Jon Cunliffe: Remarks at the Alastair Ross Goobey Memorial
Lecture
Speech by Sir Jon Cunliffe, Deputy Governor for Financial Stability of the Bank of
England, at the Alastair Ross Goobey Memorial Lecture, London, 26 April 2016.
* * *
I was very pleased to be asked to give this memorial lecture today. I worked with Alastair
when I was at the Treasury. Long before the "age of the asset manager" he was a
colossal figure who had a major impact, not just on his own industry, but on the corporate
world as a whole.
Ideas and practices that we now think of as standard corporate governance would, I
suspect, never have been adopted without his advocacy and without his willingness to
press the interests of those millions of people whose assets he managed.
And he knew about booms and busts. His dissection, in his book Bricks and Mortals, of
the anatomy of the UK property boom and bust of the late 80s and early 90s is a lesson
to those who are today concerned with financial stability in the UK.
Alastair died in early 2008, after Northern Rock but before the global financial crisis really
got underway. The ending of Bricks and Mortals is prophetic. It was written in 1992, just
before we began the long upswing in the financial cycle that ended with a bang in 2007:
"Whenever the recovery starts, there will be new participants, who will be
less constrained by the experience of this recession than those who lived
through it. They will repeat many of the mistakes of the 1980s, as many of
the companies repeated the mistakes of the 1970s. The market will then be
driven to levels which will prove unsustainable."
He was writing, of course, about the UK property market rather than the sub-prime
market in the US or over-leveraged international investment banks. But I doubt he would
have been that surprised; the subject of Bricks and Mortals is but one example of the
self-reinforcing dynamics of powerful financial cycles which, if left unchecked, often end
in tears, not just for investors but for the economy as a whole.
I hope also that he would have thought the changes to the Bank of England's
responsibilities following the crisis - and the establishment of the Financial Policy
Committee (FPC) in particular - were a major step forward in how we manage and
mitigate the risks of the financial cycle.
I want to talk a little today about the FPC's role and how the Committee sees the current
conjuncture in terms of risks to financial stability. I will focus on the UK property sector.
That is not simply because today's lecture is supported by the Investment Property
Forum and the Cambridge University Land Society. Property-related debt - for
residential and commercial real estate purposes - makes up around 60% of private
nonfinancial sector debt in the UK.
And, of course, the counterpart of that is that domestic property-related loans make up
around 55% of the domestic loans of the UK banking sector; 76% when financial sector
loans are excluded.1 Moreover, the evidence is pretty clear from history, and across
countries, that there is a strong and special link between booms in property-related debt
and financial crises in a way that is much less true for other assets like equities.2
I want also to reflect a little today on the health of banks in the UK. Since last summer,
and particularly since the turn of the year, investors have written down the value of banks
in advanced economies. Does this signal concerns about banks' resilience and
robustness? Or about their returns?
The Financial Policy Committee
The FPC is charged with identifying risks and taking action to protect the resilience of
the UK financial system. In essence this means two things.
First, we need to be confident that the regulatory framework in the UK addresses the
risks not just of individual financial firms, important though that is, but also the risks
inherent in the financial system as a whole. On that front we are well advanced in
implementing in the UK a programme of reforms to regulation that is unprecedented in
scope and effect.
To give some examples of reforms and progress: capital requirements for globally
systemic banks have increased ten-fold; and since the crisis, major UK banks' leverage
has roughly halved; they have cut the share of total funding accounted for by short-term
wholesale funding from nearly 30% in 2007 to 10%; reduced trading assets by a third
and cut inter-bank exposures by two thirds.
Second, we need to address, through time, the risks that build up in the financial cycle.
Financial cycles - the build-up of credit and risk driven largely by the dynamics of the
financial system and its interaction with the economy - are generally longer than the
"economic" or "business" cycle. The upswing of the financial cycle in Bricks and Mortals
lasted from around 1980 until the early 1990s. The last cycle was longer and more
powerful.
The FPC needs to identify, assess and mitigate risks building up over the cycle both in
the financial system and in the economy as a whole. Or to put it in the terms of Alastair's
warning, to make sure that as memories fade, confidence returns and the dynamics of
the financial cycle become more powerful we do not simply make the same mistakes
again.
The current conjuncture
The FPC's current assessment of the financial cycle is that following a subdued and
lowrisk period of post-crisis repair to bank, household and corporate balance sheets, we
have now entered a more standard period of risk and credit growth.
The stock of private non-financial credit, economy wide, is around 140% of GDP. As I
said earlier, the bulk of this is property-related debt. It is growing at broadly the same
rate as nominal GDP. In contrast, in the 10 years before the crisis it grew annually at
around twice the rate of GDP reaching 177% of GDP in 2009.
