BoE Releases October 2008 Financial Stability Report

The October 2008 edition of the BoE’s Financial Stability Report has been released.

There’s an interesting graph of Sterling credit spreads:

Despite the slowing economy, corporate insolvency rates remain near historical lows. Many companies extended debt maturities during the recent boom, with Dealogic data suggesting that only about 10% of the stock of sterling-denominated bonds and loans outstanding are due to mature in 2009. But within that aggregate picture, there are pockets of vulnerability. Company accounts suggest that the proportion of debt held by businesses whose profits were not large enough to cover their debt interest payments picked up sharply in 2007 to around a quarter of the outstanding stock of debt

Also of interest is the continuing disconnect between fundamental value and market price of AAA subprime paper:

They update their estimation of ultimate credit losses (as opposed to mark-to-market losses) initiated in the April Financial Stability Report and conclude:

As Chart C shows, it is difficult to reconcile the outlook for expected credit losses on UK prime RMBS (Chart B), and hence the likely economic value of those securities, with current implied market values (Chart A). Based on this comparison, it is estimated that a little under half of the loss of market value of UK prime RMBS is likely to reflect discounts for uncertainty about future collateral performance and market illiquidity.(12) And around one third of mark-to-market losses on US sub-prime RMBS can be attributed to the premia demanded by investors for uncertainty and market illiquidity.

They emphasize that uncertainty and excess leverage are working together to greatly increase the calculated probability of default:

The uncertainty about the underlying values of banks’ assets was amplified by the high leverage with which UK and global financial institutions entered the downturn. To give an illustrative example,(1) in the middle of 2008 major UK banks had assets of just over £6 trillion and equity capital of around £200 billion. So if the standard deviation of asset returns pre-crisis was, say 1.5% per year, then levels of UK banks’ capital would have delivered a probability of default of a little over 1% a year (Chart 4.4). But if uncertainty doubled to 3% in the crisis — for example, as a result of higher macroeconomic and counterparty risk — then the implied default probability would rise to a little under 15%. In essence, that was what happened to UK and global banks during the summer, as the combination of asset valuation uncertainty and leverage markedly increased default fears and thus raised questions about the adequacy of banks’ capitalisation. That was the case despite capital ratios being above regulatory minima throughout the period (Chart 4.5).

… which in turn places a greater importance on the mark-to-market value of assets …

When the probability of default is low, the value of assets on banks’ balance sheets is determined by their economic value — the value built up from underlying expected cash flows on those assets on the assumption that they are held to maturity. But as default probabilities rise, so do the chances of the assets needing to be liquidated prior to maturity at market prices. So as the expected probability of bank default rose during September (Chart 3.1 in Section 3), it became rational for market participants to alter the way by which they assessed
the underlying value of banks’ assets, effectively placing more weight on the mark-to-market value of these assets. Given the high illiquidity and uncertainty premia in market prices (discussed in Section 2), this implied lower asset values and higher potential capital needs for banks. This valuation effect served as an additional amplifier of institutional distress.

It appears that the BoE will be pushing for better bank capitalization:

By historical standards, banks have operated with relatively low levels of capital in recent years. For example, long-run evidence shows that capital ratios for US banks have fallen significantly from levels of around 50% in the mid-19th century (Chart 6.1). The structure of banking systems, and the safety nets in place to support them, have changed dramatically over the period. While it is difficult to determine the optimum level of capital, recent events suggest that capital levels across the financial system as a whole have fallen too far.

Existing regulatory tools need to be adapted and new ones developed, to ensure that the financial system is better capitalised in advance of the next downturn and to address the build-up of risk through the cycle. A range of specific proposals have already been put forward. A leverage ratio — a minimum ratio of capital to total assets — would impose a constraint on the growth of banks’ balance sheets relative to their stock of capital. A system of dynamic provisioning would force banks to build up reserves against future losses in good times, providing a resource which could be drawn on in bad times. These and other proposals are outlined in detail in Box 6.

All in all, a very good review of the situation.

3 Responses to “BoE Releases October 2008 Financial Stability Report”

  1. […] justified. While I in favour of market based pricing in a general way, we have seen (in the pricing of AAA sub-prime tranches) that total reliance on market pricing implies total reliance on infinite liquidity … and we […]

  2. […] I am correct – with the support of the BoE – and bank assets have, in general, been written down to far below fundamental value, this is a […]

  3. […] yields, which have been discussed many times on PrefBlog – for instance, in the post announcing BoE Releases October 2008 Financial Stability Report. According to the Financial Times: Fears are mounting over possible dividend cuts by life assurers, […]

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