Page 48 - Monocle Quarterly Journal Vol 1 Issue 1 Q4

BANKING
“As capital is topped up in sterling, so return on capital will be depressed, and in turn return on equity for UK domiciled banks will be reduced.”
increased demand for mainland European bonds and equity. Particularly in respect of German bonds, this has led to the inverse relationship between the price of bonds – driven by increased demand – and the yield on these bonds, being magni ed.
Lower yields, and in many cases negative yields on long-dated bonds, have meant that there is a price compression e ect in the treasuries of banks whose role is to fund asset creation through liability management. In simple terms: it is much harder now for banks to make the same nominal pro ts they previously did, since the spread between loan rates and funding rates is compressed. Several major European banks have already used this as the primary excuse for depressed quarter two earnings.
irdly, for UK banks in particular, the fact that sterling has plunged signi cantly against all major currencies, especially against the euro and the dollar, has meant that capital held in sterling against European loans has lost value and needs to be immediately topped up. As capital is topped up in sterling, so return on capital will be depressed, and in turn return on equity for UK domiciled banks will be reduced. is will mean that these banks will now have a reduced ability to lend further. And, in turn, these banks will then become less attractive entities for investment than some of their European and US counterparts.
Fourthly – and as an adjunct to this increased consumption of capital on existing loan books – these banks will somewhat counter-intuitively become more risky institutions. Stress tests, conducted by the European regulator, pose the question as to whether each bank, based on its own balance sheet at the moment, would still hold su cient capital were a series of instantaneous and perfectly correlated negative externalities to occur. ese hypotheses include radically increased loss rates on loans, share price declines, GDP erosion and increased unemployment.
Recall that these tests are based on hypothetical changes – or deltas – to existing balance sheets. is means that in compiling these stress test results, UK banks will need to simulate negative stresses on already stressed macro-economic factors, which will mean a sort of double- whammy e ect on their balance sheets.
In order to ensure that they don’t fail these stress tests – which would have dire consequences on reputation as well as on their ability to pay shareholder dividends – they will need either to increase capital or decrease lending. A decrease in lending will mean less pro t. An increase
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