Saturday, 28 September 2013

The FLS early warning system

The Bank of England has produced usage data for the Funding for Lending Scheme (FLS). And very interesting it is too. Here is the full list of lenders that have signed up for the scheme, the amounts they have taken and their net lending position:

FLS usage and lending data1  
Click on the table to open the FLS usage and lending data spreadsheet

The Excel spreadsheet behind this gives information on exactly when the FLS funding was drawn - which is important, given the fact that funding costs generally have reduced considerably since FLS was introduced:

(chart taken from Bank of England's Inflation Report May 2013, p.12)

There is much less incentive now for banks to take FLS funding than there was in 2012 when market funding costs were very high.

I was therefore particularly interested to note those lenders that are both contracting net lending and tapping the FLS for cheap funding. Here they are:

Bank of Ireland
Co-Operative Bank
Santander UK
West Bromwich Building Society

Also of interest are the Manchester Building Society and Clydesdale Bank, which are not currently taking FLS funding but have signed up for the scheme, and whose net lending has been contracting for the whole period of the scheme: and Lloyds Banking Group, which is now expanding its lending but whose cumulative net lending for the duration of the scheme is negative, and which took FLS funding early on in the scheme when it was still reducing its net lending.

In short, it is the usual suspects, plus a couple of building societies and - mysteriously - Santander.

Taking FLS funding while net lending is reducing is expensive. Lenders are charged a penalty for failing to expand lending while in receipt of FLS funding. However, as I have noted before, in 2012 funding costs for some banks were sufficiently high for it to be worth their while taking FLS funding and accepting the penalty. That is probably why Lloyds Banking Group took FLS funding in Q3 and Q4 2012 despite its net lending reducing at that time. The penalty was insufficient to offset the benefit from reduced funding costs. The same probably applies to RBS and Santander, both of which accepted FLS funding early in the scheme despite reducing net lending. Indeed, Santander has subsequently repaid £900m of its £1bn FLS funding.

However, the Co-Op Bank, Bank of Ireland UK and West Bromwich Building Society have chosen to tap the FLS funding scheme more recently, when the interest advantage from taking FLS funding seems much less likely to offset the penalty. Why would they do this?

The clue lies in the balance sheets of all three institutions. We are looking at two badly damaged banks and a badly damaged building society. Let's look at each one in turn.

The Co-Op Bank
The taking of FLS funding coincided with the disclosure of a capital shortfall which at the time was thought to be about the same size as the FLS funding (it is now considerably larger, partly because the PRA moved the goalposts). It looks very much as if the Co-Op took the FLS funding to shore up its balance sheet: pledging part of its asset base to the Bank of England in return for safer government debt in effect transfers some of its balance sheet risk to the Bank of England. Although this would not be reflected in the capital position, since the new securities were borrowed rather than owned, the fact that the Bank of England would now face losses if the Co-Op Bank was forced into resolution possibly gave the Co-Op's management a stronger bargaining position with the PRA, as Robert Peston suggested in his blog. It is no surprise that, following the Co-Op receiving FLS funding, its management attempted (unsuccessfully) to persuade the PRA to back down on the capital requirement.

Although the FLS transaction itself is off balance sheet, being structured as a collateralised stock lending transaction (no money changes hands - see Appendix A here), it can under certain circumstances be backdoor recapitalisation. FLS enables banks to obtain funding more cheaply. It is intended to enable banks to cut interest rates on loans - and some lenders, such as Lloyds and RBS, have done exactly that. But if the bank chooses to maintain or increase interest rates on lending, the wider spread between funding costs and income from lending should improve profitability and therefore, over time, improve the bank's capital ratio. So did the Co-Op cut loan rates? No. It raised its mortgage rates in April 2012, and has not cut them since despite taking up Funding for Lending. Nor has it cut effective rates to SMEs. And it has closed its doors completely to new business customers. Quite apart from its use of FLS to shore up its balance sheet, therefore, it may also be expecting reduced funding costs to improve its capitalisation over time. However, using FLS funding as part of a profits improvement strategy seems far more significant in the other two cases.

Bank of Ireland
The Bank of Ireland got into very deep trouble in the financial crisis and was partially bailed out by the Irish government with liquidity assistance from the ECB. It remains 15% state-owned. Like other damaged lenders, it has a portfolio of toxic loans that it is gradually unwinding, and it has made losses every year since the financial crisis, although the losses are gradually reducing.

However, it is, of course, the UK subsidiary of the Bank of Ireland that has accepted FLS funding. This subsidiary incorporates the Bristol & West building society and Post Office savings accounts.