The stock of household debt relative to income is 135%, down from 155% pre-crisis. In
1992, when Bricks and Mortals was published, it was only 100%.
Debt servicing ratios, however, are not stretched at the moment because interest rates
are very low - the household debt service ratio is now at 2001 levels of around 8%. But
the composition is very different: in 2001 the stock of debt was half the current level and
the interest rate twice the current level.
There are good reasons why the sustainable level of household debt may have risen
over the past 30 years.3 But the current level is still relatively high by historical and
international standards and is something that, in my view, the FPC needs to keep
carefully in mind when thinking of financial stability.
Hotspots
Within this current overall picture of the UK being at the beginning of a period of standard
risks, credit growing gently at a similar rate to nominal GDP, and asset prices supported
by low long-term interest rates, there are some hotter spots in property markets and
elsewhere, such as consumer lending.4 I will focus on property markets.
Buy-to-let
First and foremost, within the residential property market, lending for buy-to-let has been
growing strongly for a number of years. The stock of buy-to-let mortgage lending has
grown at an annual average rate of 6% since 2008. It rose by 11.5% in the year to 2015
Q4, while the stock of lending to owner occupiers was unchanged. Buy-to-let mortgages
now account for 17%, by value, of the total stock of secured lending.
Lending for buy-to-let has clearly been profitable. At around the start of 2016, lenders
were planning to grow their gross buy-to-let lending by, on average, almost 20% per
annum over the next two years, with some challenger banks and smaller building
societies planning to grow their buy-to-let books at a much faster rate.
A good rule of thumb for financial stability is that when some form of credit is growing
fast one needs to look very carefully at whether lenders' underwriting standards are
slipping and at what is happening to the distribution of borrowers' indebtedness.
The Prudential Regulation Authority (PRA) conducted a review of lending for buy-to-let
mortgages and concluded that there was indeed some evidence of loosening
underwriting standards and a possibility that this might increase. As a result, the PRA
Board has issued a Supervisory Statement to clarify expectations for underwriting
standards in the market. The statement includes guidelines for testing the affordability of
interest payments and a minimum stressed interest rate for use in lenders' affordability
tests.
There are also substantial tax changes affecting the buy to let market. The FPC's
expectation is that the Government's changes in stamp duty and mortgage interest tax
relief for buy-to-let, together with the PRA's actions, will probably dampen the growth of
buy-to-let lending. Mortgaged buy-to-let accounts for only around 10% of all housing
transactions for house purchase so the impact on the housing market as a whole may
not be great.
But market dynamics are difficult to predict and given the uncertainty around the impact
of the tax and supervisory changes, the FPC decided to wait and see how the market
reacted before considering whether to take action on buy-to-let. The Committee
continues to watch the buy-to-let market closely.
Lending to owner-occupiers
Second, lending to owner-occupiers at high loan-to-income (LTI) ratios remains
significant. The FPC took action in 2014 to counter the risks arising from an increase in
the tail of overly-indebted households. Its concern was that an increase in the tail of
overly-indebted households posed a threat because such households cut back
consumption very sharply in a downturn.5 Transactions, house price inflation and the
proportion of high LTI mortgages all cooled down following the FPC's actions and other
factors at the time like the introduction of the Mortgage Market Review. All of these
variables have since bounced back. Prices and mortgage approvals for house purchase
are growing at an annual rate of 7.5% and 19% respectively.6 And nearly 15% of new
mortgages extended in Q4 had LTI ratios just below the FPC's threshold of 4.5 - almost
double the proportion in 2008/9.
Commercial real estate
The third property-related area the FPC has been looking at closely is commercial real
estate (CRE). Many countries have experienced repeated booms and busts in
commercial property and the UK is certainly no exception.
Over the past 100 years, the UK has experienced five CRE cycles and similar cycles
have been seen in a range of developed economies. At the end of the 1980s CRE boom
documented by Alastair, prices fell by over a third and 25 banks failed or were closed
down.7 And, more recently, 9% of the UK banks' pre-crisis stock of CRE lending was
written off between 2008 and 2014 compared to 0.4% for mortgage lending. Over the
past two years, commercial property prices have risen strongly by 18%. Up to the second
half of last year, the market seemed to be "simmering" if not "bubbling".
Unlike in previous cycles, however, a much greater proportion of CRE activity has been
financed by equity investors, in large part overseas investors, rather than by UK bank
lending. The share of equity finance in UK CRE transactions in 2015 is estimated at
around 55%, compared to around 30% in 2007 and a peak of around 80% in 2010. So
the direct risks to major UK banks from this sector are not as high as one might assume.
