Banking Industry Country Risk Assessment: The United Kingdom

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MINISTRY OF EDUCATION AND SCIENCE OF THE REPUBLIC OF KAZAKHSTAN

INTERNATIONAL ACADEMY OF BUSINESS

Banking Industry Country Risk Assessment: The United Kingdom

Done by: the 3^rd course student

specialty finance

Suleimenova A.

Checked by: c.e.s. docent IAB,

Serikbayeva Zh.D.

Almaty, 20121. Major Factors

Strengths:

· Very low risk assessment of economic resilience for the U.K. stemming from a wealthy and diversified economy, and other sovereign credit strengths.

· Low net external funding of the banking system, deep U.K. debt capital markets, and strong government systemwide support.

· Moderation in the sector's risk appetite and greater competitive discipline stemming from consolidation.

Weaknesses:

· Credit risk in the economy owing to high private and public sector debt, exacerbated by the U.K.'s lackluster economic recovery and fiscal consolidation.

· Modest role of core customer deposits in funding domestic loan book.

· Reactive approach of the financial regulator in the past expansionary environment, although measures to strengthen the supervisory regime are under way.

Rationale

We have reviewed the banking sector of the United Kingdom (AAA/Stable/A-1+ unsolicited ratings) under our updated Banking Industry Country Risk Assessment (BICRA) methodology. We rank the U.K. in BICRA group '3' along with countries such as Chile, Denmark, Korea, New Zealand, and the U.S. We define the U.K.'s peers as Canada, Germany, Japan, and the U.S.

Our criteria define the BICRA framework as one "designed to evaluate and compare global banking systems." A BICRA analysis for a country covers rated and unrated financial institutions that take deposits, extend credit, or engage in both activities. The analysis covers the entire financial system of a country while considering the relationship of the banking industry to the financial system as a whole. A BICRA is scored on a scale from 1 to 10, ranging from what Standard & Poor's views as the lowest-risk banking systems (group 1) to the highest-risk (group 10). The BICRA comprises two main areas of analysis--economic risk and industry risk--where the U.K. scores '4' and '3', respectively.

Our economic risk score of '4' for the U.K. is based on: a "very low risk" assessment of "economic resilience" (defined in our criteria as the underlying stability of an economy to absorb adverse economic developments); a "high risk" assessment of "economic imbalances"; and an "intermediate risk" assessment of "credit risk in the economy," as our criteria define these terms.

Standard & Poor's Ratings Services considers that U.K. banks benefit from the country's wealthy and diversified economy, fiscal and monetary policy flexibility, and relatively adaptable product and labor markets. The banking system also benefits from the high and stable sovereign rating and a well-established political system. united kingdon bicra banking system

In accordance with our criteria, we consider that the U.K. is in a "correction phase." The U.K. has experienced little growth in GDP since the fourth quarter of 2010, weak bank lending trends, and a sluggish national property market. We expect that the full extent of economic correction in the U.K. will continue to significantly affect the banking system. This reflects the stress that the government's continuing fiscal discipline is exerting on unemployment and household sector incomes, as well as the persistent interest spread compression arising from holding base rates at all-time lows.

Our "intermediate risk" assessment of credit risk in the U.K. economy reflects high household and corporate debt, which combined is currently around 200% of GDP. The main loan concentration outside residential mortgages (60% of the domestic loan book) is commercial real estate (12%)--a higher-risk sector that is still subject to downside risk in our view. Nevertheless, we note that underwriting standards across loan portfolios have improved since 2008, with, for example, minimal new nonprime, or high loan-to-value (LTV), mortgage lending.

Our industry risk score of '3' for the U.K. is based on: an "intermediate risk" assessment of the "institutional framework"; an "intermediate risk" assessment of "competitive dynamics"; and a "low risk" assessment of "systemwide funding," as our criteria define these terms.

