The seven things you need to know about the Financial Stability Report

The best thing about the Bank of England’s Financial Stability Report is the brilliant charts it includes about the state of the financial system. To save you from reading the whole thing, here, in no particular order, are some of the most striking ones.

1.Things are getting (a bit) better.

The good news is that the financial system is getting a touch healthier. As you can see from the chart above, the perceived chance of a “high-impact event” in the UK banking system has fallen sharply since this time last year. And, as you can see below, the funding gap between banks’ deposits and their lending – the key metric of financial vulnerability ahead of the crisis, has narrowed to the lowest level on recent record.


2. But banks still need more capital

This is the chart from the report which is probably going to get the most attention in tomorrow’s newspapers. It shows Bank calculations that British banks may have been overstating the value of certain risky assets they hold in their balance sheets by as much as £35bn. That’s one of three elements of why the Bank believes the banks will have to raise more capital, as I write about here.

3. A fifth of commercial property loans are in negative equity

If you wanted evidence of the ill health of the commercial property market you can find it in this graph, showing just how large a proportion of commercial property loans (20%) have a loan to value ratio of over 100% – eg are in negative equity.

4. British banks are still highly exposed to the eurozone

This chart might help answer the question of why we ought to be worried about an economic crisis of any sort in the euro area. As you can see, RBS and Lloyds have tens of billions of pounds worth of exposure to Ireland; Barclays has major exposure to Spain and Italy.

5. Who has increased lending in the UK?

This chart shows you that since 2009, Barclays, HSBC and Banco Santander have both increased their lending to UK customers (the dark blue part of each bar). But this has not been not enough to offset the drop in lending by RBS and Lloyds.

6. UK households are far less indebted than other countries around Europe

It might surprise you to learn that household debt in Britain is actually lower (as a percentage of disposable income) than in many other countries around the world, including the Netherlands, Norway, Sweden and Australia. In fact, it’s barely higher than in Canada, home to the Bank’s next Governor, Mark Carney.

7. Value creation and the banking system

This chart builds on a point made by Andy Haldane a number of times: banks have not produced much, if any, extra value, set against the amount of assets they have in their balance sheets. The key thing here is to note that the x axis represents return on equity: this means that if you invested in bank shares (the pinky purple dots) you would have received a decent return between 2000 and 2011. But in comparison to assets, banks have created next to no value, while other non-bank companies (the blue dots) have created lots of value.

It underlines the point Lord Turner made a couple of years ago: a lot of what banks do is, effectively, socially useless.

This is what Mark Carney should be most worried about

Much ink has been spilled about the “enormous challenges” facing Mark Carney in his new role as Bank of England Governor – but I’m afraid to say that most of it has missed the point.

The challenges everyone’s tended to focus on so far have been the country’s financial problems – the broken banking system – and its broken economy. And while it’s right that these will be considerable issues facing the new man at Threadneedle Street, for me the biggest challenge he faces is something far more important.

The Bank of England is sitting on a bed of financial nitroglycerine. And the smallest misstep from the Canadian could cause a crisis that would dwarf anything we’ve seen over the past few years.

The explosive stuff I’m talking about is the record amount of Government debt – gilts – sitting in the Bank’s own bank account.

The Bank of England has the biggest proportionate stock of Government debt in the world – bigger than Japan, bigger than the US. You can see the situation from the pie chart above from a recent working paper by Jochen Andritzky of the IMF [pdf]. If you want to compare Britain internationally, see the whole load of pie charts below.

In short, the Bank of England owns more than twice the amount of government debt (19.7% of the total debt stock and rising – in case you have trouble with the colour scheme above) of its nearest counterpart, the Bank of Japan.

This debt is, of course, the consequence of the Bank’s quantitative easing programme, under which it’s been creating money and buying up Government debt, in order to attempt to stimulate the economy.

Why does that matter? Because in many ways this is precisely what happened in Weimar Germany in the 1920s and Zimbabwe in the 2000s: when the central bank buys up government debt, it often leads in turn to hyperinflation and an international capital crisis (investors refusing to buy your debt).

The difference (and it is an absolutely fundamental one) is that in Britain’s case, the central bank is not buying up Government debt specifically in order to help finance the state. It is doing it in order to carry out its own job of getting the economy going. In this, the Bank is broadly regarded as independent from the Government – something Sir Mervyn King has generally reinforced with the occasional public sideswipe at one or other politician.

But the moment anyone starts to question the Bank’s impartiality in holding this Government debt – if the Bank of England Governor blinks, if there is any hint of collaboration with the Treasury to help it with the deficit – that independence, the key thing separating Britain from Weimar Germany is threatened.