The Bank of Ireland cut interest rates on Post Office savings accounts in the UK in January 2013, following this up with two tranches of FLS borrowing. It then hit its tracker mortgage borrowers with a margin increase, taking some mortgages from 0.85% over base (total 1.35%) to 2.99%. A further 1% margin rise is planned for this October. This does not look like the action of a lender that intends to increase lending. It looks like the behaviour of a lender that is desperately trying to stop the bleeding by widening its credit spreads. So what is going wrong?

From the Bank of Ireland Group's interim results for June 2013 (p.40), it is clear that all is not well with Retail UK. Operating profit of £65m was wiped out by £177m of impairment charges on loans and advances - 10% higher than in 2012 - mostly on corporate lending and construction loans. This resulted in a pre-tax loss of £97m. Admittedly, this loss is tiny compared to the losses still being incurred by its parent. But of course the parent is not in a position to shore up its subsidiary. The Bank of Ireland UK is on its own. It must do something urgently to improve its profitability. Hence the rate hikes to borrowers, the rate cuts to depositors - and the use of FLS funding.

West Bromwich Building Society
This little building society nearly failed in the financial crisis. It still has a large legacy loan portfolio which it is gradually unwinding; it has made losses every year since 2009, although the losses are reducing, and like other financial insitutions with commercial property, its impairments are rising. Although its net lending was still reducing at 30/6/12, it looked as if West Brom took FLS funding in anticipation of a rise in mortgage lending, as it is a major player in the booming Buy-To-Let marketplace (60%  of its prime residential mortgages are Buy-To-Let). Until last week, that is....when it hiked the rates charged to its prime residential SVR borrowers, a large proportion of whom are Buy-To-Let investors, by 2%. This is not the action of a lender intending to increase net lending. No, it is the action of a lender in trouble. Clearly, the reduced cost of funds due to FLS was not enough to restore its profitability, especially in the light of rising impairments. So it has widened the spread by hitting borrowers.

A quick look at West Brom's report and accounts shows what the main problem is. Its cost base is shockingly high - 91% of its income. It is normal for smaller banks and building societies to have higher cost/income ratios than larger ones, but that is exceptionally high. And it is not because its costs have increased. It is because its income has halved since 2009. It desperately needs to improve its income as well as cutting costs if it is to survive: a cost/income ratio of that size is not remotely sustainable. 

So those were the three financial institutions that have taken FLS funding RECENTLY while reducing net lending. The indications are that all three are in trouble. Could it be that take-up of FLS by an institution that is not acting in accordance with the FLS rules and expectations (namely, that net lending should increase and interest rates on loans reduce) is a warning sign? 

Let's look at two institutions that have signed up for the scheme while reducing net lending but are not yet tapping it - the Manchester Building Society and the Clydesdale Bank. 

Manchester Building Society
The Manchester is in something of a mess. This is from the Chairman's statement in the 2012 accounts (my emphasis):
The financial statements for 2012 have seen a material write-down in the Society’s opening reserves resulting from a change in the accounting treatment for certain financial instruments. Whilst the underlying business and profitability of the Society has remained unaltered, the accounting treatment was revised in order for the Society to comply with the requirements of International Financial Reporting Standards (“IFRS”). 
The accounting principles involved are complex. Included within the Society’s range of mortgage products are a number where the borrower pays a fixed rate of interest. By offering fixed rate products, the Society is exposed to the risk that future movements in interest rates will see its interest margin eroded or otherwise adversely affected. The Society has entered into interest rate swap arrangements which, where terms match, lock in an interest rate, thereby gaining economic certainty as to the margin that it will earn on these products.
At each year end, the Society has calculated the “fair value” of both the swaps and the mortgages and historically reported the fair value of both in its balance sheet under the hedge accounting provisions of IFRS. The Society has now identified that this accounting treatment does not comply with IFRS hedge accounting requirements and the mortgages should be reported at their amortised cost. The resulting accounting adjustments have been back-dated across a number of years in line with accounting conventions and the Society’s opening reserves have been adjusted to take account of the pre-2012 effect of these adjustments. Prior to these adjustments, a pre-tax profit of £1.86 million was achieved in 2012; after adjustment this figure becomes a post-tax loss of £2.72 million. Remedial action has already been taken, in consultation with the Society’s regulators, to rebuild the Society’s capital by issuing, in April 2013, £18 million of new equity in the form of Profit Participating Deferred Shares.
In line with the Board’s risk appetite, the size of the balance sheet was reduced during 2012. £4.8million of mortgages were sold at a small premium to book value. In addition, three key initiatives were taken during 2012: an application to participate in the Bank of England’s Funding for Lending Scheme, a diversification of the Society’s retail deposit base (via our North West Air Ambulance Affinity Account and a range of competitive SME Business Deposit Accounts) and the development of Introducer deposit accounts.
Ouch. I hope they sacked their Chief Financial Officer and their auditors. More importantly, though, the restatement left the Manchester terribly short of capital. That is a huge reserve hit for a financial institution of that size.  Like all mutuals, the Manchester relies mainly on organic growth (retaining profits) and/or divestment to increase equity capital. It has raised some new Tier 1 capital*. And it has divested some assets. If its income were stable or improving, that might be enough to restore its fortunes. But that's not the case. Stripping out the restated derivatives loss in the income statement reveals a drop in interest income of £3.3m - about 20% of its 2011 net interest income. Admittedly this is probably at least partly due to asset divestment, but.....ouch again. So the Manchester not only needs to repair the capital hole that has suddenly opened up due to a gross error in its use of accounting standards, it also desperately needs to improve its profitability. No wonder it is looking at cheaper forms of funding.