Our "intermediate risk" assessment of the institutional framework is somewhat restrained by our view of the reactive approach of the financial regulator in the expansionary financial environment prior to late 2007, mainly as a result of its "light touch" supervisory philosophy. Having reacted swiftly to the urgent demands arising out of the systemic turbulence of 2008 and 2009, the regulatory authorities have subsequently been particularly active in fortifying the U.K.'s regulatory structure. Measures include rigorous stress testing, substantially higher capital and liquidity requirements, and a stronger resolution regime.

Our "intermediate risk" assessment of the U.K.'s competitive dynamics reflects the moderation of the sector's risk appetite in the past few years. Management strategies now in place assume that higher capital norms, and generally more restrictive supervision, will constrain risk profiles and suppress achievable return on equity in the future. The competitive discipline of the U.K. banking sector is underpinned by the reduction in capacity, stemming from consolidation during the period of stress, the exit of some foreign competitors, and the ongoing deleveraging across the sector. Recent measures to attract new players could, in our view, reverse the current concentration of the top six financial institutions, which account for more than two-thirds of retail deposits and lending. However, we consider it unlikely that the dominant position of the major players will be materially diluted, at least in the medium term.

We base our "low risk" assessment of systemwide funding in part on the low net external funding of the system. While recourse to (gross) external funding is considerable among banks in the U.K., we note that the many foreign-owned banks located in London use this funding for nonresident lending. Our assessment also stems from the depth of the U.K. debt capital markets, and our view of the strong government systemwide support. However, the substantially increased role of wholesale funding in the precrisis expansion period, and the correspondingly modest role that core customer deposits play in financing the domestic loan book, temper these positives, in our opinion.

We classify the U.K. government as "supportive" toward its banking system. We recognize the government's significant track record of supporting the banking sector in times of economic duress.

2. BICRA Overview

Our bank criteria use our BICRA economic and industry risk scores to determine a bank's anchor, the starting point in assigning an issuer credit rating (ICR). The anchor for a commercial bank operating only in the U.K. is 'bbb+'. Our assessment of economic risk incorporates the strengths supporting the 'AAA/Stable/A-1+' unsolicited rating on the U.K., including its wealthy and diversified economy. The U.K.'s lackluster economic recovery and high household, corporate, and government debt are offsetting factors. Our assessment of industry risk is underpinned by the depth of its debt capital markets, strong government systemwide support, and moderation in the sector's risk appetite. The reactive approach of the financial regulator during the expansionary environment prior to 2007 continues to constrain our assessment of the institutional framework, although we recognize the measures taken over recent years to strengthen the supervisory regime.

Economic Risk: 4

The economic risk score for the U.K. is '4', based on our assessment of three main factors: economic resilience, economic imbalances, and credit risk in the economy--all of which our criteria define.

Economic resilience: very low risk

Our assessment of economic resilience is based on our view of the underlying stability of an economy and its resistance to adverse economic developments, such as external shocks.

Economic structure and stability.   With an estimated GDP per capita in excess of $39,000 in 2011, the U.K. has a wealthy, open, and diversified economy. Long-term economic prospects are underpinned by flexible and competitive markets and resilience to external shocks, supported by a freely floating exchange rate. The City of London remains one of the world's leading financial centers.

Economic growth, however, has been lackluster over recent quarters following a sharp recession in 2009. Moreover, economic output is still some way from recovering to prerecession levels and, based on current expectations, this timeframe may be even slower than the severe recession of 1980-1981 or the early 1930s. Fiscal consolidation, household deleveraging, and tighter bank lending terms are likely to continue to weigh on the economy over the next few years. As a result, we expect the U.K. will post relatively modest growth rates of around 1.2% on average in 2011-2014. High inflation also weighs on consumer confidence and the recent expansion of the Bank of England's quantitative easing program clouds the central expectation that inflation will moderate considerably.

