Krishna SrinivasanBy Krishna Srinivasan

The UK economy is a long way from a strong and durable recovery. Growth has been flat for more than two years now, per capita income is about 7 percent below its pre-crisis peak, unemployment is elevated at 7.8 percent, with youth unemployment alarmingly high at 21 percent, and credit to the economy remains severely constrained.

Recent data are, however, encouraging, and policies should capitalize on the nascent signs of recovery to secure strong growth and rebalance the economy.  Fixing the financial sector, including by addressing banks’ asset quality, is a pre-requisite for a durable UK recovery. See the IMF’s assessment of the UK economy.

A multipronged approach

Fiscal consolidation has been a brake on growth, and policy should be aimed at offsetting the drag from planned near-term tightening, notably by bringing forward capital investment. Structural reforms, such as expanding vocational training, adopting new technologies and attracting qualified workers from abroad, should be accelerated to improve the economy’s skills base and competitiveness. And monetary policy should remain accommodative. These policies will, however, need to be complemented by financial sector repair, which must proceed with a greater sense of urgency to normalize credit intermediation, improve the effectiveness of monetary policy, and ensure a durable exit from the crisis.

To be clear, financial sector repair in the UK has advanced. Banks’ funding costs have come down, as has their reliance on wholesale funding. Noncore deleveraging of bank balance sheets has progressed well, regulatory capital ratios have edged up, and profitability has improved recently, albeit modestly.

But this is not enough.

Significant questions remain about the quality of bank assets. The share of non-performing and delinquent loans is still high (estimated to average over 10 percent for Royal Bank of Scotland (RBS), Lloyds Banking Group (LBG), and Barclays), and lender forbearance remains a concern, adding to doubts about the health of banks. Net bank lending to households and firms has not picked up since June 2012, notwithstanding a sharp decline in bank funding costs since then. Moreover, credit to businesses has declined continuously since September 2008 (cumulatively by 12 percent). All this points to weak bank balance sheets and the inadequacy of capital buffers. These concerns are reinforced by the slowdown since 2009 in the build-up of provisions against expected losses, and of tangible capital buffers to meet unexpected losses, across major banks.

Here, the US experience demonstrates well the benefits for credit markets and the economy of the early and comprehensive treatment of banks’ asset quality problems. The US focused on the building of tangible capital (which, as a share of tangible assets, has risen by about twice as much since 2008 for major banks in the U.S. as for those in the UK), and credible stress tests, backed by supervisor-approved capital plans. Moreover, it shows that a vigorous capital-building effort can help break the vicious circle, where banks’ health and their willingness to lend depend on the strength of economic recovery, which in turn depends on the extension of credit by banks. Indeed, credit recovery in the U.S. has been quite spectacular, with lending to businesses increasing by 30 percent since the trough in 2010.

Building bank capital

Any bank capital building effort in the UK should be robust, alleviate uncertainty and promote greater lending. Three steps are critical in this regard.

First, it is important that the Prudential Regulation Authority (PRA) ensure that individual financial institutions take the necessary measures to meet without delay the capital shortfalls identified by the Asset Quality Review (AQR).

Second, given the AQR was not a stress test, and did not measure banks’ resilience to shocks, the system-wide stress tests planned for 2014 need to cover a broad range of risks, employ sufficiently stringent scenarios, and aim for commensurately ambitious capital buffers. Transparency over methodology, results and supervisor-approved bank-by-bank capital plans would significantly enhance the credibility of the stress tests.

Third, to boost lending, banks’ capital building efforts, now and in the future, must be based on a combination of new equity issuance, reduction of dividend payments, restrained remuneration, and balance sheet restructuring that does not reduce net lending.

A strategy for the state-intervened banks

Going beyond this, a clear strategy is needed for the two state-intervened banks, RBS and LBG, with a view to returning them to good health and eventually to private ownership. Together, the two banks account for almost two-fifths of the stock of UK net lending to the non-financial private sector. These banks have, no doubt, made progress in repairing their balance sheets and improving profitability, but significant challenges remain, particularly in the case of RBS.  Any strategy should seek to return the banks to private hands in a way that maximizes taxpayer value, safeguards financial stability, strengthens confidence and competition in the sector, and minimizes outward spillovers. In this context, a sovereign backstop—if required—should be provided to meet a capital shortfall, as it would result in a boost to growth far offsetting its cost.