January 13, 2009 11:16 pm

‘Bad bank’ plan could stimulate UK lending

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British politicians are desperately trying to encourage the country’s banks to lend more. To succeed, however, they may first need to tackle the loans that lenders already have on their books.

That is the logic behind a growing debate about the merits of the UK government setting up a “bad bank” to absorb Britain’s troubled loans.

In spite of a series of increasingly radical steps to prop up the banking system, ministers and regulators have failed to restore the flow of credit to the UK economy.

There are many reasons. The drought in the wholesale markets has made it difficult and expensive for banks to finance new lending. Foreign banks and niche lenders have fled the market. Meanwhile, the economic slump means the remaining large banks are increasingly cautious.

However, banking executives are also concerned about the quality of the loans already on their balance sheets. As the economy deteriorates, more of those loans risk going bad.

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The problem is amplified by the sophisticated systems that banks and regulators use to measure capital.

Under the Basel II framework, banks estimate the likelihood that a borrower will default, and the likely size of any loss. This determines the size of the bank’s risk-weighted assets that it uses to calculate how much capital it needs to hold.

But banks’ capital models are not static. They are constantly updated with new data about how loans are performing. In a recession, banks’ risk-weighted assets are likely to expand. This, in turn, makes their capital reserves look smaller.

The recent bail-out of Commerzbank illustrates the problem. Last week the German lender, which is buying Dresdner Bank, asked the German government for another €10bn ($13bn) capital injection.

This appears to have been triggered by deteriorating loans and the effects of exchange rate fluctuations on the bank’s balance sheet. Citigroup estimates that the combined risk-weighted assets of Commerzbank and Dresdner expanded by at least a quarter in the final three months of 2008.

The uncertainty about future balance sheet moves has made British banks understandably nervous about deploying their capital, says Carla Antues da Silva, an analyst at JPMorgan.

She says: “While the recent recapitalisations are designed to create a ‘buffer’ to absorb potential losses in a ‘stress’ scenario, it is virtually impossible to determine how bad things could get whilst all the balance sheet risks remain.”

Ms da Silva argues this can be addressed only if the British government removes potentially troubled assets from banks’ balance sheets by placing them in a state-backed “bad bank”.

This would free the banks’ balance sheets, allowing them to start lending again. JPMorgan reckons £260bn ($378bn) of ‘bad’ assets held by British banks represent 15 per cent of their total assets, but account for 58 per cent of risk-weighted assets.

The bad bank concept has its drawbacks, however. British banks would probably have to write down the value of any loans they transferred, eroding their capital.

The state would also have to issue large amounts of government bonds to finance the purchase, greatly increasing the national debt. The plan would also be likely to face political resistance, similar to the outcry that almost derailed the US Treasury’s troubled asset relief programme.

An alternative suggestion receiving close attention from some policymakers is for the government to insure banks against large losses on existing loans. This idea, similar to recent bail-outs of UBS and Citigroup, involves the government agreeing to absorb losses above a certain level on a defined loan portfolio.

Because future losses would be capped, banks could hold less capital against these assets. And the government would have to step in only if losses materialised, meaning the commitment would not immediately add to the national debt.

The drawback is that, unlike the bad bank, the insurance cannot remain in place indefinitely.

Whatever form it takes, setting up a “bad bank” would be a radical option for the British government. However, if the credit crunch does not ease soon, ministers may have little choice. Jonathan Pierce of Credit Suisse wrote in a recent note: “If initiatives work we will see a rally in the banks. If they don’t, it is questionable whether further capital injections could work and a jump to nationalisation might loom large.”

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