Clydesdale Bank
On 23rd August 2013, Moody's downgraded Clydesdale Bank's senior debt. The reasons it gave are telling:
The lowering of the BCA reflects Moody's view that Clydesdale faces longer-term structural challenges from its weakened franchise and past risk-management/control weaknesses. The rating takes into consideration the bank's efforts to address these challenges by strengthening its risk management and controls framework and improving efficiency through a cost reduction program, but Moody's believes that these measures will take some time to be effective, while at the same time the bank remains exposed to ongoing short-term pressures. These include (1) a business loan portfolio whose asset quality remains under pressure; and (2) low profitability, which reduces the bank's financial flexibility.
Clydesdale Bank is currently owned by the National Australia Bank (NAB), which has recently recapitalised it and taken on to its own balance sheet the Clydesdale's distressed commercial property portfolio. This looks like the sort of action that a parent would take if it were preparing its subsidiary for eventual divestment, and Moody's takes this into account. But the Clydesdale still has a commercial lending portfolio that is not doing too well, and its profitability is poor. Cutting funding costs, as I have explained already, is a way of improving profitability. It may be that the Clydesdale plans to use the FLS to reduce its funding costs as part of a profits improvement strategy. If so, I would expect to see FLS takeup coupled with interest rate rises on loans and cuts to deposit rates. Furthermore, FLS can be used as part of a strategy to bolster the capital position over the medium term: as it seems likely that the Clydesdale will face further impairment charges, improving its capital position is important. Once again, we have FLS (though admittedly not yet in receipt) associated with a lender that appears to be in some trouble.

I haven't looked in detail at the lenders that borrowed in the early months of FLS while contracting net lending, because - well, we all know what state RBS and Lloyds were in at that time, and Santander was undoubtedly preparing itself for a Spanish default (since its parent is Spanish). But I think the cases I have looked at above are sufficient. FLS may not be very effective as a lending boost. But it is an excellent early warning system for banks and building societies in trouble. 

Related reading:
Funding for Lending Scheme Usage & Lending Data - Bank of England
The Funding for Lending Scheme - Bank of England
The fatally flawed FLS - Coppola Comment
Has the Bank of Engalnd's loan scheme failed? - Robert Peston (BBC)
Under the Radar - Coppola Comment
Bank of Ireland Group interim results 2013
Bank of Ireland's losses are falling - BBC
West Bromwich Building Society report & accounts 2013
Manchester Building Society Report & Accounts 2012
Moody's downgrades Clydesdale Bank's senior debt - August 2013

* In 2009 the West Brom converted its subordinated debt into PPDS. The Manchester is subtly different, in that it has issued new PPDS rather than converting sub debt. But the result is the same. Arguably, neither the Manchester nor the West Brom is really a true mutual any more, since PPDS are much like non-voting equity shares. FT Alphaville, quoting the FSA extensively, attempted to explain them here.

I am indebted to Robert Bothwell for his assistance with the financial analysis behind this post. 


  1. It would help if someone bothered to publish the details of the penalties banks and b soc face for not lending using FLS
    Without knowing what the true resulting rate they have to pay no saver can work out who is shafting who

    1. The penalties are published here:

      I also outlined them in my earlier post on FLS. "The fatally flawed FLS", which is in the links above.