The fact that there is less UK leverage in the sector does not mean however that a sharp
correction in CRE prices poses no financial stability risks. Property is an important source
of collateral for UK corporates, SMEs in particular. A sharp drop in CRE values could
constrain their access to credit. Recent research by Bank staff found that a one pound
rise in the value of a company's property is associated with around a five to ten pence
rise in investment.8 More broadly, Bank staff estimate that around a quarter of business
investment is related to commercial property.
In this context, it is encouraging to see that the industry itself is taking forward a set of
recommendations, set out in the cross-industry report on the "Vision for Real Estate
Finance in the UK", for reducing risks to financial stability from the CRE market. The
report included, among others, recommendations to build a database of each UK CRE
loan and its collateral, as well as using long-term valuation measures for risk
management purposes. The Bank is very supportive of these initiatives - and is working
with industry to take them forward.9
The UK CRE market has shown marked signs of easing in 2015 H2 and 2016 Q1. The
annual growth of UK CRE prices weakened to 6% in March and CRE prices fell by 0.6%
between February and March, the first monthly fall since 2013. And the amount, by value,
of secondary market transactions fell by around 40% in Q1 relative to Q4 and 60%
relative to a year ago. The CRE market seems to have gone into a deep freeze ahead
of the EU referendum.
The FPC, of course, also assesses risks that originate outside the UK financial system
but can, if they crystallise, damage its stability. The Committee has also identified risks
around the current global macroeconomic conjuncture and around emerging markets.
And there are concerns about potential risks in some sectors of financial markets where
there has been substantial investment in asset classes in which liquidity may be limited.
And the FPC assessed the risks around the EU referendum to be the most significant
near-term domestic risk to financial stability.
There will always be risks to UK financial stability from outside the UK financial system.
The point I want to emphasise today, however, is how important UK property markets
and property-related lending have been and will continue to be for UK financial stability.
I would expect the FPC's attention to risks around property to increase as the credit cycle
becomes more established.
Banks and property lending
I want now to look at stability from the banking end of the telescope. As I have said,
property-related lending is the largest component of UK banks' domestic loans. Mortgage
lending, in particular, is the single largest asset class on UK banks' balance sheets.
This was not always the case. Until the 1980s, short-term loans to non-financial
businesses constituted the majority of UK banks' loans. Looking back further, fewer than
10% of banks' loans to businesses at the start of the twentieth century had a contractual
term greater than a year - loans were mainly used for working capital or to support cash
flows rather than to finance long-term assets.10
Banks acted in line with the advice in George Rae's celebrated banking textbook,
published in 1885:
"As a banker, you are a dealer in money, or in securities readily
exchangeable for money, and building-land does not come within this
category. It is practically inconvertible into money on rational terms, and
ought therefore to have no place amongst a banker's assets."11
It is clear that, now more than ever, the returns and resilience of the banking system are
intimately tied to property markets. Is banks' unwillingness to follow George Rae's advice
responsible for their current subdued market values?
Banks: a crisis of resilience or returns?
UK banks currently have an average price to book ratio of around 0.7 compared to an
average of two in 2006. In other words, investors seem to be assuming that, looking
forward, banks will destroy value. This is not the sign of a vibrant banking system ably
supporting the real economy. The last time price to book ratios were this low was in the
euro-area crisis in 2011/12 and before that in the global financial crisis in 2008. In those
cases, particularly the latter, the fall in banks' price to book ratios reflected concerns
about their resilience and indeed their solvency - that is, whether they had sufficient
capital to back the riskiness of their assets. Low price to book ratios were accompanied
by very high debt spreads on bank debt for the same reason.
This time round, banks' low price to book ratios are accompanied by relatively low debt
spreads.12 In the main, they probably do not reflect concerns about banks' resilience,
which has improved significantly since the crisis.
The FPC and PRA Board, in 2014 and 2015, subjected the UK banking system to severe
but plausible hypothetical stress tests. The 2014 test was centered on a sharp
contraction in UK economic activity - in the test house prices fell by 35% and CRE prices
fell by 30%. The 2015 test featured a global slowdown emanating from weak growth in
emerging-market economies. The results of both tests showed that, on the whole, UK
banks would be able to withstand these scenarios and continue lending to the real
economy. Therefore, the current low price to book ratios probably reflect concerns about
banks' future prospects. That is, whether they can make adequate returns to satisfy
shareholders' expectations.
The most obvious reason for the difference between banks' returns on the one hand and
shareholders' expectations on the other is the disappointing returns that UK banks have
made in recent years. Average return on equity for UK banks fell from around 17% in
2006 to 2% in 2015. But there may be another reason, on the other side of the equation.