Macroeconomic policy flexibility.   The 'AAA/A-1+' unsolicited sovereign credit ratings on the U.K. reflect our view of its fiscal and monetary policy flexibility, among other things. In response to high and rising government net debt levels resulting from the structural deterioration in public finances between 2007 and 2009, the U.K. government is pursuing a program of fiscal consolidation. Revenue-side measures have already been enacted, while spending cuts, which will account for nearly three-quarters of total fiscal consolidation of ?126 billion (about 8.5% of 2010 nominal GDP), are being spread over five years. We believe the net general government debt burden will peak at just under 93% of GDP in 2014 and then stabilize.

An accommodative monetary policy, with base rates at all-time lows of 0.5% since March 2009, is providing some support to the economy through low private-sector debt-servicing costs and a competitive currency. Low rates, however, are leading to liability spread compression for U.K. financial institutions, and are indicative of the scale of the problems the U.K. economy faces.

Political risk.  The highly centralized political system in the U.K. allows for quick and decisive decision making. We expect the U.K. political consensus on fiscal policy will broadly hold for the near future, and the coalition government will implement the measures specified in its fiscal consolidation program.

Table 1

Economic imbalances: high risk

The economic imbalances factor focuses on imbalances, such as credit-fueled asset-price bubbles and persistently lopsided current account flows, which affect financial institutions.

Correction phase.   We believe the U.K. economy remains in a "correction phase" after the credit and housing market boom that peaked in 2007. The U.K. enjoyed a strong period of house price growth between 1995 and 2007 on the back of economic growth, high demand, lack of housing supply, greater availability of credit, and, in the latter years, very accommodative lending criteria. We believe the latter had the greatest effect in 2006 and 2007, at a time when wholesale funding availability had become both cheap and plentiful, and competition was intense. The pace and severity of house price decline from the second half of 2007 through to the first half of 2009 was severe, with a peak-to-trough decline of 23% in just 21 months. Since then, house prices have been generally more resilient. Nevertheless, house prices remain about 19% below their peak in third-quarter 2007 (Source: Halifax House Price Index). The near-term outlook for property prices appears weak, reflecting the difficulties borrowers face in obtaining finance and low consumer confidence. Limitations in housing supply relative to demand suggest to us that the U.K. housing market will continue to demonstrate more volatility than for peers over the medium term.

The country is approaching the fourth year of what in our view is likely to be a long deleveraging cycle. Meanwhile, the banking system is still dealing with the fallout from a high private sector debt burden, property price correction, and structural weaknesses in banks' balance sheets. We believe that risks relating to the "correction phase" are likely to extend for at least the next two years.

Current account and external debt position.   As private sector debt declines, the current account deficit is projected to narrow to around 1.5% of GDP over the forecast horizon to 2014, from its peak of 3.4% in 2006.

We consider the government has a relatively modest net external debtor position. However, London's position as a global financial center gives rise to high levels of external assets and liabilities as a share of GDP. The financial sector has been the largest external debtor, with a net external debt position equivalent to about 24% of current account receipts in 2010. We expect further balance sheet repair by financial institutions to result in a reduction in the sectors' net external debt position. In our opinion, the external debt of both bank and nonbank debtors is sustainable and should not pose a risk to the sovereign.

Table 2

Credit risk in the economy: intermediate risk

Our credit risk score summarizes our view of a banking sector's credit risk relative to its exposure to households and companies, and to the sovereign. We assess credit risk largely by looking at private sector debt capacity and leverage; lending and underwriting standards; payment culture and rule of law; and sovereign government credit stress.

Private sector debt capacity and leverage.  With GDP per capita in excess of an estimated $39,000 in 2011, we classify the U.K. in our top tier for debt capacity, according to our criteria. However, we consider the private sector to be highly leveraged. The ratio of private sector domestic credit to GDP peaked at 214.4% in 2009, and we expect it to be just below 200% over the next three years. This level of private sector leverage is higher than that of the U.K.'s major European peers and the U.S.

Over a period of years to 2007, the U.K. household sector rapidly accumulated debt. In first-quarter 2008, household debt to disposable income peaked at over 170%--a high level compared with that of peers. The extent of leverage in the system has left the sector exposed to an economy that faces higher unemployment and inflation, sluggish nominal wage growth, and hikes in indirect taxation.

