Banks are proving that capital counts in a crisis

THE Bank of England has, essentially, ordered the UK’s largest banks to scrap dividends this year. That’s a blow for investors relying on dividends for income, but perhaps not entirely surprising.

The Government and Bank of England have taken drastic action to free up capital and encourage lending to smaller business. Paying dividends to shareholders in that environment was never going to be politically popular.

The good news is banks can still distribute the cash at the end of the year if the dividend ban turns out to be premature. However, with some tough months ahead, preserving capital might be no bad thing. We’ve already seen several companies file for bankruptcy and, as the lockdown drags on, we expect to see more.

That means a rise in loan defaults which will eat into a bank’s profits and ultimately capital. Mortgage holidays and debt relief would also reduce cash coming through the door.

Even financially sound businesses will be leaning heavily on their bankers in the months to come.

As many businesses see sales fall to near zero, borrowing is the only way to meet expenses. Banks’ key capital ratios are calculated by dividing available capital by ‘risk weighted assets’ or ‘RWAs’.

The move by the BoE to cut rates to just 0.1 per cent (a record low) in March is also bad news.

The lower interest rate should be passed on to borrowers relatively quickly. But the interest banks pay to savers is already on the floor.

With little room to push funding costs lower, the net interest margin (the difference between what the bank charges on loans and pays for funding) will be squeezed. That significantly reduces profitability.

There is some good news hidden in the gloom, though.

Banks are generally in much better shape today than before the financial crisis. The question now is how long lockdowns last, and how strong is the eventual economic recovery?

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