Thursday, November 25, 2010

UK Banks Counterparty Risks and Exposure to European Sovereign Debt

UK Banks Counter party risk and exposure to European Sovereign Debt. According to the Irish Times the amount that Britain contributed in a direct loan to Ireland, is equivalent to what the British banks are paying their staff in bonuses this year. On top of the previously mentioned £7bn there is also the possibility of an additional £3bn UK taxpayer contribution  as part of an IMF deal.

All of which throws light onto the problem of how the banks were and, still are given incentives to create this mess. The principle of taking on the returns whilst shuffling on the risk to the taxpayer has gone on undiminished in its vigour. The last time around, the public were sold the story that all of this had hit the banking sector by 'surprise'. Is that the case this time around?  

I doubt it.

 Even as recently as June the Bank of England had highlighted the banks counter party risks in their bi-annual Financial Stability Report. I recommend a reading, particularly as it came at a time when the markets were dealing with the de-risking effect of the Greece bailout plus concomitant ECB Sovereign Bond purchase program. The risks were clear. Not lease for the risk to UK banks over European Sovereign Debt difficulties. On page 21-22 of the report

"UK banks’ direct claims on Greece and other small European economies facing economic pressures are modest relative to their capital (Chart 2.6).They are also small relative to UK banks’ other foreign claims (Table 2.B). But the interconnectedness of the financial system amplifies the credit risk faced by individual banking systems. In the euro area, a number of banking systems have significant exposures to countries under economic pressure — including countries in Central and Eastern Europe (CEE) and the Balkans.

Together, French and German banks have large exposures to borrowers in Spain, among which credit risk remains elevated. The IMF reported in its April World Economic Outlook that it expects Spain to grow more slowly than the euro area during 2010 and 2011. UK-owned banks are particularly exposed to the French and German banking systems, which account for around one quarter of their claims on banks globally"

There is no doubt the banks understood these counterparty and sovereign debt risks. In addition, the close proximity of the dramatic rise in Greek bond yields was a clear warning to the potential exposure to counter party risk, should sentiment turn against certain countries Sovereign Debt. The response of the banks to this risk has been to raise their Tier 1 Capital Ratio and hoard cash (in other words they are not loosening credit conditions)  whilst awarding their staff huge bonuses.

This has the effect of holding back the economic recovery-loans are not being made- which ultimately hurts the banks as it puts pressure on their assets. However, their staff are awarded bonuses for benefiting from the recovery in the economy. A recovery which was only put in place by taxpayer largesse in the first place. The banking sector stocks have underperformed massively, so the shareholders (including the UK taxpayer) are not benefiting, as usual.

In a sense, nothing has been learnt. The financial services sector is still gaming the system at the taxpayers expense and, will continue to do so unless legislative action is taken.


Bank of England, "Financial Stability Report" June 2010

Irish Times Article, "Rescuing Irish banks costs same as UK bonuses" Nov 24, 2010

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