TEN years after the run on Northern Rock Bank precipitated the financial crash there is a warning that the British banking system could not survive a similar shock and is an “accident waiting to happen”.

It comes in a report today from one of the world’s leading free market think tanks the Adam Smith Institute, which says the latest round of Bank of England (BoE) stress tests “drastically underestimates” the vulnerability of the UK’s banking system and risks to the economy.

It claims the tests are “worse than useless – offering false comfort while herding banks into identical business models”.

Loading article content

Report author Kevin Dowd, a senior fellow at the institute and professor of finance and economics at Durham University, says the BoE stress tests continue to “greatly overstate” the financial resilience of the UK banking system.

High bank leverage – the ratio of its loan capital to the value of its ordinary shares – was a key factor in the severity of the financial crisis and UK banks are still highly leveraged, but easy-to-game risk weighting measures hide this.

The BoE stress tests look at book values – values of assets and securities recorded in accounts. On these measurements UK banks’ leverage fell by around a third since 2006. Using more accurate numbers based on real market value reveals that banks’ leverage has actually increased by around a half.

Market valuations of bank capital are more reliable than book valuations, says the report, indicating the markets believe banks are still carrying large hidden losses not reflected in book valuations, or in the stress tests. By doing so, the report suggests, the stress tests provide the public with false assurances about the financial health of their banks.

UK banks saw losses of around half a trillion pounds from the last crisis. The BoE, as recently as last week, suggested from its view that British banks were in a far better shape to cope with a major shock than they were ahead of the last recession.

However, the paper argues this is not the case and says another crisis on a similar scale could wipe out the entire capital of the banking system many times over.

Dowd suggests the stress test programme is so severely compromised that it should be scrapped. Instead, he says the BoE should focus on the reforms needed to get the UK banking system on its feet, such as raising capital standards, establishing tighter corporate governance and reforming accounting standards.

Another shock on the scale of 2007-08 is a possibility, something the tests are designed to prepare for, but UK banks and the BoE are not remotely ready for it, says Dowd.

Instead, his report argues, the BoE’s policies towards the banking system amount to a form of Russian roulette risking disastrous consequences for the UK economy.

“The stress tests are about as useful as a cancer test that cannot detect cancer,” says Dowd. “They seek to demonstrate a financial resilience on the part of UK banks that simply isn’t there.

“It is disturbing that 10 years on from Northern Rock, the best measures of leverage – those based on market values – indicate that UK banks are even more leveraged than they were then.

“The biggest risk facing the UK banking system now is the Bank of England’s own complacency.”

The institute’s head of research, Ben Southwood, added: “The Bank of England, now with all its extra powers, should focus on improving the rules of the game, not micromanaging banks’ balance sheets.”