Banking - Banks learned the lessons of recession (but there's new lessons on the

Property prices heading due south, six months of manufacturing decline, 350,000 industrial jobs expected to go by the end of next year – can those two consecutive quarters of negative growth, pushing Britain officially into recession, be far behind? And with that, how long before the bad debt cycle rears its ugly head in earnest?

The market consensus now is that the banks are facing a gradual downturn in consumer credit quality rather than an outright collapse, as was the case with the LDC lending crisis of the early 1980s and the domestic property bust a decade later.

All eyes are on Barclays and NatWest, the two banks that took the most severe hit in the last recession and the ones with the greatest exposure to the corporate sector. Barclays’ bad debt provisions are forecast to reflect an expected deterioration in loan quality, rising to about #475m next year from some #275m in 1998. The bank estimates that in the long term its portfolio has a #700m risk tendency, so it will still be a very acceptable credit performance. For other banks it’s a question of the starting point. NatWest has a similar book to Barclays and their provisions this year will be closer to #500m, so any rise in that number should be small.

Since climbing out of the last hole, the major British clearers have put in place risk management systems which they are confident can deal with a normal cyclical downturn in credit quality. That is the good news.

The not-so-good news is that this time the problems are likely to come from outside the branch network, where credit control mechanisms may not be quite so efficient.

As for the question of steps taken to change the whole credit culture and the credit monitoring and risk management processes, there has been a lot of strengthening of the systems as related to risk concentration and particularly focused on the property sector. All the banks claim they have re-trained their lending officers and the great majority of them have moved to a separate approval line. They have separated the relationship management from the credit review and approval responsibility and this offers better control of the loan process, albeit at the risk of being less responsive to client needs.

“There have been big changes since the late 1980s, the period that got us into the last recession,” says Kent Atkinson, finance director at Lloyds TSB. “The emphasis has been on credit scoring procedures and the amount of the portfolio that is credit scored.” Where Lloyds TSB differs from its high street rivals is the extent of its retail and personal business. “In the late 1980s we were in a boom and bust situation,” he says. “That is not the case now on the retail side and we are in a safer area than those people with big corporate and investment banking exposures.”

Barclays has been one the most aggressive of the high street banks in trying to insulate itself against volatility in its loan portfolio, and with good reason – the bank frittered away the proceeds of a #920m rights issue on lending to the property sector in the late 1980s and, as a consequence, in 1992 it took its first-ever loss and dividend cut. Since the arrival of chief executive Martin Taylor in 1994, Barclays has implemented a rigorous analytical process to evaluate business lines on the basis of their returns on economic capital employed after allowing for risk characteristics over the full cycle. A risk grading model for middle-market business lending was introduced, in which its conclusions feed into a target pricing matrix for these relationships. Volume and revenue targets have been replaced by profitability targets. This challenges the account officer to raise pricing on loans, sell additional services, restructure the relationship in a less risk- and capital-intensive manner or, failing these, to persuade the borrower to make other arrangements.

NatWest has always been sceptical on the economic outlook which is reflected in slower loan growth. The bank forecasts an economic slowdown and as a consequence is adopting a “more cautious approach” to lending. NatWest maintains that sluggish loan growth means they have been weeding out weaker credit more aggressively, while some would argue that the bank’s business development has not been as focused as that of Barclays. When the downturn comes, the market will know who was right. However, nothing will ever fully insulate a bank from credit problems in the context of a bad economy.

But back to that not-so-good news. Barclays’ surprise #250m of losses on Russian securities and a #75m loss in Barclays Capital suggest that the focus on the next downturn has shifted from the branch network to the dealing room and investment banking activities. There were recent reports that Barclays had large exposures through a bridge loan to a highly leveraged transaction with a company that had planned to issue bonds and then didn’t. The magnitude of the exposure suggested that if the operation had been hit by serious problems it would have brought a major increase in the year’s provisions.

“The market risk element is a hotter topic right now than the credit risk element,” says Leonard. “We’ve already seen Barclays show up with a large investment in Russian government securities and several of the banks have become quite active in different tiers of financing of leveraged corporate transactions. In many cases there is a short-term lending commitment which is expected to be funded out by the issuance of high-yield securities.

Sometimes these are broadly syndicated out to other banks, other times, because the transaction is expected to be short term, the bank will hold most of it on its own books. In the last downturn some of these cratered pretty spectacularly.”

The danger is that events in Asia and Russia, leaving aside unpleasant surprises elsewhere in the coming months, will lead the banks to fall back on their core credit business as a driver of earnings growth, and this always fuels the temptation to allow lending criteria to slip.

Jules Stewart is a freelance journalist.