Banks and the scale of their lending are currently controlled by regulation. The regulators place on them capital requirements. Clearly the Regulator has confidence in our banks and believes all our main UK banks have sufficient capital to trade – as his permission is needed for a bank to enter and stay in business.
Because there is such an intense de-leveraging underway – stemming from a wish by the authorities to cut overall lending and borrowing – many now think banks should have more capital than the minimum required by the Regulator, and more than some of them currently have above that minimum. Fear within the banking sector is also forcing banks to raise more capital than the Regulator requires, and more than they have been used to employing in recent years for a given level of lending.
The principal requirement is to have sufficient Tier One capital. This is basically funds provided by shareholders to their bank when the shares are first issued, and the accumulated profits left in the bank after all payments of bonuses to staff, dividends to shareholders and other payments. Typically a bank will have at least £5 or £6 of Tier One capital for every £100 of advances made to customers. The idea is that if the bank proved a bad judge of these loans, then the shareholders funds can pay the losses. It would usually be unheard of for a bank to lose more than 5-6% on all the advances it made, owing to failure of customers to repay, or failure to raise enough money to repay the loan from the security lodged when a customer does give up the payments. Bad debts on most quality lending would normally run at less than 1% overall, after taking into account money released from security where payments are not met.
The back up requirement is to have some Tier 2 capital as well. This is money held as provisions against losses, surpluses on the banks assets like its directly owned property, and long term money borrowed from others. In the unlikely event of the bank having to go into Administration this money could also be drawn down or released by asset sales to pay off the depositors and other creditors. Tier One and Tier Two capital together might amount to say £10 for every £100 of loans.
A bank does not have to provide the same shareholder cover for assets held like Treasury bills and government bonds, as the Regulator assumes these can easily be turned into cash. It is just the “risk assets” – the mortgages and company overdrafts – that need the full shareholder cover.
This means a bank may be 10x geared – it can lend 10 times its combined Tier One and Tier Two capital. It raises the money to make these extra loans by taking in deposits from the public and companies, and borrowing in the markets. Those banks that have relied heavily on shorter term borrowing in money markets are the ones who have faced the most difficulties – Northern Rock was the worst example. When the money markets dried up the Rock was left short of borrowing to finance its substantial mortgage lending.
The authorities have to decide how much extra capital cover they think banks should now be required to hold. The more they request, the less lending will continue to British individuals and businesses. The banks themselves may decide to hold more capital, to reassure fellow banks that they are safe to do business with in current conditions. Banks also have to raise more capital if they make substantial losses, as the shareholders have to make good the funds their managers have lost.
NB THE ROUGH FIGURES ARE FOR ILLUSTRATION ONLY AND DO NOT REPRESENT ANY PARTICULAR BANK. THE DEFINITIONS ARE APPROXIMATE, NOT PRECISELY TAKEN FROM THE REGULATIONS