Counterparty Risk – weathering turbulent times

Counterparty Risk – weathering turbulent times

Welcome to our May edition of ‘Insight’ by Insignis. Each month, we discuss a topic of interest within the UK financial sector. This month, we are looking at Bank Counterparty Risk.

Thirteen years ago, although it may seem like only yesterday for many, the financial system across the globe imploded. Major casualties included the Icelandic Banks, Bear Stearns, Lehman Brothers, and Northern Rock, with the governments stepping in to support those institutions that were once deemed “too big to fail”.

The Coronavirus pandemic has placed enormous pressure on the financial system, with related credit losses for UK Banks expected to be “somewhat lower than £80 billion” according to the Bank of England. This article delves into why the UK banking system was well prepared to deal with the pressure and how you can best protect your cash deposits in light of the current economic climate.

Where are we now?

The UK financial system went from disaster, to recovery, to forgiveness… and now to unprecedented pressure to support individuals and businesses in the economic fight against Coronavirus. The banking and finance industry has offered millions of customers mortgage and credit card repayment holidays, lent over £75billion in Covid-related finance, whilst simultaneously managing volatile financial markets and historically low (and possibly negative) interest rates. This has all come at a cost – in terms of credit losses on the balance sheet and reduced profitability.

What lessons were learned from 2008 to ensure the Banks and Building Societies are well equipped to withstand the ongoing financial and economic turbulence?

What’s changed from 2008 to 2021?

“Never again” was the regulatory battle cry after the fallout from the financial crisis of 2008. Therefore, Global and Local Regulators stepped in to not only make the financial system safer but to also make sure taxpayers were not on the hook to bailout banks again should an institution get into difficulty.

Within this, four main areas of reform have occurred to better protect our financial system:

Reformed Governance

The Financial Services Authority (FSA) was abolished, and two new Regulatory Bodies created – the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA). The FCA remains an independent body with the responsibility to regulate the conduct of financial services firms, to ensure “financial markets need to be honest, fair and effective so that consumers get a fair deal”. The PRA is a body of the Bank of England with the trusted role of the supervision of Banks and Building Societies in the UK to ensure financial stability.

There is also the additional oversight from the Financial Policy Committee – tasked by Parliament to monitor the risks in financial services that could cause issues in the wider economy.

Good Behaviour 

Banks have worked hard to ensure they can withstand much larger shocks (and therefore losses) without getting into difficulty:

  • The large banks now hold c.10x more capital than before the financial crisis, having raised over $1.5trillion globally to strengthen their balance sheets
  • Banks now report a “leverage ratio” – a measure which, according to the Bank of England, “protects the system from risks and uncertainties that can be hard to measure through risk weights and models”
  • Banks are taking fewer risks – trading assets have halved
  • The Bank of England states “Banks are less dependent on each other” – which reduces the likelihood of a domino effect of bank failures, with interbank lending having fallen by two thirds and with short-term wholesale funding falling from 25% of funding to 10%

Here in the UK, Banks have raised over £130bn of true loss absorbing capital, with an average ratio of capital to RWAs having gone from 4.5% to 14.3%

Multiple Lines of Defence 

To protect against a systemic bank failure, there are three main lines of defence:

  1. Intrusive supervision – the job of the PRA to keep a watchful eye on financial institutions
  2. Stress test lenders – to ensure banks have enough strength to withstand a severe recession and keep lending
  3. Bail-in not Bail out – shareholders and creditors bear losses, not the taxpayer

Historical stress tests showed Banks could withstand substantial credit losses which likely would have wiped out those Banks in the financial crisis, primarily due to the increased capital buffers now held.

Increased Protection

The FSCS scheme has increased to £85k from £32k, with temporary options for short-term balances of up to £1million (such as inheritance or property sale).

To ensure financial institutions maintain enough liquidity to withstand 30 days of funding difficulties, including savers withdrawing their deposits, UK Banks now hold over £700billion in highly liquid assets.

Best Practices To Protect Your Cash Deposits:

  1. Know your counterparties: Utilise public credit ratings where available, or financial implied ratings if not. Also, consider key financial ratios such as capital and leverage to monitor the financial health of financial institutions.
  2. Diversification: Protect your deposits against single institution risk by spreading them out amongst multiple counterparties, in the event that something should go wrong, you are protected against having all of your eggs in one basket. Depending on eligibility and the size of your cash deposits, diversification helps to maximise the FSCS protection available to you.
  3. Counterparty policy: Companies, Charities, and all institutions should have a Bank Counterparty Policy in place which is reviewed on a regular basis and adhered to in terms of amounts per approved institution.

Find out more

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