The very ugly truth about RBS

I wanted to talk to you today about a topic that is on everyone’s lips at the moment: the re-privatisation of RBS. Because I think there is a disturbing story here that is not being widely reported in the mainstream press. And it goes right to the heart of the economic problems that Britain will face over the next few years. It certainly affects your investments.
When Stephen Hester took the head job at RBS, he was given the task of shrinking and de-risking the bank. The ultimate goal was to bring about a sufficient recovery so that the government could reprivatise at a higher share price, and make back the €45bn they had invested in 2008-9.
Now that Stephen Hester is being pushed out to make way for a new head of RBS – who will take the bank private again before the end of 2014 – the market is speculating about just how fixed the UK banks now are.
Stock prices have rallied strongly from the lows, though they are still well below where the government bought shares in Lloyds and RBS on our behalf. However, with the political timeline fixed for a sale ahead of the next election in 2015, the story about the banks’ solvency has become political. And that is where this story gets a little dirty

Why these banks can’t lend

The trouble with banks is that the public rarely knows the true health of their balance sheets. The big four British banks – Barclays, Lloyds, RBS and HSBC – all had strong balance sheets (by which I mean they reported strong capital ratios) ahead of the crisis. But it turned out all was not as it seemed when disaster struck. And since then investors have largely been operating in the dark.
Still there’s nothing like a share price rally to make your average broker believe that the banks’ balance sheets are fixed. The problem is that every historical precedent has shown the banks to be hiding bad debts on their balance sheets for several years before they finally get fixed. In the wake of a serious banking crisis, banks can’t show the full extent of losses because these would wipe out too much of their capital, so they parcel out losses against earnings over time.
The way we, the public can see that the banks are hiding losses (though we can only ever guess how large these may be) is by watching their behaviour. No matter how fixed a bank claims it is, no bank has ever been shown to shrink loans when policy was easy unless it was subsequently shown that the bank in question was suffering solvency issues. Therefore if the banks really are fixed, we will see it in the form of rising bank lending. After all, the banks are sitting on record amounts of unused liquidity in the form of excess bank reserves, so there’s absolutely no liquidity constraint.
Well, up until the start of 2012, record liquidity and the lowest base rates for over 300 years had done nothing to encourage the banks to lend. How could they? As we know, they were sitting on further as yet undeclared and capital eroding losses. How big are those losses?
Well, we don’t know exactly. Investor consultancy PIRC reckons that hidden losses at British banks come to a total of £40bn. I wouldn’t be surprised if losses were five times that size. Here’s the rub. The big four British banks sport some £255bn in core tier 1 capital, so if hidden losses of £200bn were to be revealed, so would the fact that the sector is still practically insolvent. Banks have already realised £230bn of losses, but that has taken almost five years of earnings.
The figure below shows how much progress banks have made towards repairing their balance sheets.
Bank Cumulative Loan Write-Offs as a Percentage of Peak Assets

Source: Companies data, Westhouse Securities
As you see, in a typical banking crisis, banks end up having to write off about 10% of their loans. In a bad crisis, they write off 15%. If it’s a Japanese scale crisis, they write off 20%. That can take anything between five and 15 years to play out. And the big four have made very little progress so far compared to their US counterparts.
Since 2008, US banks have written-off 12.6% of their loans. And so they may soon be strong enough to start lending again. But the big four UK banks have only written down 6.2%.
Another big problem is that half the sector’s capital resides at just one bank: HSBC. But because HSBC has also done more loan-loss realisation than any other bank, it’s a really good bet that far less than half of the remaining losses will come from HSBC.
That leaves the other three banks, RBS, Barclays and Lloyds, in a tricky position. As hedge fund manager Chris Hohn pointed out in a letter to the Financial Services Authority earlier this year, a £20bn post-tax loss would send Lloyds’ capital ratio below 5%. The same would also be true for the other two banks.
That’s because liquidity is not the real underlying problem here.