A rout in the domestic commercial real estate market will undermine further the position of UK banks (which maintain material exposure to CRE equivalent to 55% of their CET1 capital at end-2015, according to the Bank of England), and the extent of their exposure could whack their shares, which have already suffered a pitiful run of late.
Any deterioration in CRE pricing could also stymie the ability of corporates to access funding and could leave collateral-based refinancing in tatters. The signs are worrying.
Suspending dealing in M&G’s £4.4bn Property Fund, the £1.8bn Aviva Investors UK Property Trust and the £2.9bn Standard Life UK Real Estate Fund (and feeder funds) may well reflect liquidity needs as much as inherent CRE distress. But the suspensions will add layers of uncertainty, and of course they come on top of a dramatic withdrawal of foreign capital from the market, highlighted today by Bank of England governor Mark Carney at the launch of the Financial Stability Report.
Carney said adjustments in commercial real estate were more likely to tighten credit conditions for UK businesses. He noted that foreign capital flows into UK commercial real estate – accounting for around 45% of the value of total UK CRE transactions since 2009 – had fallen by 50% in first-quarter 2016, and that transaction volumes had fallen further in the second quarter, while the share prices of property REITs have dropped sharply following the Brexit referendum.
Alas, CRE is just one of Carney’s concerns. He’s also worried about the vulnerability of the UK current account deficit to material outflows of foreign portfolio capital and FDI; about slowing portfolio flows into UK equities and corporate debt; and the potential for the number of vulnerable households to increase owing to a tougher economic outlook and a potential tightening of credit conditions.
He also highlighted high levels of UK household indebtedness, potential debt-service issues, and pro-cyclical buy-to-let behaviour that could amplify movements in the housing market. Future deterioration in the UK’s terms of trade and supply capacity is also on the BoE’s list, even if the hammering taken by sterling (trading below US$1.31 mid-afternoon Tuesday) could provide support to UK exporters while the sharp fall in Gilt yields had lowered all-in corporate borrowing costs over the course of last week.
“Financial markets have managed the volatility around the referendum well and have not added to stress,” Carney said. I guess that depends on where you set expectations; I’m not sure everyone would agree with him on that one.
La-la land and cutting the capital buffer
I often get the impression that central bankers inhabit some kind of alternative reality and rarely venture into the world inhabited by mere mortals. I certainly got that impression from the impact the Bank of England expects from today’s removal of the 50bp counter-cyclical capital buffer with immediate effect until at least June 2017.
Sure, large banks have raised in excess of £130bn in capital since the global financial crisis and hold £600bn of high-quality liquid assets while eligible counterparties have, we’re told, prepositioned collateral with the Bank of England that creates the capacity to access more than £250bn of funds through normal BoE facilities.
So net-net, the financial system is more resilient than before the crisis (Tier 1 capital equivalent to 13.5% of RWA, Carney said). Hence the decision to allow banks to draw down their buffers. Yet isn’t there a serious disconnect between the technical removal of the 50bp capital buffer and the stated impact of the action: to encourage banks to continue to lend to UK households and businesses, “even if times prove challenging”?
The fact that UK households are leveraged to the hilt and face several vulnerabilities, that bank equity prices reflect investor concerns over the uncertain economic outlook (not to mention lower profitability) and the current gloom and referendum uncertainty have delayed business investment surely tells you all you need to know.
Yet the Bank of England folks say that three-quarters of UK banks, accounting for 90% of the stock of UK lending, “will immediately have greater flexibility to supply credit to UK households and firms”. That may be technically correct, and the FPC action may well immediately reduce regulatory capital buffers by £5.7bn and raise banks’ capacity to lend to UK businesses and households by up to £150bn (based on a banking sector that, in aggregate, targets a leverage ratio of 4%).
But there’s a lot of psychology at play here between theory and practice. The BoE’s comments underplay the mood in the real economy and the motivations of consumers as well as business owners. I note that the Prudential Regulation Authority will make sure that banks can’t play the BoE’s action by increasing dividends or distributions to shareholders. (Shouldn’t that be the decision of bank management?)
Years of close to zero interest rates in the UK have done little to open the credit taps as borrower reticence continues to trump levels of available capital technically available to lend. The prospect of even lower policy rates will likely have limited effects on borrower behaviour at the corporate or consumer level while we suffer the chaos and live through the funk of the post-referendum world.
“The FPC’s past efforts have created resilient financial institutions which can draw on their substantial capital and liquidity reserves to support the real economy, even during challenging times … Today’s action means that UK households and business who want to seize viable opportunities in a post-referendum world can be confident they will be supported by the financial system”.
Yep. Meanwhile, in the real world…