However, debt-servicing costs for households appear to have remained manageable because of the very accommodative monetary policy. Mortgage repayments to income have rapidly declined from their cyclical peak of 48% in third-quarter 2007 to 27% in third-quarter 2011 (Source: Halifax House Price Index). The quasi variable rate U.K. mortgage market has ensured that rate reductions have fed through more quickly to borrowers than would be the case in long-term fixed-rate markets, although the benefit is likely to be unevenly spread across different income groups. Credit losses on secured loans have also been limited by somewhat greater forbearance on the part of lenders than in the early 1990s.

Although not expected for several months, a meaningful rise in interest rates represents a key risk factor for future credit losses. This is owing to the high sensitivity of some leveraged borrowers to an adverse shift in their monthly outgoings, combined with the negative equity position for material proportions of some lenders' mortgage books. For example, Lloyds Banking Group PLC (A-/Stable/A-2), the largest lender with a market share of over one-quarter, reported that over 12% of its mortgage portfolio had an indexed loan-to-value ratio (LTV) in excess of 100% on June 30, 2011.

Within the corporate sector, we note the trend for larger and stronger corporates to pay down debt and refinance bank debt in the bond markets. Smaller commercial borrowers have, however, been more exposed to the weakening macroeconomic environment. Of particular note is the exposure of many U.K. banks to the highly cyclical commercial real estate (CRE) sector, which grew strongly through the decade to 2008. Since 2008, falling capital values and macroeconomic weakness have put borrowers under pressure and strained their credit quality. As a result, CRE loans have accounted for a disproportionate share of impairments over the past three years. Many of these loans are now in workout or forbearance because they cannot be refinanced or have breached covenants. This is because borrowers have insufficient equity and the supply of new credit to the sector is now highly constrained. The weak macroenvironment, potential further falls in collateral values, and the possibility that banks may not yet have fully provisioned their troubled assets, lead us to conclude that the CRE sector poses continued downside risk to U.K. lenders.

Lending and underwriting standards.  We have observed a strengthening in underwriting standards across loan portfolios since the financial crisis, with, for example, minimal new nonprime, or high LTV, mortgage lending. The percentage of new mortgage lending with a LTV above 75% has declined from 51% in 2007 to 28% in the first half of 2011 (Source: Council of Mortgage Lenders). We note, however, that the volume of new mortgage lending is a fraction of precrisis levels. The greater regulatory focus on income verification and affordability is likely to constrain any medium-term recovery in self-certification and subprime lending. Restrained risk appetite and further deleveraging is also likely to limit any recovery in lending volumes in the CRE sector.

U.K. bank loan books are relatively broadly spread and single-name corporate exposures are not outsized in our view.

Payment culture and rule of law.   We view the payment culture and rule of law in the U.K. as being "at least moderately strong", according to our criteria, and supportive of our intermediate assessment of credit risk in the economy. The assessment is supported by top decile assessments for rule of law and control of corruption, according to the World Bank Governance Indicators.

Table 3

Table 4

Industry Risk: 3

The industry risk score for the U.K. is '3', based on our assessment of three factors: institutional framework, competitive dynamics, and systemwide funding.

Institutional framework: intermediate risk

Our institutional framework risk score is based on an analysis of banking regulation and supervision; regulatory track record; and governance and transparency.

Banking regulation and supervision.  Our assessment of the institutional framework views the U.K. as intermediate in terms of banking regulation and supervision. We recognize the significant measures enacted to strengthen banking regulation and supervision since the financial crisis, including rigorous stress testing, substantially higher capital and liquidity requirements, and a stronger resolution regime. The Banking Act, effective February 2009, provides enhanced powers for the Bank of England, in conjunction with the FSA and the Treasury, to resolve a distressed bank or building society in an orderly way via a Special Resolution Regime. A new regulator for banks, the Prudential Regulatory Authority, is also expected to be in place by year-end 2012 with a remit to adopt a more judgment-based approach and provide greater challenge of business models.

