Business

The year of living dangerously for UK banks

BBC business editor Robert Peston on eurozone suffering that becomes our pain

2011 will be a make-or-break year for our banks.

That is the implicit message of the Bank of England's latest Financial Stability Review.

By the end of the coming year, we should know whether our banks are once again capable of standing on their own feet, without exceptional support from taxpayers - although they will still be in receipt of some measure of such exceptional loans and guarantees from the state.

The biggest inescapable challenge is a very substantial bulge in the borrowings that our banks have to repay.

According to the Bank of England, up to £500bn of wholesale debt is due to mature by the end of 2012. That includes something over £200bn effectively owed to taxpayers through the Treasury's Credit Guarantee Scheme and the Bank of England's Special Liquidity Scheme.

Of that £500bn or so, between £350bn and £400bn falls due for payment this year.

Now that is a substantial amount of money to raise, in wholesale markets that are a long way from the kind of depth and liquidity of the pre-2007 boom era.

It is on a par with the peak amounts raised by banks in the balmy years, so it is by no means certain they will be able to raise it all, in this chillier climate.

To put the challenge in context, the Bank of England regards it as almost miraculous that gross issuance of term debt by the UK's banks over the past year was more than £130bn - a fraction of what will be needed in the coming year.

Of course the banks could reduce what they need to borrow by simply failing to make new loans to businesses and households, as existing loans are repaid.

But I don't think any of us would see that kind of return to a credit-crunch lending drought as a good idea.

How can the banks help themselves? Well, the stronger they are perceived to be, the easier and cheaper it will be for them to borrow.

That's why the Bank of England says that "banks' board should apply restraint in distribution of profits to equity holders and staff".

In other words, cash should be hoarded as capital, to protect against potential future losses, rather than paid out in bonuses and dividends.

With decision time looming for banks' boards on how much to reward both shareholders and staff, it will be fascinating to see whether they are prepared to defy their new regulator.

And it isn't as though there aren't potentially substantial shocks for the banks to absorb in the coming few weeks.

The big looming risk for the world's banks - not just ours - is a funding strike for weaker eurozone economies that threatened insolvency for governments, companies, households and banks (see my recent note on the refinancing challenge for Spain, for example).

As the Bank of England points out, the direct exposure of the UK's banks to Greece and Portugal is relatively small.

But what they are owed by all sectors in Ireland and Spain, for example, is typically equivalent to three-quarters of their loss-absorbing capital.

So any perceived worsening in the ability of Ireland and Spain to keep up the payments would do genuine harm to our financial institutions.

But perhaps the greatest immediate threat is of contagion via the banking system, because of the interconnectedness of banks - whose perniciousness was demonstrated beyond doubt in the Great Crash of 2008.

So, for example, major UK banks' claims on French and German banks are around £140bn, or not far from 70% of loss-absorbing capital.

Which means that if those eurozone banks most directly exposed to the fortunes of the eurozone begin to suffer, their pain will be felt by our banks - and, by extension, by a British economy dependent on the health of the banking system.‬‪

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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