2014-2015. The measures announced by George Osborne, Chancellor of the Exchequer, include the elimination of nearly 500,000 public sector jobs, postponing the retirement age from 65 to 66 by 2020 and budget cutbacks that could reach as high as 20% over 4 years in some ministries. 11 The Bank Tax could bring in about £2.5bn net per year. This measure would consist of taxing financing of less than one year at 0.07% and longer term debt at 0.035%. 12 See the G20 press release, "Declaration on strengthening the financial system – London, 2 April 2009": http://www.g20.org/Documents/Fin_Deps_Fin_Reg_Annex_020409_-_1615_final.pdf 13 See EcoWeek of 17 September 2010 by Laurent Quignon for a detailed presentation of the new capital adequacy requirements. See also the BIS press release of 12 September 2010, "Group of Governors and Heads of Supervision announces higher global minimum": http://www.bis.org/press/p100912.pdf 14 Press release by the French Banking Federation (FBF), 20 April 2010: http://www.fbf.fr/web/Internet2010/Content.nsf/DocumentsByIDWeb/87MDV6?OpenDocument 15 According to the BIS definition, on an ultimate-risk basis, the geographic classification of a foreign claim is the residence of the guarantor of the financial claim or the country where the head office is legally located, and not the immediate borrower's country. The debtor bank can be legally tied to a guarantor whose place of residence is different from that of the immediate borrower. Foreign debt includes claims granted to foreigners and the financial assets held on behalf of foreign entities (debt securities and capital). 16 Northern Rock was split into two entities, a bad bank pooling together its real estate loan activities and a healthy entity comprised of the group's retail banking business, which could be reprivatised at an estimated minimum of €1.4 bn.

February 2011 Conjoncture 16 Economic Research Department Philippe d'ARVISENET 33 1.43.16.95.58 [email protected] Chief Economist – OECD countries

Jean-Luc PROUTAT 33 1.58.16.73.32 [email protected] Head of OECD countries

Caroline NEWHOUSE-COHEN 33 1.43.16.95.50 [email protected] Country economics

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UNITED STATES, CANADA Jean-Marc LUCAS 33 1.43.16.95.53 [email protected] JAPAN, AUSTRALIA, NEW ZEALAND, BENELUX, PENSIONS, LONG TERM FORECASTS Raymond VAN DER PUTTEN 33 1.42.98.53.99 [email protected] EURO ZONE, ITALY, EUROZONE LABOUR MARKET Clemente De LUCIA 33 1.42.98.27.62 [email protected] FRANCE, EURO ZONE PUBLIC FINANCES Frédérique CERISIER 33 1.43.16.95.52 [email protected] GERMANY, AUSTRIA, SWITZERLAND, EU ENLARGEMENT Catherine STEPHAN 33 1.55.77.71.89 [email protected] SPAIN, PORTUGAL, GREECE, IRELAND Thibault MERCIER 33 1.57.43.02.91 [email protected] , NORDIC COUNTRIES Caroline NEWHOUSE-COHEN 33.1.43.16.95.50 [email protected]

BANKING ECONOMICS Laurent QUIGNON 33 1.42.98.56.54 [email protected] Head Céline CHOULET 33 1.43.16.95.54 [email protected] Laurent NAHMIAS 33 1.42.98.44.24 [email protected]

COUNTRY RISKS Guy LONGUEVILLE Head 33 1.43.16.95.40 [email protected]

François FAURE Deputy Head 33 1.42 98 79 82 [email protected] Capital flows to emerging markets, ASIA Delphine CAVALIER 33 1.43.16.95.41 [email protected] Christine PELTIER 33 1.42.98.56.27 [email protected] LATIN AMERICA Sylvain BELLEFONTAINE 33 1.42.98.26.77 [email protected] Valérie PERRACINO-GUERIN 33 1.42.98.74.26 [email protected] AFRICA Stéphane ALBY 33 1.42.98.02.04 [email protected] Jean-Loïc GUIEZE 33 1.42.98.43.86 [email protected] EASTERN EUROPE Central Europe, Baltic countries, Balkan countries Alexandre VINCENT 33 1.43.16.95.44 [email protected] RUSSIA, FORMER SOVIET REPUBLICS Anna DORBEC 33 1.42.98.48.45 [email protected] MIDDLE EAST – SCORING Pascal DEVAUX 33 1.43.16.95.51 [email protected]

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