A negative outlook for the UK economy – at least that’s what Moody’s believes. The credit rating agency has put the UK economy’s sovereign credit rating, together with 2 other European nations (France and Austria) on the ‘negative outlook’ list.
The UK currently has a triple A rating and we have been able to maintain this despite the credit crunch and subsequent recession. However, with weak economic data and the continuing crisis in the eurozone, Moody’s took the decision to give the UK a ‘negative outlook’, which means the UK, as well as France and Austria have about a 30% chance of losing their triple A rating in the next 18 months.
Both Labour and the Coalition government have claimed this decision supports their view of the economy. Labour says this decision shows that the economy needs a stimulus and the Coalition should change its stance on cutting the budget deficit. However, the Coalition says that it shows the importance the Credit ratings agencies attach to budget deficits. Indeed, Moody’s statement showed no signs that it feels the UK should ease up on its austerity measures. The statement suggested the reverse – that a downgrade would only occur if the outlook worsened or if the government eased up on its cuts. The Coalition’s focus on cutting the deficit could even be something that has prevented the UK being put on the ‘negative watch’ list, as opposed to the ‘negative outlook’ list. The former is definitely worse than the latter, as it implies a 50% chance of a downgrade, rather than the current 30%.
The triple A rating doesn’t guarantee market confidence, but it does help keep the cost of borrowing for the government low. Indeed, the UK government’s cost of borrowing is at an historic low. A key problem therefore for the government is that there is a certain trade-off that it faces. Moody’s says that 2 things would make the UK lose its rating – a worsening economic outlook or if the government eases on its austerity plans. However, many would argue that it is the austerity plans that are creating the bad economic outlook. If the cuts stop, the economy may respond positively, but the deficit would worsen, potentially leading to a downgrade. On the other hand, if the austerity plans continue and the economy fails to improve, a downgrade could also occur. The next few days will be crucial in determining how the markets react to this news. The following articles consider this issue.
The meaning of ‘negative’ for Mr Osborne and the UK BBC News, Stephanomics, Stephanie Flanders (14/2/12)
Relaxed markets remain one step ahead of Moody’s move The Telegraph, Philip Aldrick (14/2/12)
George Osborne tries to be positive on negative outlook for economy Guardian, Patrick Wintour (14/2/12)
Moody’s wants it may cut AAA-rating for UK and France Reuters, Rodrigo Campos and Walter Brandimarte (14/2/12)
Moody’s rating decision backs the Coalition’s path of fiscal consolidation The Telegraph, Damian Reece (14/2/12)
Moody’s rating agency places UK on negative outlook BBC News (14/2/12)
Britain defends austerity measures New York Times, Julia Werdigier 14/2/12)
Questions
- What does a triple A rating mean for the UK economy?
- Which factors will be considered when a ratings agency decides to change a country’s credit rating? What similarities exist between the UK, France and Austria?
- Which political view point do you think Moody’s decision backs? Do you agree with the Telegraph article that ‘Moody’s rating decision backs the Coalition’s path of fiscal consolidation’?
- If a country does see its credit rating downgraded, what might this mean for government borrowing costs? Explain why this might cause further problems for a country?
- How do you think markets will react to this news? Explain your answer.
- What action should the government take: continue to cut the deficit or focus on the economic outlook?
- Why has the eurozone crisis affected the UK’s credit rating?
Big challenges face the global community in making its financial institutions more resilient to withstand the difficulties that arise from the macroeconomic environment and, at the same time, better aligning their private interests with those of wider society.
This is no easy task. It is not easy either to keep tabs on the international responses to try and deliver these aims.
This is no better illustrated by some of the recent changes to the capital requirements of financial institutions outlined by the Basel Committee on Banking Supervisions. (Click here for a PowerPoint of the above chart.) The so-called Basel III framework will, in effect, increase the capital that banks are required to hold and, in particular, specific types of capital. In the process this will reduce gearing, i.e. the amount of assets relative to capital. Recent announcements have detailed how large global banks will have to hold even more capital. This blog tries to make sense some of the changes afoot. Further reading is identified below.
The details of the Basel III framework are complex, there are an enormous amounts of financial acronyms to sift through and the definitions of capital change from time. But, at the heart of the proposals is the aim of increasing the resilience of our financial institutions. To do this the proposals focus predominantly on the liability side of a bank’s balance sheet. More specifically, they focus on long-term liabilities which help banks to resource their assets, i.e. to fund their provision of credit (their assets). This capital is ranked by its quality or by tiers; this terminology has recently changed.