Shareholders' expectations may not yet have adjusted to the change in the risk and
return profile that banks now represent.
I want to look in a little detail at both the question of disappointing returns and the
question of unrealistic expectations.
Banks' returns
First, what is behind the disappointing returns? It is not lending on residential property.
Our latest estimates of the return on equity of bank mortgage books seem to be around
20%, on average, beaten only by overdrafts and asset and motor finance.13 Indeed, UK
banks' underlying return on equity on retail lending overall is currently around 20%.
Margins on the flow of UK retail business for the large UK banks are currently lower than
margins on the stock because new mortgages are being written at a lower average
interest rate than average back-book mortgage rates. So return on equity on new lending
is lower.
Some of this is probably due to the fact that with low interest rates and high employment,
impairment charges are at a very low rate by historical standards - impairment charges
as a proportion of total loans are now back to pre-crisis levels.
Of course, underlying returns only tell you part of the story. When one adds in the cost
of misconduct, including for PPI, that banks have paid and are likely to pay on past retail
lending activities, and other costs, the overall returns drop markedly. But even adjusted
for conduct and other costs, returns on retail lending still seem to be around 10%.
Cost of equity is the relevant comparator for return on equity. For large UK and
international retail and commercial banks it is estimated to be around 9%. So retail
lending does not seem to be the source of the problem.
Nor, on the surface, does corporate lending. Estimates of return on equity on SME and
corporate lending are around 8% to 9%, which is roughly around the cost of equity for
these activities, though it's hard to say with absolute precision.
Investment banking, however, is a different story; return on equity in the investment
banking parts of UK banks is around 5%. It was 20% in 2010. Returns at European and
US investment banks have followed a similar trend although the decline has not been as
steep as for UK banks.
Overcapacity, excess costs, removal of the implicit Too-Big-To-Fail government subsidy,
tighter capital regulations and restructuring costs are all contributing to reduced returns
on equity in investment banking. Large parts of investment banking are not meeting
required returns which are estimated to be in the region of 11% overall for a sample of
UK and international banks. Parts of investment banking are therefore not economically
profitable.
Banks have made good progress on restructuring their overall balance sheet - they have
cut funded assets by nearly £1 trillion since the end of 2010 - but they will probably need
to shrink parts of their investment banking businesses or boost returns, for example, by
increasing prices or cutting costs. Variable remuneration has fallen in absolute terms in
investment banking and other parts of banks but that has been offset by an increase in
fixed remuneration. Staff cost to income ratios for banks as a whole are similar to
precrisis levels or if anything a little higher. Banks' staff costs have not fallen anywhere near
as much as shareholder returns.
Conduct costs have also depressed returns in investment banking as well as retail
banking. Indeed, looking forward, concerns about future conduct risks, generally, may
also be clouding investors' perceptions of banks' prospects. The scale and uncertainty
around conduct losses is notable. UK banks' overall misconduct costs have totalled
nearly £50 billion to date - they have exceeded £10 billion per annum in each of the past
four years. This uncertainty, one hopes, should fall over time.
Investors' expected returns
Turning to the other part of the price to book equation, expected returns, the reforms to
the prudential regulation of banks since the crisis and, in particular, to the level and
quality of capital required from banks has reduced the risk to investors. That reduction in
risk should, all else equal, be reflected in the return investors demand. There are signs
that investors have, albeit slowly, started to lower the returns they demand to reflect
lower risks. Banks have cut their medium-term pre-tax return on equity targets by about
3.5 percentage points on average since 2009 - from around 15% to around 11.5%.
This is welcome and necessary. Some of the reduction probably reflects lower risk-free
rates. But some reflects the significant increase in banks' resilience. There may,
however, be factors that are still inflating required returns beyond the levels merited by
risk. I want to briefly mention two possible factors that may be affecting investors'
perceptions of risks and hence of the returns necessary to compensate for them.
First, there may be a collective action problem on the part of asset managers. Around
half to two-thirds of the shares of the largest UK banks are owned by institutional
investors and managed in-house or by asset managers.14 These tend to operate to
common benchmarks and are subject to rigorous peer comparison. Asset managers,
particularly those managing assets on behalf of institutional investors that have fixed
liabilities, are currently under great pressure to find returns in a low return environment.
Before the crisis, banks made high double-digit returns on equity boosted by very high
leverage. There may well be a reluctance among managers of institutional money and
investment funds to be the first to drop required returns. This could account for some of
the stickiness that we have seen in banks' return on equity targets.