That is the real problem Mark Carney will have to wrestle with when he takes up office. Given how much more government debt the Bank owns than any other central bank around the world, it is far more incumbent on him than any of his counterparts to maintain his independence.

Because if investors convince themselves he and the Treasury are in cahoots to monetise the deficit, then Britain is in serious, serious trouble.

What was really agreed last night in Brussels

On the basis that if Jean-Claude Juncker denies something, it’s probably true, it’s worth examining the deal cranked through Brussels last night to “save” Greece. Juncker and his fellow eurocrats insist it doesn’t involve any debt forgiveness for the benighted country.

And that’s odd, since the more one examines it, that’s precisely what this looks like. As a result of this deal, eurozone governments (in other words taxpayers) will have to take a hit on the billions of euros of loans they’ve given to Greece. Whatever name you give to it, euro member states will forfeit a hefty chunk (Dario Perkins at Lombard Street Research reckons it amounts to a potential €12bn) of cash.

Here’s the simple version of the story: euro governments will voluntarily allow the Greeks to pay lower rates on their bail-out loans; they will also donate (not loan) Greece the proceeds they earn from the European Central Bank’s bond-buying programme. Greece will not have to pay as much cash back; the lenders will not get as much cash back.

Were this a private sector loan agreement, the probability is this would be regarded as a technical default.

But this being Brussels, that simple story has been shrouded with just enough to complexity to bamboozle the majority of outsiders into believing it really is a pain-free solution. Here, for those with the sanity to avoid the communique [pdf], is how it works.

  • The interest rate on the original loans to Greece will be lowered by 100bps, which will save the Greek government/cost euro governments €4.2bn by 2020 (the sums here are from LSR – don’t expect anything as blunt as numbers from the eurogroup)
  • The guaranteed fee costs paid by Greece on its EFSF loans will by cut by 10bps. (around €600m)
  • The maturity on bilateral and European Financial Stability Facility loans will be doubled from 15 to 30 years, with a deferral of 10 years on EFSF loans  Paying the loans off more slowly will save Greece large sums, although that depends on whether the deferred interest payments are accrued – the communique is unclear on this.
  • EU member states will return Greece the profits they make on Greek bond purchases under the SMP. LSR reckons this is worth around €7bn.
  • Greece will now get the latest tranche of its bail-out cash (remember, the stuff above refers to previous bail-out money), worth €43.7bn euros.
  • It will also be allowed to buy back some of its debt at a knock-down price – although there is a big question about where it will actually get the cash to do that, probably the EFSF. There is also a bigger question about how much Greek government debt is actually out there to be bought, since most of it is already owned by the very European institutions who would be lending Greece the money to buy it back. According to Raoul Ruparel of Open Europe probably only about 10% of the country’s bonds could be eligible for purchase.
  • Meanwhile, the eurogroup deferred the existing target for Greece to get back to a 4.5% of GDP primary surplus (eg when debt payments are ignored) from 2014 to 2016. The special escrow account into which Greece must pay its debt repayments will be strengthened, but, crucially, there’s no specific effort to try to recoup the billions of euros the euro members will forgo as a result of all of the above.

The upshot of all of this will, according to the communique, be to get the country’s net debt down to 124% by 2020, which is lower than the 120% target Christine Lagarde had been arguing for previously.

But while the International Monetary Fund MD might be disappointed about that, she can at least be reassured that the IMF won’t lose any money as a result of last night’s deal. The entire €12bn or so hit will be absorbed by European governments, since they recognise that to allow the IMF to lose any money would cripple the credibility of the institution entirely.

Because the IMF won’t lose anything, that means Britain’s contribution to the bail-out is also safe. It will receive all its interest repayments precisely as was always agreed.

Anyway, when you run through all of the above it’s hard to escape the conclusion that what was agreed last night was a kind of stealth debt forgiveness.

Greece is so deeply mired in the credit quagmire, and so trapped in a depression worse than the Great Depression, that, eventually, its lenders will probably have to go the whole hog and write off principle amounts of debt. But for the time being, the best they can do is to subtly reduce the interest and maturity element of what’s owed.

The subtlety is necessary here because to have completely forgiven the debt ahead of the German election would have been political suicide for Angela Merkel.

And, on balance, you have to say that what was agreed last night was, at least, a step in the right direction. As I’ve written before, at some point Greece’s enormous debts will have to be written off – whether through agreement or default. The sooner Europe faces up to that, the better.

Mark Carney: should we believe the hype?