Tier 1 capital is now split into two groups: Common Equity Capital (CET1) and Additional Tier 1 (AT1). The former – the ‘best’ capital – is made up of common equity (ordinary share capital) and retained profits. Holders of common equity can expect to receive dividend payments, but these are discretionary, largely dependent on the financial well-being of the firm. The remainder of CET1 are the retained profits of the firms and, hence, that parts of profits which are not distributed to its shareholders (owners). Additional Tier 1 capital – ‘second best’ capital – comprises preference shares and perpetual subordinated debt. Preference shares are more akin to bonds and provide regular coupons. However, their payment continue to place a burden on firms during more difficult financial times. Subordinated debt is debt where the creditors would not have any financial redress before depositors and other creditors have been attended to. Perpetual subordinated debt (bonds) is debt with no maturity date. Finally, Tier 2 capital is subordinated debt where the time to maturity is greater than five years.
The Basel III framework outlines a series of ratios known as Capital Adequacy Ratios (CARs) that financial institutions should meet. The ratios define a type of capital (numerator) relative to risk-weighted assets (denominator). The denominator involves weighting a bank’s category of assets by internationally agreed risk factors. These range from zero for government debt instruments to 1.5 for certain types of loans to companies. In other words, the more risky a given level of assets are the greater is the denominator and the lower is the financial institution’s capital adequacy.
From January 2013, the so-called ‘hard core minimum’ of Basel III, which is a combined level of Tier 1 and Tier 2 capital, will need to be the equivalent to 8 per cent of the bank’s risk-weighted assets. This is actually unchanged from Basel II. But, it is not quite as simple as this. First, the composition of capital matters. The overall 8 per cent ratio must be meet by a Common Equity Capital (CET1) ratio, including retained reserves, of no less than 4.5 per cent (previously 2 per cent). Second, there is the phasing-in between 2016 and 2019 of additional Common Equity Capital (CET1) equivalent to 2.5 per cent of risk-weighted assets. This is known as the Capital Conservation Buffer. Third, depending on the assessment of national regulators/supervisors, like the Bank of England here in the UK, financial institutions generally could be required to hold further Common Equity Capital of between 0 per cent and 2.5 per cent of risk weighted assets. This is known as a Counter-Cyclical Buffer. So, for instance, if the regulators/supervisors become unduly worried by rates of credit growth, they can impose additional capital requirements. This is an example of macroeconomic prudential regulation because it focuses on the financial system rather any one single financial institution.
In September 2011, Basel III added a fourth qualification to the ‘hard core’. This too will be phased-in from 2016. It is to be applied to those financial institutions, which through a series of indicators, such as size, are to be identified as global systemically important financial institutions (G-SIFIs). Depending on their global systemic importance the amount of CET1 relative to risk weighted assets could increase by between a further 1 to 2.5 per cent (and even by as much as 3.5 per cent, if necessary). These four qualifications could take the overall capital adequacy ratio from 8 per cent to as much as 15.5 per cent: 8 per cent plus 2.5 per cent capital conservation buffer plus 2.5 per cent for G-SIB surcharge plus 2.5 per cent for counter-cyclical buffer.
However, capital requirements may be even more stringent in the UK for retail banks. The UK’s Independent Commission on Banking has proposed that retail banks in the UK become legally, economically and operationally independent of the investment part of banks. In other words, that part of the bank which focuses on deposit-taking from households and firms be separated from the investment bank which largely provides services involving other financial institutions. The ICB proposed in its report last Autumn that the separate retail subsidiary faces an overall CAR of between 17 to 20 per cent with a CET1 ratio of at least 10 per cent. We will have to wait to see whether this comes to pass as the government’s legislation passes through Parliament, but it is not expected that the ICB’s proposals come into force before 2019.
Recommended Materials
Final Report: Recommendations Independent Commission on Banking , September 2011. (See Chapter 4 for a readable overview of Basel III and the general principles involved. See Chapter 3 for a discussion of the functional separation of retail and investment banking).
Basel Committee on Banking Supervision reforms – Basel III Bank for International Settlements
Articles
Basel III – the case for the defence Financial Times (23/1/12)
Finance: Banks face a perfect storm that is getting worse Financial Times, Patrick Jenkins (24/1/12)
Banks in EU, US and Japan to face capital reviews BBC News (9/1/12)
Questions
- What is meant by capital and by capital adequacy?
- Explain the construction of a Capital Adequacy Ratio. Distinguish between the CET1 ratio and the overall CAR ratio.
- What do you understand by macro-prudential regulation?
- How do liquidity and capital adequacy differ?
- If financial institutions provide deposits to individuals who can draw out their money readily but extend credit over long periods of time, why don’t financial institutions regularly face financial problems?