Our assessment remains constrained because a number of important measures to strengthen the regulatory regime have yet to be fully implemented. For example, the recommendations of the U.K. Independent Commission on Banking (ICB) propose major structural change for U.K. banks. However, we believe the long gestation period and optionality in the ICB recommendations add to the continuing uncertainty over the rules and regulations for banking. Furthermore, because they are new, we are as yet unable to assess their effectiveness in imposing strong market discipline.

Regulatory track record.   The U.K. regulatory track record is one of the key constraints on our institutional framework score. This reflects the reactive approach of the financial regulator in the expansionary financial environment prior to late 2007, mainly as a result of its "light touch" supervisory philosophy. In our opinion, the U.K. banking system remains hampered by the reputational fallout from the wide-ranging government support that two of its major banks required. For example, we understand that the capital that the U.K. government injected into Royal Bank of Scotland Group PLC (A-/Stable/A-2) was the largest for any financial institution globally. In addition, there were a number of other high-profile bank failures, including the first "run on a bank" by a U.K. high street lender (Northern Rock PLC) since the 19th century.

Governance and transparency.  We consider that governance and transparency is supportive of our assessment. The U.K. corporate governance code (formerly the Combined Code) sets out standards of good practice concerning Board leadership and effectiveness, remuneration, accountability, and relations with shareholders. For financial years beginning on or after June 29, 2010, it incorporates some of the recommendations of the Walker Review of corporate governance of the U.K. banking industry.

Listed companies report under International Financial Reporting Standards (IFRS), supporting cross-border comparisons and transparency. Most U.K. banks report semiannually, rather than quarterly, but in response to greater investor demand, interim management statements (in effect first-quarter and third-quarter updates) contain increased detail on performance trends.

Competitive dynamics: intermediate risk

The competitive dynamics factor represents the structural implications of the competitive landscape faced by a bank within the broader banking industry. It is determined by risk appetite; industry stability; and market distortions.

Risk appetite.  Our "intermediate risk" assessment of the U.K.'s competitive dynamics reflects the moderation of the sector's risk appetite in the past few years. Management strategies now in place assume that higher capital norms, and generally more restrictive supervision, will constrain risk profiles and suppress achievable return on equity in the future. The ability of banks to charge high transaction and penalty fees such as excessive overdraft charges, or sell profitable fee products such as payment protection insurance (PPI), have become less acceptable and have dampened noninterest earnings. Moreover, the apparent high returns on PPI products have returned to impair the sector in 2011 and we note that significant compensation payments were made to consumers that were mis-sold these products. We note that U.K. banks have a track record of periodically incurring high provisions as a result of previous retail product mis-selling.

Despite the more conservative approach to financial management, we expect the U.K. retail market to remain more innovative than many peers, which is indicative of the sector's risk appetite.

Industry stability.   The competitive discipline of the U.K. banking sector is underpinned by the reduction in capacity, stemming from consolidation during the period of stress, the exit of some foreign competitors, and the deleveraging across the sector. Recent measures include the planned sale of 632 branches by LBG as part of its EC-agreed state aid. Moreover, the U.K. government has recently returned Northern Rock PLC to the private sector through a sale of its holding. These actions could, in our view, modestly reverse the concentration of the top six financial institutions, which account for more than two-thirds of retail deposits and lending. The U.K. has a track record of being both open and attractive to new entrants. However, we consider it unlikely that the dominant position of the major players will be materially diluted, at least in the medium term.

Market distortions.  We estimate that government-controlled institutions now account for over 40% of system deposits. An institution such as government-owned National Savings & Investments is a strong competitor for retail savings given its competitive advantages of unlimited government deposit protection and certain tax-advantaged products. However, we do not consider government involvement a significant market distortion for the sector. Government interest in the U.K. banking sector is primarily a function of the significant capital support it provided during the financial crisis. The institutions that received state support continue to operate on commercial terms and government ownership is temporary, in our opinion. As a result, we do not consider RBSG and LBG to be government-related entities (GREs) under our criteria.

