August 8, 2008 | posted by Michael Baxter in Banking |

And so RBS reveals its first ever half yearly loss in the forty years since it became a public listed company. It was also the second largest loss ever revealed by a British bank. Only Lloyds has ever managed to out do it, but that was back in 1989, and over Latin American debt.

Of the big five, RBS is the first bank to reveal a credit crunch related loss. But the key question is this: Is the worst now over, can we look forward to improved bank results, or is this just the thin end of the wedge?

RBS lost £691m in total – that is bad, but then again, consider this in the light of a £5bn profit in the same period last year, and while the decline in its fortunes is worrying, it is not as if the bank doesn’t have years of cumulative profit to fall back on.

Also, consider the losses in the light of the £12bn or so the bank has raised through selling shares lately.

These days, the strength of a bank’s balance sheet is measured by something called a Tier 1 Capital Ratio. This takes cumulative pre tax profit minus dividends, adds this to all investment the bank has received though the sale of shares, and then states this total value as a proportion of risk-weighted assets.

RBS now has a tier 1 capital ratio of 5.8 – that is after taking into account the sale of the bank’s stake in Tesco Personal Finance. To put that in context, the Basel Committee on Banking Supervision says banks should have a tier 1 capital ratio of at least 4 per cent. Barclays recently said it has a tier 1 capital ratio of 6,3; HSBC 8.8; Lloyds 7.4; and HSBC 6.5 per cent.

To put it another way, despite the massive fund-raising, the RBS has a lower tier 1 captial ratio than any of its four main UK rivals.

And the reason is easy to see. RBS, Santander of Spain and Fortis of Belgium forked out $110bn to purchase ABN Amro last year.

Although Santander seems to have absorbed its share of the takeover in its stride, both Fortis and RBS have had to get shareholders to stump up money, even though both the banks at first said this would not be necessary.

Mind you, there was some good news from RBS. The loss was much lower than expected.

In part this was because the bank has had some luck selling leveraged loans at a higher price than it had expected. The bank saw an £182m reduction in the value of its debt.

What about the future? Sir Fred Goodwin, chief executive at the bank said: “It doesn’t feel like we’re heading back to the good old days, but we are seeing some movement,” and he added: “Its a brave person that can try and predict this market through year-end, but we feel these are strong marks and we have a reasonable degree of confidence. We’re still reducing exposure. We feel more comfortable with these marks now than at the end of April.”

The big snag, though, with all the write-downs announced by the banks so far, is that it seems unlikely that, moving forward, they have taken sufficient account of the effect the credit crunch will have on indebted UK consumers.

It may be that we have seen the majority of US subprime write-downs taken into account now, but the US and UK property markets have an important difference.

As is explained in the article below – “House prices fall again, but at least they rise in the US,” in the US, the banks often have to pay the cost of the negative equity in a mortgage. In the UK, most of us with negative equity have to just struggle on. Meaning, the effect of negative equity could take longer to be felt in the UK.

The underlying forces that shape the economy can affect different sectors at different times. At the moment, it is the banks who are feeling the full force of the credit crunch. Over the next year or two, it will be business and consumers.

The economist Hyman Minsky once talked about three stages in the development of a credit bubble. Stage 1, borrowing is affordable. Stage 2, borrowers can’t afford to repay the loan, but they can afford to pay interest. Stage 3, they can’t even afford the interest, and may borrow from elsewhere to repay existing loans. Then, all of a sudden, credit dries up – backlash against the untenable borrowing occurs – this is called the Minsky moment.

For many consumers it seems as if they are close to reaching that Minsky moment. This will be the point of maximum danger for the economy. It seems that as consumers find they are no longer able to borrow to repay borrowing, defaults will rise.

Businesses could face a double blow. As the economy slows they may need to borrow more, but for many, the credit crunch will make this impossible.

As a result, British banks could face rising defaults from both consumers and business – and for those reasons, it is quite possible bank losses have further to rise.