Doubts over Bank of England’s £25bn confidence game

As the meltdown of the Cypriot financial system has demonstrated, banking is an illusion – a confidence trick. The scheme works so long as everybody believes the money they have in their high street bank is safe. But chip away even just a little at this belief and chaos will ensue.

In Britain, the past five years has seen confidence in the banks shaken to the core, and only tens of billions of pounds of direct taxpayer support and hundreds of billions more in state guarantees have kept the queues from the doors.

While convincing the average punter the banks are safe might be relatively straightforward, getting the market to buy in to the game has proved harder, reports The Telegraph.

As a result, five months ago, the Bank of England’s Financial Policy Committee (FPC), worried that investor confidence in Britain’s banks was deteriorating, ordered a thorough review of lenders’ balance sheets to work out how much more capital they might require to rebuild trust.

Yesterday, the FPC reported back, saying that it had found a £25bn capital shortfall among the country’s largest banks that would have to be filled by the end of the year.

Though £25bn might seem like a lot of money, it is, as City analysts pointed out, not too much for banks to raise and is unlikely to involve any institution having to sell enormous amounts of new shares.

“The shortfall of capital, which the FPC has identified today, is not an immediate threat to the banking system and the problem is perfectly manageable,” said Sir Mervyn King, Governor of the Bank of England and chairman of the FPC.

Manageable as it may be, the fact that Sir Mervyn and the FPC declined to identify which banks might have to raise money has inserted a degree of uncertainty that many had hoped the report would remove.

However, it has also raised questions about the way bank capital levels are set and whether Britain’s answer to making the financial system safer is the right one.

Hours before the FPC made its statement, the Institute for Economic Affairs (IEA), the think tank, released its own report calling for regulators to give up entirely on the idea of prescribing how much capital banks should hold.

The IEA argues that banks are the best judge of how much capital they need and points out that, instead of trying to make banks safer, the system would be improved by coming up with ways to make the failure of a lender a smoother process.

In fairness to Sir Mervyn and his Bank of England colleagues, there is little doubt they would also prefer a banking system in which no financial institution was “Too big to fail”. On Tuesday, regulators announced plans to encourage smaller lenders to challenge the existing banks. The problem is, that for all the talk of “too big to fail”, all of the country’s largest banks remain essentially that.

Inside the Bank of England, officials privately point out that dealing with the failure of a major clearing bank today remains as dangerous and difficult as it was back in 2008, when Royal Bank of Scotland and HBOS’s near-death experience brought the financial system as close to collapse as at any time in living memory.

The Commission on Banking Standards has already suggested a series of reforms aimed at tackling this problem, most notably its recommendation for “electrifying” the ring-fence that large banks will soon be forced to create between their retail and investment banking operations.

In effect, the electrification power, which will allow regulators to order the break-up of a bank, will be the ultimate sanction available in future should the authorities conclude that nothing they are doing is capable of making the financial system safer, other than the wholesale restructuring of a major bank.

Whether this would be enough to restore confidence in the system at the moment it was deployed remains to be seen. Indeed, some critics point out that regulators are being given the legal equivalent of a nuclear weapon that they would neither want nor need to use under any circumstances.

What seems clear is that the new Bank of England-run regulatory system will contain an awful lot more hands-on oversight of how banks conduct their day-to-day operations than has existed at any point in the recent past.

With annual stress tests, ring-fence reviews, and a whole panoply of other oversight tools within their remit, the Bank of England will be able to impose its control in a far more meaningful way than the tripartite system it is replacing. Of course, this means that, should confidence be shaken in the future, there will only be one place to blame.