The role of nonbanks (defined as money market mutual funds, ABS issuers, finance companies, REITs, brokers and dealers, and funding corporations) has reduced since 2007. In our opinion, this reduces risk, as the highly competitive practices of the nonbank lenders contributed to the industry's move toward more aggressive products and looser underwriting standards.

Table 5

Systemwide funding: low risk

The systemwide funding risk score assesses the relative stability of a banking sector's funding sources and its access to alternative funding sources.

Core customer deposits.  The ratio of core customer deposits to loans has remained relatively stable over recent years in a range of 72%-75%. In our view, this highlights the resilience of deposits, despite low interest rates. We consider this ratio to be relatively low compared with peers, and believe that it reflects the substantially increased role of wholesale funding in financing the domestic loan book in the pre-crisis expansion period, which we consider adds to funding risks for the sector. However, we also believe it indicates the diversity of funding sources available to U.K. financial institutions.

External funding.  The net external debt of the U.K. banking sector was about 12% of systemwide loans in 2010, according to our definition. We expect further balance sheet repair by financial institutions to result in a reduction in the sector's net external debt position. We believe the current position represents a relatively low net external funding of the system. While recourse to (gross) external funding is considerable among banks in the U.K., we note that the many foreign-owned banks located in London use this funding for nonresident lending.

Domestic debt capital markets.   The depth of U.K. debt capital markets is a strength in our overall "low risk" assessment of systemwide funding. U.K. banks benefit from a large and liquid domestic market for short- and long-term debt. However, there are potential longer-term risks relating to the cost and availability of funding if "bail-in" proposals are adopted and Solvency II regulatory changes for insurers--key investors in the banking sector--significantly penalize holding long-term higher risk debt instruments. The U.K. government's annual public borrowing needs, although lower than peer sovereigns, also represent a source of competition for banks in securing funding.

Government role.   Our assessment of systemwide funding also benefits from our view of strong government support. During the financial crisis, extensive liquidity and capital support was provided to U.K. financial institutions, as well as credit guarantees. The IMF estimates that the total size of direct support measures utilized by the U.K. financial sector has been in the region of 7.3% of GDP, above that of any other "advanced" economy.

The Discount Window Facility, launched in October 2008, provides a bilateral liquidity insurance facility against a wide range of collateral. An asset protection scheme (APS) was also announced in January 2009, although only RBSG utilized this scheme. The APS initially covered about ?282 billion of RBSG assets with the government bearing 90% of the losses above a first loss piece of ?60 billion. The sector also benefitted from a credit guarantee scheme for issuance from October 2008 to December 2009, a large proportion of which matures in 2012, with little remaining outstanding thereafter. Capital support included the nationalization of two banks and capital injections worth ?66 billion into RBSG and LBG.

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3. Peer BICRA Scores

A key strength for the U.K. relative to peers is our view of its economic resilience. However, in all other components of our BICRA criteria we consider the U.K. to be weaker than peers, most notably in terms of economic imbalances. This is reflected in our economic risk score of '4', which is below that of its peers. The industry risk score of '3' is more in line with its peers, with the notable exception of Canada, which we view as one of the most stable and lowest-risk banking sectors.

Table 7

4. Government Support

We classify the U.K. government as "supportive" toward its banking system in recognition of the government's significant track record of providing support to failing systemically important banks in times of economic duress.

While we understand that the U.K. government wishes to avoid putting taxpayers' money behind failing banks in the future, we continue to view the U.K. government as supportive because we believe that in practice it cannot yet walk away from systemically important institutions without causing wider systemic contagion and further disruption in the supply of credit to households and businesses. However, we think that the proposed structural measures, if adopted, could make it increasingly unlikely that the government would need to support a failing systemic U.K. bank in the future.

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