As published on IREF Europe

Published on 6th July 2023

UK Consumer Price Inflation remained at 8.7% in May. The Bank of England has raised the cost of overnight money to 5% via increases in its Base Rate, and has caused the cost of medium-term money to rise by selling off the bonds that it bought since the Global Financial Crisis (the ‘GFC’).

A variable-rate mortgage now costs above 6%, three times what it was a year ago. Borrowers’ incomes are under pressure from this, general inflation, and tax increases. An increase in delinquent loans and of ones at risk of becoming so is indicated.

Officialdom has mobilized its customary toolkit of denial, attribution of blame elsewhere (COVID-19, Ukraine), and now concealment of the consequences.

Concealment techniques – known as ‘restructuring’ and ‘forbearance’ – were pioneered by the Eurozone to reduce the bad loans reported by its banks. These techniques are in turn manipulations of the measures taken to get banks to resume lending, after the sovereign debt crisis of 2010-12 in the Eurozone and after the GFC in the UK.

The Eurozone’s version was to permit banks to hold almost no Common Equity Tier 1 (CET1) against any form of debt that can be tracked back – however distantly and indirectly – to the public sector, as if all public sector lending was risk-free. The public sector has since become the engine driving economic activity in the Eurozone, displacing the private sector.

The UK’s version has been to pump mortgage lending back up to pre-GFC levels – via low interest rates, by the Bank of England buying up mortgage bonds, and by the Prudential Regulatory Authority permitting banks to set aside almost no CET1 against their mortgage loans.

UK banks have a high asset allocation towards mortgage lending, they have lent a relatively high amount compared to the property’s value, and they have continued to add new loans when property values were already elevated. The banks have ‘bet the ranch’ – on the ranch, with a thin loss cushion of CET1 against a fall in UK house prices. The result is a threat to the UK’s financial stability, the same as in the run-up to the GFC.

The government’s response came on Friday 23rd June in three measures straight out of the Eurozone playbook for suppressing reports of bad loans:

A borrower can talk to their bank about their problems without its affecting their credit scoreThe bank can overlook the degree of the borrower’s financial distress, and avoid setting aside more CET1 against the loan to reflect the higher chance of loss
A borrower can elect to extend the final maturity of their loan and/or switch the loan to payment only of the interest, and then switch back to the original contract within six months without going through an affordability check or a credit score reviewExample of the ‘restructuring’ technique used by Eurozone banks to forestall the loan being reported as one in the first stage of a Bad Debt, called ‘Past Due and Non-Performing’, and to  sidestep the setting aside of more CET1
The banks will grant a minimum of a 12-month grace period from the point at which the loan has defaulted until when the bank repossesses the propertyExample of the ‘forbearance’ technique used in the Eurozone to keep ‘Past Due and Non-Performing’ loans from falling into the stage ‘Unlikely to Pay’, and subsequently into ‘Bad Exposures’, which would make the reports look worse and trigger the allocation of ever more CET1
Table of UK government measures and their real meanning

The banks can window-dress their accounts without the borrower having to come up with any money as debt service. The bank’s already low loss-absorption cushion is not increased despite the deterioration in the quality of the loan book. A gap opens up between the apparent strength and stability of the bank – as measured by its claimed CET1 Ratio, Tier 1 Capital Ratio, Total Capital Ratio, Leverage Ratio, Liquidity Coverage Ratio and Net Stable Funding Ratio – and reality.[1]

The bank passes its Stress Test[2] with flying colours, the bank’s accounts having been distorted to conceal the indicators of adverse market conditions.

Only later do the financial regulators acknowledge that the flag colour under which the bank sailed through its Stress Test was not green – as it appeared to be through the regulator’s telescope – but yellow, for The Plague.

[1] These are the key measures of banks’ strength and stability set internationally through the offices of the Bank for International Settlements in Basel subsequent to the Global Financial Crisis. The agreements underpinning these ratios are sometimes referred to as the ‘Basel Accords’, and their successive versions are referred to as Basel II, Basel III and so on

[2] Periodic exercise whereby a financial regulator subjects the accounts of a bank to various adverse scenarios of market conditions that can be expected to increase the risk of its business, requiring it to set aside more capital and liquid assets, thereby depleting its ratios. The bank passes the Stress Test if its ratios continue to be greater than the regulatory minima under even the most drastic scenario