“The best central banker in the world” – The Economist on Alan Greenspan, 2000

“The outstanding central banker of his generation” – George Osborne on Mark Carney, 2012

Is anyone else out there taken aback by the almost universal adulation of Mark Carney, the incoming Bank of England Governor?

I’m not suggesting Carney isn’t worth the money or effort that’s gone into his recruitment. There’s no doubt the Canadian financial system performed well during the crisis. No bank was bailed out; the country recovered its pre-crisis peak faster than any other major developed economy.

But to lay that at the feet of a single individual – whether explicitly or implicitly – is a foolhardy exercise. Remember the adulation with which Alan Greenspan or Gordon Brown were regarded for their handling of their respective economies until a few years ago?

The reality is that it is rare, to put it mildly, for an individual to have single-handed sway over an entire economic system. They are more often beneficiaries (or victims) of a combination of circumstance and deep-seated systemic features.

Canada’s economic and financial success surely owes something to Mark Carney, to his slightly more intrusive nature of bank regulation, to his clarity on the future level of Canadian interest rates.

But it also owes something to powers beyond his control: the country has long had a culture of sensible banking: back in the Great Depression only a few, small Canadian banks failed. The system is smaller and more manageable than the American or British systems. And the economy has benefited from the commodity boom, just as its fellow Commonwealth nation Australia did.

As I’ve said, the last thing I want to do is to do down Osborne’s achievement in hiring such a highly-rated individual. And that may well benefit the institution of the Bank, which could undoubtedly do with a change of leadership.

But don’t expect him to single-handedly save the UK economy. As we learnt to our cost with Greenspan and Brown, we are far too quick to worship false idols when it comes to economics

Mark Carney: How Osborne got his man

Until last month, George Osborne had more or less given up hope of persuading Mark Carney to come over to the UK to succeed Sir Mervyn King as Bank of England Governor.

As a result, the mood in Downing Street was one of depressed resignation: all of the other candidates, while worthy, had niggling flaws.

Paul Tucker, the deputy governor and runaway favourite, was tainted by his handling of the Libor crisis – and having been a Bank insider since the beginning of his career, wasn’t the obvious choice to shake the institution up. Lord Turner had been at the FSA during much of the crisis, and Treasury insiders suspected he would spend most of his time as Governor lecturing them.

Carney had the virtue not merely of being an outsider, but of having the entire suite of abilities to do the job: a fine economics pedigree from Harvard and Oxford; a stint in the City showing he understood how finance really works; a period as chairman of the Financial Stability Board, overseeing international finance.

And, most of all, as Bank of Canada Governor he had helped Canada avoid the worst of the crisis. Indeed, his handling of the country’s economy and financial system was broadly regarded as a case study of how to do things right.

The problem was that he didn’t seem to want the job.

Osborne had been chasing Carney since early this year, when he first floated the idea with the Canadian at a G20 summit in Mexico. He then asked him officially in August.

Carney said no. He still had 18 months left in the job. He didn’t want to do the eight year term Osborne was stipulating. And that was before one even considered the notion of becoming the first non-UK Governor in the Bank of England’s 318-year history.

So until last month he was dismissed from the running. Then Osborne made another approach. This time around, he sold the prospect more aggressively. Plus he said that if Carney insisted, he would reduce the term to five years – after all the main principle was to have a single term rather opening up the messy question of reappointment – as had happened after Sir Mervyn’s first term.

This time around, Carney didn’t say no. Outlandish as the prospect of the appointment was, he was interested. The weekend before last he made a surreptitious visit to London, and on the Sunday he was interviewed by the Treasury/Bank of England panel – and by Osborne himself. Shortly afterwards, he signed on the dotted line, and this most unconventional of all central bank appointments became a reality.

So Osborne has got his man – someone he regards as a genuine one-of-a-kind – and, as an added bonus, he also managed to keep it secret from the journalists and traders desperate to know the new Governor’s identity.

But Carney’s honeymoon is unlikely to last long. Once he takes office next summer he will be faced with one of the biggest challenges in economic policymaking. It isn’t merely that the UK is still in dire economic straits – still barely recovering from the financial crisis, still stuck on the brink of recession.

The Governor role has become a mammoth, almost unmanageable challenge. Carney will have more powers and responsibilities than any Governor in recent history – and the expectations to match. He will have to overhaul an institution which has been built in his predecessor’s image. And he will have to try to create a new system of banking regulation that turns Britain from a financial basket case back into a word leader.

It’s quite a check-list – but Osborne is convinced that if there’s one man capable of this, it’s Mark Carney. Time will tell. As England football fans know to their cost, hiring in a highly-rated manager from overseas might seem like a cure all. But in economics, as in football, having the best manager isn’t everything.