A perfect storm: the UK’s next banking crisis

The UK has recently undergone a banking crisis, the reasons for which have been much analysed, but basically boil down to a mixture of liquidity problems (banks unwilling to lend to each other) and solvency problems (assets being valued lower than expected and off-balance-sheet liabilities materialising on the balance sheet).

I think it is uncontroversial to say that the activities that gave rise to the solvency problems are not the mainstream business of the UK banking sector, which focuses on lending to domestic customers – both personal and corporate. I would like to briefly look at the prospects for these two sectors, which represent the main assets of the high street banks.

Personal loans can be split into secured and unsecured loans. The former are mainly secured against the value of a property. Such properties, which are declining in value at an alarming rate, are often mortgaged by up to 125% of their value. Though interest rates are low, unemployment is rapidly rising, meaning we are likely to see a large number of defaults.

Unsecured loans are predominantly made up of credit card debt against households which are breaking all records for indebtedness. These are households facing wage freezes and rapidly increasing levels of unemployment.

  

Then there is the corporate sector. We are currently witnessing a series of bankruptcies of high street shops. This will inevitably work its way up the supply chain to wholesalers and manufacturers, resulting in more bankruptcies and more unemployment and creating a positive feedback loop of less spending in shops, lower property values etc.

Vacant properties spell trouble for the already distressed commercial property sector. You only have to look at the London skyline to see the huge number of soon-to-be-completed empty buildings – many of which represent bank collateral. And then there is the recent fashion of leveraged buy-outs and high gearing so that companies maximise their leverage potential in profitable times 

All of this means banks are facing wave upon wave of bad debt, at a time when they are already distressed and have just been bailed out. The government will probably chose again to rescue the banks, but the three main high street banks’ liabilities are each greater than the UK’s GDP.

The British government’s debt is already growing and its credit default swap rates are rapidly rising. It also faces collapsing tax revenues and increased expenditure. Iceland has shown us what could happen next – a further collapse in the currency and an IMF bailout.

So what should the UK government be doing now? Before a storm you batten down the hatches. The big risk is sovereign default. It is probably too late but the government should be reducing debt and building up reserves – in fact the exact opposite of current policy.

Don’t you mean negative feedback loops in Para 5?Many thanks for excellent pieceRegardsAllan

Nick, you missed off a fourth major category – investment in US sub-prime. Unsecured debts are relatively small. However, I guesttimated losses on UK morgages using BoE LTV figures from early 2008, assuming a 42% fall in house prices from peak and arrived at a total bad debt figure of £40 billion, which ain’t that huge (click link above).

No. Positive feedback loop is just a posh name for a “vicious circle”.

@ Allan StewartThe “positive” in “positive feedback” refers to the feedback loop and not the consequence of the feedback loop. http://en.wikipedia.org/wiki/Positive_feedbackAlex

A couple of points:1. UK sovereign debt is denominated in UK currency. Since sterling is a fiat currency default is no more than a theoretical risk. The government can always print more money.2. The banks were recapitalised with the express aim of putting them in a position to withstand a sharp downturn. There is no reason at the moment to believe they underestimated how much cash they will need.There is trouble ahead but this is scare mongering.Ian

Ian,RE: 1: Something I’ve wondered about fiat currencies… If the risk is only theoretical why would the spread on CDS against UK debt be non-zero? (Even the US has a positive spread, and I can’t see default there without financial Armageddon.)

Readers may also be interested in Nick Silver’s recent discussion paper: A Bankruptcy Foretold: The UK’s Implicit Pension Debt. See http://blog.iea.org.uk/?p=180 for a summary.

@6. Ian, although UK sovereign debt is GBP based. The rapidly accumulating pile of toxic assets at the BoE is likely to be anything but. The next phase of the ‘crunch’ will be UK/Euro zone based and focus on non domestic currency lending as the emerging economies surrounding us explode and their currencies collapse. Holiday home in bulgaria financed with a yen mortgage anyone?

In the light of Nick Silver’s argument that the Government should be wary about the very high level of debt could someone comment on the article by Tim Congdon and Gordon Pepper in last week’s Telegraph?http://www.telegraph.co.uk/finance/economics/4140601/How-to-stop-the-recession.htmlIn a monetarist analysis they state that the Government should urgently borrow large sums from private banks and spend to increase the money supply. From other economists one might feel comfortable in dismissing this argument, but from two such distinguished academics of Thatcherite persuasion I don’t think this can be done lightly.If Nick Silver or others could illuminate I would be very interested.

