Peston on Banking

In the last couple of years, I have read at least twenty books on the causes and cures of the Global Financial Crisis. I try to grab every one that turns up in our local library. The last one to arrive is “How do We Fix This Mess” by Robert Peston and Laurence Knight. This is the first one by a British author, so it gives and interesting perspective. Robert Peston is the Business Editor for the BBC.

One interesting fact that he brings out is that during the 1930s, no significant banks failed in the United Kingdom. This is different from the United States, where thousands of banks failed. The reason British banks survived that disaster was that they had more adequate capital and liquidity back then.

Peston notes that the leverage of banks has been increasing for more than a century. In the 1840s, banks in the United States would typically hold capital equivalent to around half of their loans and investments. By 1880, a typical US bank had capital equivalent to around a quarter of its loans and investments, whereas the equivalent ratio for British Banks was not far off twenty percent. However, by mid-2008, Royal Bank of Scotland held capital capable of absorbing losses of around a tenth of that, or only 2.23 percent of gross loans and investments, while Northern Rocks capital-to-assets ratio in 2007 was just 1.7 percent.

Peston explains what this difference means. A century ago, a bank would go bust if a quarter of its loans went bad. In the latest financial crisis, one of the biggest bans in the world, RBS was no longer viable if could not get back 2% of what it was owed. In the case of Northern Rock, if it lost just one in every 60 dollars, it was kaput. By the time of the 2008 banking crisis, British banks had on average capital equivalent to less than 3 percent of their loans and investments, a fall of more than three quarters through the course of the twentieth century. The US banks had only a little bit more.

In the latest crisis most of the large banks in the UK had to be rescued. It is not surprising, given the inadequacy of their capital.