The free market think-tank says the Bank of England (BoE) stress tests for UK banks designed to prevent a re-run of the financial crisis are covering up major continued balance sheet vulnerability.
High bank borrowing was central to the financial crisis. For instance, Royal Bank of Scotland’s core tier one capital ratio – the capital backing its loan book – had fallen to a threadbare 4 per cent or so as wholesale funding markets froze up.
Capital ratios in the sector are much stronger now, but the Adam Smith report says it is false comfort because the BoE’s balance sheet stress tests look at book values – the values of assets recorded in accounts.
It says that on these measurements, UK banks’ leverage has indeed fallen by about a third since 2006, but that more accurate numbers based on real market value of assets would reveal their leverage has actually increased by half.
Another weakness says Kevin Dowd, report author and professor of finance and economics at Durham University, is that the BoE tests herd banks into identical business models.
He adds that meeting improved required regulatory capital ratio levels is a system that is easy for banks to game because it is a risk-adjusted measure. By implication, this could suggest that, while a cruder measure, the leverage ratio would be more relevant because it pays no regard to the theoretical riskiness of the loans.
The institute believes market valuations of bank capital are more on the money in every sense than book valuations, and that the BoE’s claim that banks are much more financially resilient is untrue.
I have reservations. The scale of the stress tests from the Bank are draconian, involving synchronised recessions, collapses of housing markets and stock markets, a sharp spike in both interest rates and unemployment just for starters. In UK banking, it is hardly a case of all is for the best in the best of all possible worlds.
But bank balance sheets simply do not bear any comparison with the time of the crash. We shouldn’t be complacent or panicky.