As a resident of Bristol it is with considerable interest that I’m following the development of the Bristol pound, due for launch in September 2012. One Bristol pound will be worth one pound sterling.
The new currency will be issued in demoninations of £1, £5, £10 and £20 and there is a local competition to design the notes. Participating local traders will open accounts with Bristol Credit Union, which will administer the scheme. It has FSA backing and so all deposits will be guaranteed up to £85,000.
The idea of a local currency is not new. There are already local currencies in Stroud in Gloucestershire, Totnes in Devon, Lewes in East Sussex and Brixton in south London. The Bristol scheme, however, is the first to be introduced on a city-wide scale. The administrators are keen that use of the currency should be as easy as possible; people will be able to open accounts with Bristol Credit Union, pay bills online or by mobile phone.
As the money has to be spent locally, the aim is to help local business, of which more han 100 have already signed up to the scheme. Bristol has a large number of independent traders – in fact, the road where I live is off the Gloucester Road, which has the largest number of independent traders on one street in the UK. The organisers of the Bristol pound are determined to preserve the diversity of shops and prevent Bristol from becoming a ‘clone town’, with high streets full of chain stores.
But how likely is the scheme to encourage people to shop in independent shops and deal with local traders? Will the scheme take off, or will it fizzle out? What are its downsides? The following articles consider these issues.
Articles
The Bristol Pound set to become a flagship for local enterprise The Random Fact, Thomas Foss (7/2/12)
What is the point of local currency? The Telegraph, Rosie Murray-West (7/2/12)
The Bristol pound: will it save the (local) economy? Management Today, Emma Haslett (6/2/12)
‘Bristol Pound’ currency to boost independent traders BBC News Bristol, Dave Harvey (6/2/12)
We don’t want to be part of ‘clone town Britain’: City launches its own currency to keep money local Mail Online, Tom Kelly (6/2/12)
British Town Prepares To Launch Its Own Currency — Here’s How That’s Going To End Business Insider, Macro Man (7/2/12)
They don’t just shop local in Totnes – they have their very own currency Independent, Rob Sharp (1/5/08)
Videos and webcasts
The town printing its own currency [Stroud] BBC News, Tim Muffett (22/3/10)
Brixton launches its own currency BBC News (17/9/09)
Local currency BBC Politics Show (30/3/09)
Local currency for Lewes BBC News, Rob Pittam (13/5/08)
The Totnes Pound transitionculture.org on YouTube, Clive Ardagh (21/1/09)
Local Currencies – Replacing Scarcity with Trust Peak Moment on YouTube, Francis Ayley (8/2/07)
Questions
- What are the advantages of having a local currency?
- What are the dangers in operating a local currency?
- What steps can be taken to avoid the dangers?
- Can Bristol pounds be ‘created’ by Bristol Credit Union? Could the process be inflationary?
- What market failures are there in the pattern of shops in towns and cities? To what extent is the growth of supermarkets in towns and the growth of out-of-town shopping malls a result of market failures or simply of consumer preferences?
- Are local currencies only for idealists?
In the third quarter of 2011, the UK economy grew by 0.6% – nothing to shout about, but at least it was positive. Since then there has been growing concern about the state of the recovery with many commentators widely expecting to see much lower growth in the final quarter of last year.
Today, those commentators were proved right, as official figures released show the UK economy shrank by 0.2%. It doesn’t mean we’re in a recession (that requires 2 successive quarters of negative growth), but if growth doesn’t pick up in quarter 1 of 2012, then ‘Double-Dip Recession’ headlines will fill the front page.
Despite the disappointment that the UK economy has shrunk, the figures were not wholly unexpected, especially given the data released a week or so before, which showed unemployment had risen. Furthermore, with the crisis in the eurozone and many other countries still struggling to mount an economic recovery, there have been few external stimuli for the UK.
Although the fall in growth was larger than expected (0.2% as opposed to the predicted 0.1%), the UK economy is expected to grow throughout 2012. However, the IMF has reduced its forecast annual growth rate from 1.6% to 0.6%. The economic climate for 2012 remains uncertain and much will depend on developments in the eurozone. Further problems could spell trouble, but if there is an improvement in the fortunes of Europe, confidence could return to the markets and economic recovery could be faster. Ian McCafferty, the Chief Economic Adviser of the CBI said:
While the acute fears seen at the end of last year over global demand may be subsiding, 2012 will prove to be a difficult year for UK manufacturing, as the crisis in the eurozone – our biggest export market – has yet to reach any definitive resolution.
Whether or not we do move into a double-dip recession is uncertain and following this latest data, many commentators say it is a 50:50 change; and even then it hinges on many factors. However, even if quarter 1 of 2012 sees negative growth and hence a return to recession for the UK, Chris Williamson from Markit said that ‘there are growing indications that any downturn is likely to be ‘mild and short-lived’. The following articles consider the state of the UK economy.
