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Jeremy Warner

Jeremy Warner, assistant editor of The Daily Telegraph, is one of Britain's leading business and economics commentators.

Mystery of Royal Bank of Scotland's insolvency explained

 

By Jeremy Warner Economics Last updated: December 4th, 2009

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Why’s everyone so mystified by the idea that Royal Bank of Scotland could have been deemed to have adequate capital by the Treasury at the beginning of October last year, but by the middle of the same month be thought so bust that it needed a £20bn recapitalisation by the taxpayer?

According to a National Audit Office report this week on the costs to the public purse of supporting the banking system, “internal papers prepared by the Treasury suggested that RBS’s capital position [at the beginning of October] was reasonably strong, but noted that the bank was increasingly dependent on short term wholesale funding”.

The essential Robert Peston, no less, has been banging on about it on his blog, and concludes that the Treasury must have been like a benighted passenger on the Titanic as it ploughed towards its icy nemesis, oblivious to the impending catastrophe. It’s all a bit odd, he concludes. He’s not the only one. How could the authorities have been so blind, everyone is asking?

In fact, there is no mystery about this at all. It’s called leverage, and it explains not only why RBS could have been solvent one moment but insolvent the next, but also why the whole banking system had become an accident waiting to happen.

Leverage (or borrowings) in an average industrial company would be perhaps one times capital. In circumstances where there is a 5 per cent loss in the value of the assets, the cost to the equity base is therefore 10 per cent. Assets would need to lose half their value before the equity was completely wiped out and the meltdown started to eat into borrowings. That’s why on the whole bankers like to demand lots of equity from their customers. It protects the banks’ lending.

But they don’t apply the same rules to themselves. Many banks became as much as 40 times leveraged in the boom, but let’s for the sake of this exercise assume 25 times leverage, which is about average for a bank. In an organisation 25 times leveraged, a loss of 5 per cent in the value of the assets would equate to 125 per cent of equity capital. In other words, it only requires a quite small loss in the value of the assets to produce a total wipeout in the equity and a consequent insolvency.

Rewind to October 2008, and even though Lehman Brothers had by that stage collapsed, few appreciated the scale of the recession that was about to hit. I say, few, but the markets were of course ahead of the game. In banking, there is a simple arithmetic relationship between the health of the economy and the level of loan impairment that will occur.

The further the economy sinks, the more assets will become impaired. In the funding markets, it was quickly appreciated that though RBS might at that point in time have adequate capital, the effects of leverage meant that it would require scarcely any downturn at all for the bank to become insolvent. Wholesale funders therefore rushed to get their money out, eventually forcing the Bank of England to provide covert emergency liquidity support.

So there really is no mystery here, other perhaps that supervisors seem to have forgotten about the effects of leverage in allowing banks during the boom to run such extreme balance sheets.

Tags: HM Treasury, insolvency, leverage, National Audit Office, Royal Bank of Scotland