UK Banks Fail? Hell Will Freeze Over First: Analysts

Moody’s downgrade of 12 British banks last week is irrelevant to the current state of the UK banking sector, analysts told CNBC.com, adding that hell has a better chance of freezing than any British bank failing.

Sharon Lorimer

The 12 banks, among them the two part-nationalized banks Royal Bank of Scotland (RBS) and Lloyds Banking Group , had been under review by the ratings agency since May and a downgrade in their credit ratings was widely expected by the markets.

But the move did lead to fears about the solvency of at least one of the banks, RBS, following reports it might need another bailout in the Financial Times, and about the overall health of the UK banking sector as a result.

Analysts were quick to defend Britain’s banks, pointing out the downgrades were not reflective of the situation in the City of London and that British banks’ exposure to the euro zone debt crisis was less than in other countries such as France and Germany.

“Moody’s is supposed to tell us what is going to happen not what has happened," David Buik market analyst at BGC Partners told CNBC.com. "I thought it was pouring salt into the wound unnecessarily and I thought the timing was atrocious. They [Moody’s] are trying to rebuild their reputation after the subprime crisis, I think they should be very careful how they do this."

“The downgrade is irrelevant and it’s a bit ridiculous. Why do we want to frighten people when both Lloyds and RBS are virtually entirely state owned? Hell has a better chance of freezing over than the government letting either go to the wall," Buik added.

The downgrade was "extremely highly expected" but Moody's waited to get the Independent Commission on Banking (ICB) report to publish it, Steven Hayne, banking analyst at Morgan Stanley, told CNBC.com.

Fair Risk

“It [the review] does not include HSBC , Standard Chartered or Barclays and it is casting no comment on anything going to right now. So there’s no comment on credit performance, credit issues or sovereign debt issues,” Hayne said.

“It’s reflecting a singular methodology change, which was the assumption that the banks would get government support if they ran into problems and the change now reflects the fact they are unlikely to get that help. Moody’s are taking away the notches of support,” he added.

Meanwhile, Jim Leonard, banking credit analyst at Morningstar, pointed out in a research note that RBS was a “fair business risk” suggesting it would lose a minimal amount of capital under stress test scenarios he had conducted but still had poor capital levels, low reserves and a higher balance of non-performing loans.

The case for Lloyds was rather more grim, given its exposure to the Irish property crash, according to Leonard. Lloyds still holds £25 billion of Irish loans as well as being heavily exposed to the UK’s property market.

Leonard said losses associated with these loans would continue to significantly impact Lloyds' profitability but again suggested the bank was a fair risk.

Moreover, Hayne said while the Moody’s rating downgrade reflected a lack of continuing government support for the UK banking sector, the ICB had suggested a way forward for the banks and government should the sector be hit by another financial crisis.

“It’s likely that banks will in future have to absorb between 17 and 20 percent of their own debts, according to the ICB report which made an explicit referral to senior and subordinate bondholder debt. If the ICB is correct, then UK banks already have lots of senior debt,” he said.

“So it suggests that if the UK banks get into any more difficulties, senior bondholders can expect to be forced to accept haircuts,” Hayne explained.

The ICB proposal was designed to reduce the burden on the taxpayer should a banking institution which poses a systemic risk to the overall economy fail by making bondholders take some of the pain.

Buik said this was something British banks would be very likely to resist.

“The banks would not be keen on it. The ICB was saying it’s an option but I don’t think the banks would go for it. These are the people you go to when you want to launch a rights issue. You can’t upset those people,” he said.

Greek Exposure

Hayne also pointed out that RBS had announced losses of 50 percent on its exposure to Greek sovereign debt compared to a market average in Europe, based on the original Greek bailout deal, of 21 percent.

That presented European banks with a significant problem because if RBS had marked its losses on Greek sovereign debt to market, it raised questions about the exposure of European banks and what their real level of exposure to Greece was.

Hayne suggested this was one of the main reasons that French, Italian and German banks had lost significant value during the second quarter of the year, in some cases, such as Societe Generale , losing as much as 50 percent of their share price during the quarter.

Put simply, investors didn’t believe the banks when they said losses on their exposure were only 21 percent and were acting accordingly to save their own investments.

“The market is not stupid,” said Buik. “It’s marked these share prices down between 40 and 60 percent; we’re talking about billions.”

For Buik the issue was simply that “Greece is broke” and until European leaders accepted this and let Greece default on its debts and restructure those debts, Europe would remain in a state of paralysis.

“Contagion is like the black plague, it runs amok where the frustration creeps in, is where the Trokia is getting things wrong. Greece is broke, what is important is to save the banks. So let Greece go broke, restructure its debts and give Greece the chance to pay those debts back over a long period of time,” he said.

Buik also suggested that it would be perfectly sensible to let many smaller European banks go bust rather than try to recapitalize them as the leaders the euro zone’s two largest economies, France and Germany, proposed at the weekend.

Those proposals are due to be presented by the European Commission on Wednesday in Brussels but Buik suggested they would do little to solve the real problem.

“This is the classic example of a time when we need a cull of 30 percent in the banking sector across Europe and I think we should let the smaller, less well-run banks, get swallowed up by the larger, better-run banks. Why do we want Mickey Mouse Plc?” he said.