Have we seen the last of the bad-debt banks?

You might hope, given the volume of cash pumped into keeping them alive and subsequent discussion around separating ‘bad’ parts of their businesses from the ‘good’, that the banking sector had seen the very worst of its losses and would probably spend 2010 proving its financial strength and winning back customers’ hearts.

But at least one eminent voice has suggested there is plenty of undisclosed trouble still lurking in bank balance sheets. Citing his comment in Le Figaro in late November last year, The Daily Telegraph quoted International Monetary Fund head Dominique Strauss-Kahn late last year saying that he thought “banks around the world have, to date, only admitted to around half of the $3.5 trillion (£2.1 trillion) of likely damage on their balance sheets,” adding that the proportion is probably higher in Europe than even in north America.

“The history of banking crises, notably in Japan, shows that there won’t be healthy growth again until the banks have been cleaned up completely,” he warned.
Given how dependent the UK economy is on the services (and particularly financial services) sector and its status as a financial hub, this is bad news for any 2010 recovery.

So how seriously should Strauss-Kahn’s thoughts on potential disasters in bank balance sheets be taken, as we ponder the likely fortune of the banking community in the year ahead? Tom Vosa, head of UK market economics at National Australia Bank, believes that the obligation on (or lack of) banks to disclose losses is a major factor. “The real story for UK banks is whether the debt on their balance sheets can continue to be serviced without triggering mark-to-market losses,” Vosa says. Presently, the answer seems to be ‘yes’, so banks can ‘extend and pretend’ – let the debt ride, even if the value of securities held against it is now under water.

The problem for banks, Vosa suggests, may lie not in 2010, which is still likely to be characterised by low central bank interest rates, but in 2011 if, as a consequence of the quantitative easing effort which pumped billions of pounds into the economy, inflationary fears start to dominate central bank thinking. Higher interest rates could push more loans into default and could trigger a wave of mark-to-market ‘events’, exposing any lingering holes in bank balance sheets.

Taxpayers’ burden
However, Vosa points out the fact that as far as the UK’s two most wounded banks, RBS and HBoS, are concerned, the debt burden rests with the taxpayer – and the taxpayer can have a much longer time horizon than financial markets. “The taxpayer can wear the debt for 100 years if it has to and if assets rise in line with inflation and GDP, ultimately the taxpayer will end up making a profit, not a loss.” Hard to agree after the events of the last year.

What is certain is that banking stocks have been strong beneficiaries of a market rally since March. Vosa, though, argues that there are simply too many unknowns to predict whether the banking sector can sustain this kind of rally. “How changes in regulatory policy and bank remuneration policies will feed through into long-term earnings across the sector is unclear at present,” he says.

Will all the work done by regulators to force banks to have a rigorous, transparent and spirit-as-well-as-the-letter approach to risk bear fruit in 2010 and beyond?

European Central Bank president, Jean-Claude Trichet, put the matter to a collection of bankers at the International Colloquium in Paris last January, monikered Nouveau Monde, Nouveau Capitalisme. “Its root cause was a widespread undervaluation of risk in the global financial system [including] an underestimation of the quantity of risk financial institutions took upon themselves, and an under-pricing of the unit of risk” – polite central banker speak for, “they had their heads stuck where the sun don’t shine”.

Pre-Christmas rumblings about RBS’s intent to distribute a bonus pot even larger than previous years to its staff after its government rescue and the revelation around the same time that RBS and HBoS received £61.6bn in additional, undisclosed emergency loans from HM Treasury (£36.6bn to RBS; £25.4bn to HBoS), on top of the quantative easing efforts, have not done much to quell that image. Those loans have been repaid in full, but the debt to society may hang around for generations.

HSBC’s group FD Douglas Flint said recently there is little doubt that the shape of financial data “will be very influenced by regulatory factors” – by which he means both changes introduced by banking regulators in the UK and the European Union and the impact of international financial accounting standards, particularly IAS 39, on financial instruments.

“In a crisis, there is ever more demand for higher quality information and a real focus on the integrity of the data,” Flint says. “What can you do to help people get comfortable with the data that you are producing?” It is an interesting question in the context of ‘lend and pretend’.