Unemployment to soar as UK heads back into recession The Telegraph, Philip Aldrick (25/1/12)
UK economy shrinks by 0.2% in last 3 months of 2011 BBC News (25/1/12)
UK GDP: what the economists say Guardian (25/1/12)
UK recession threat: can we dodge the double dip? Citywire, Chris Marshall (25/1/12)
Double-dip recession fears as UK economy shrinks 0.2 percent Independent, Peter Cripps (25/1/12)
PM says ‘no complacency’ on economy Financial Times, Norma Cohen and Elizabeth Rigby (25/1/12)
The UK economy is shrinking. Time to listen to gloom-mongers? Guardian, Phillip Inman (25/1/12)
UK economy shrinks in Q4, raising recession fears The Associated Press (25/1/12)
FTSE CLOSE: Stocks slide as 0.2% GDP fall sparks recession fears; banks among the biggest fallers This is Money (25/1/12)
Sorrell: ‘UK will avoid double-dip recession’ Sky News, Tom Rayner (25/1/12)
Recovery in rehab BBC News, Stephanie Flanders (25/1/12)
Questions
- How is a recession defined? What are the typical characteristics of a recession? (Think about the macroeconomic objectives).
- Which particular sectors of the UK economy were the most severely affected in Q4 of 2011?
- Examine the main causes of the UK’s decline in national output.
- Which of the causes identified in question 3 do you think is the key factor keeping UK national output from growing? Explain your answer.
- Why is there a growing presence of companies from emerging markets in the top 100?
- Why are many commentators suggesting that even if the UK goes into a recession, it is likely to be ‘mild and short-lived’?
- What has happened to stock markets following the release of this latest economic data?
- Evaluate the options open to the Coalition government in stimulating the UK economy. To what extent would your policy solution damage the Coalition’s aim of cutting the UK’s structural budget deficit?
Throughout the credit crunch and since then, one of the major problems in the global economy has been a lack of lending by banks. A key cause of the credit crunch and many of the debt problems countries and people face today is because of people living off borrowed money. In the past, credit was so easy to obtain – people could receive a mortgage for more than 100% of the value of their property. However, when more and more people began to struggle to make their monthly mortgage repayments, the banking crisis began and since then mortgage lenders have become increasingly wary about who they lend to and how much.
The Bank of England has said that in the coming months it will become even harder to obtain mortgages, as banks become increasingly wary about who becomes their customer and potential home buyers put off even applying for a mortgage. Although mortgage approvals are at a 2-year high, they still remain significantly below their pre-crisis level. Indeed, the Bank of England said:
“Lenders expected the proportion of total loan applications being approved to fall over the coming quarter with some lenders commenting that they had revised down expectations for households’ disposable incomes and hence the affordability of taking out new secured loans.”
As part of this new rationing of mortgages, lenders are requiring applicants to put down larger and larger deposits and so for first time buyers, getting on to the property ladder is becoming more and more of a dream. The property market has been suffering from this mortgage rationing as house sales are down below their pre-crisis level. The housing market is crucial to any economy, as so many other sectors and hence jobs depend on it. If mortgages remain scarce and the required deposit so high, the UK housing market is likely to remain stagnant and this will certainly prove damaging for the prospects of the UK economy in 2012.
Articles
Mortgage approvals hit new two-year high The Telegraph, Angela Monaghan (4/1/12)
Mortgage approvals up but overall lending weak Reuters (4/11/12)
Mortgage rationing becomes worse, Bank of England says BBC News (5/1/12)
Mortgage demand fell in Q4 2011, say lenders Mortgage Strategy, Tessa Norman (5/11/12)
Mortgage lending still stagnant, Bank figures show BBC News (4/11/12)
BoE: Lending to be tighter in Q1 2012 Mortgage Introducer, Yuan Phoon (5/11/12)
Data
Lending to Individuals Bank of England
Questions
- Why are mortgages being rationed?
- Why is the housing market so important for the UK economy?
- Which other sectors of the economy employ people whose jobs are dependent on a buoyant housing market?
- Why has the Bank of England said that in the coming months it will become harder to get a mortgage?
- Why would increased mortgage lending be a much needed stimulus for the UK economy?
- Using an aggregate demand and aggregate supply diagram, show how rationing of mortgages and other loans will affect the UK economy.
A negative outlook for the UK economy – at least that’s what Moody’s believes. The credit rating agency has put the UK economy’s sovereign credit rating, together with 2 other European nations (France and Austria) on the ‘negative outlook’ list.