Adrian – I think there is a marked disagreement between ‘monetarists’ and Austrian economists about the best way to deal with the recession. Austrians might argue that quantitative easing risks distorting the necessary (but painful) economic adjustment process and that it also risks stoking inflation in the longer term (though this shouldn’t happen if it’s managed correctly). The high debt levels highlighted by Nick Silver arguably make the strategy more risky as they could deter investors from financing UK government borrowing and increase the risk premium demanded (i.e. put upward pressure on interest rates which could counteract the desired effect of the easing). There are other negative effects of high government borrowing including the ‘crowding out’ of private sector activity, which would also tend to hamper economic recovery.

Adrian wants comment on Congdon’s article. Here goes.
This article is a variation on a letter from C. to the FT (31.12.08). C. is essentially advocating money printing, but in a novel way. This is a “Bernanke helicopter drop”. George Soros also advocates money printing (see FT 29.1.08), but he wants the IMF to do it. I agree with a bit of printing.
C. is too harsh on Mervyn King: King is surely right to say that lack of credit is currently a brake on the economy.
Congdon’s claim that the effect of extra money comes from it passing from hand to hand is bizarre ( his 8th last para: “The loan typically…”). Velocity of circulation RESULTS from a desire to trade, it does not CAUSE it.

Don’t you mean negative feedback loops in Para 5?Many thanks for excellent pieceRegardsAllan

Nick, you missed off a fourth major category – investment in US sub-prime. Unsecured debts are relatively small. However, I guesttimated losses on UK morgages using BoE LTV figures from early 2008, assuming a 42% fall in house prices from peak and arrived at a total bad debt figure of £40 billion, which ain’t that huge (click link above).

No. Positive feedback loop is just a posh name for a “vicious circle”.

@ Allan StewartThe “positive” in “positive feedback” refers to the feedback loop and not the consequence of the feedback loop. http://en.wikipedia.org/wiki/Positive_feedbackAlex

A couple of points:1. UK sovereign debt is denominated in UK currency. Since sterling is a fiat currency default is no more than a theoretical risk. The government can always print more money.2. The banks were recapitalised with the express aim of putting them in a position to withstand a sharp downturn. There is no reason at the moment to believe they underestimated how much cash they will need.There is trouble ahead but this is scare mongering.Ian

Ian,RE: 1: Something I’ve wondered about fiat currencies… If the risk is only theoretical why would the spread on CDS against UK debt be non-zero? (Even the US has a positive spread, and I can’t see default there without financial Armageddon.)

Readers may also be interested in Nick Silver’s recent discussion paper: A Bankruptcy Foretold: The UK’s Implicit Pension Debt. See http://blog.iea.org.uk/?p=180 for a summary.

@6. Ian, although UK sovereign debt is GBP based. The rapidly accumulating pile of toxic assets at the BoE is likely to be anything but. The next phase of the ‘crunch’ will be UK/Euro zone based and focus on non domestic currency lending as the emerging economies surrounding us explode and their currencies collapse. Holiday home in bulgaria financed with a yen mortgage anyone?

In the light of Nick Silver’s argument that the Government should be wary about the very high level of debt could someone comment on the article by Tim Congdon and Gordon Pepper in last week’s Telegraph?http://www.telegraph.co.uk/finance/economics/4140601/How-to-stop-the-recession.htmlIn a monetarist analysis they state that the Government should urgently borrow large sums from private banks and spend to increase the money supply. From other economists one might feel comfortable in dismissing this argument, but from two such distinguished academics of Thatcherite persuasion I don’t think this can be done lightly.If Nick Silver or others could illuminate I would be very interested.

Adrian – I think there is a marked disagreement between ‘monetarists’ and Austrian economists about the best way to deal with the recession. Austrians might argue that quantitative easing risks distorting the necessary (but painful) economic adjustment process and that it also risks stoking inflation in the longer term (though this shouldn’t happen if it’s managed correctly). The high debt levels highlighted by Nick Silver arguably make the strategy more risky as they could deter investors from financing UK government borrowing and increase the risk premium demanded (i.e. put upward pressure on interest rates which could counteract the desired effect of the easing). There are other negative effects of high government borrowing including the ‘crowding out’ of private sector activity, which would also tend to hamper economic recovery.

Adrian wants comment on Congdon’s article. Here goes.
This article is a variation on a letter from C. to the FT (31.12.08). C. is essentially advocating money printing, but in a novel way. This is a “Bernanke helicopter drop”. George Soros also advocates money printing (see FT 29.1.08), but he wants the IMF to do it. I agree with a bit of printing.
C. is too harsh on Mervyn King: King is surely right to say that lack of credit is currently a brake on the economy.
Congdon’s claim that the effect of extra money comes from it passing from hand to hand is bizarre ( his 8th last para: “The loan typically…”). Velocity of circulation RESULTS from a desire to trade, it does not CAUSE it.

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