The behaviour of institutional investors may also explain the so-called "low risk" anomaly.
In theory, lower risk ought to be matched by lower returns. But some research suggests
that this may not be a simple relationship. The "low risk anomaly", under which lower risk
stocks generate no lower - and in some cases higher - returns than higher risk stocks
has been identified for banks. A number of possible explanations have been provided as
to why this apparent arbitrage opportunity exists, including preferences by fund
managers for "high-beta", i.e. risky, assets to try to beat peers and attract inflows, or
because there is insufficient risk adjustment when assessing asset managers'
performance.15
The second factor that may be affecting perceptions of risks is regulatory clarity. The
crisis stimulated an unprecedented programme of reform of the prudential regulation of
banks. Most of the main components of that reform are now being implemented. Some
important elements remain, however, including in relation to the capital framework for
banks.
Uncertainty around the future end point for bank capital could be affecting investors'
assessments of the returns required from banks. The official sector needs to give as
much clarity as possible about the overall end point of the capital framework. For the UK,
the Bank of England's Financial Policy Committee has done that, setting out in December
last year its view of the overall capital framework.16 Internationally, the Group of
Governors and Heads of Supervision has said that it does not expect the completion of
the remaining elements of the risk-weighted capital framework to increase significantly
overall capital requirements.17
Closing the gap
Taking all this together, there is clearly at present a wide gap between banks'
disappointing returns on the one side and investors' expectations on the other. This is
reflected in current price to book ratios. This gap may need to be closed from both
directions.
It is, however, clearly not the case that all banking is unprofitable or un-investable. The
health of UK retail banking is almost certainly being masked by conduct costs, current
and expected, and by outdated and costly business models that need restructuring,
especially in relation to investment banking. But the returns expected by investors in
banks may well be sticky and have further to fall to come into line with risk. The
authorities may be able to assist this by giving greater clarity on the end point of the
regulatory structure.
On this last point, the stickiness in investors' required returns may be part of a more
general adjustment to a lower interest rate environment. We are unable to measure them
directly, but there is some evidence that despite the very low market rates we are now
seeing across the yield curve, hurdle rates for corporate investment - namely, the rate
of return required by corporates on new investment - have not reflected lower risk-free
rates but rather have been sticky and remained near pre-crisis levels. The Bank is doing
more work on this.
A recent Bank of England Discussion Paper looking at measures of finance for
productive investment cites data on hurdle rates as a material data gap in assessing the
availability of finance for productive investment.18 The Bank plans to use its Agency
network to run a survey of hurdle rates later this year.
Conclusion
What would Alastair have made of the issues I have raised today? He knew well the risks
that property markets can pose to stability. I hope he would be reassured by the creation
in the UK of the Financial Policy Committee within the Bank of England which is now
specifically charged with managing these systemic risks. The Committee is monitoring
property markets closely. It has already taken action and would not hesitate to do so
again if it is needed to protect financial stability.
Alastair was also a champion of investor activism. I think investors have a role to play in
restoring the economic profitability of banks, both by encouraging business model
restructuring and monitoring risks and perhaps by lowering their expectations a little as
well. But investors are only one part of the story. Banks need to work with the authorities
to implement fully the reforms that have been agreed to boost their resilience. And banks'
management need to maintain their restructuring momentum. The business model for
banks in the UK may look very different in the future than it did before the crisis. I think it
is clear that, in the new framework, it is possible for banks both to lend to the real
economy and to make adequate returns.
Thank you.
References
Bahaj, S, Foulis, A and Pinter, G "The Residential Collateral Channel", by, Bank of
England Staff Working Paper, forthcoming.
Baker, M and Wurgler, J (2013) "Do Strict Capital Requirements Raise the Cost of
Capital? Banking Regulation and the Low Risk Anomaly", NBER Working Paper,
No.19018.
Bank of England (2015) "The framework of capital requirements for UK banks",
Supplement to the December 2015 Financial Stability Report.
Bank of England (2016a) Financial Policy Committee statement from its policy meeting,
23 March 2016, available at http://www.bankofengland.co.uk/financialstability/
Pages/fpc/default.aspx.
Bank of England (2016b) "Understanding and measuring finance for productive
investment - A Discussion Paper".
Benford, J and Burrows, O (2013) "Commercial property and financial stability", Bank
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- and those who made it, Century Business.
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Financial Crises', John Wiley & Sons.
Knott, S, Richardson, P, Rismanchi, K and Sen K (2014) "Understanding the fair value
of banks' loans", Bank of England Financial Stability Paper 31.
Rae, G (1885) The country banker: his clients, cares, and work from an experience of
forty years, Jon Murray.