Are Banks at Risk of Default in 2017?

Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall and I'm joined today by Andrew Mills of Insight Financial Research to talk about 10 years since the collapse of Northern Rock.

Hello, Andrew.

Andrew Mills: Hello.

Wall: So, I suppose I should start by asking what caused the collapse of Northern Rock a decade ago.

Mills: Yeah. Well, great question. I suppose – I mean, the approximate cause was an inability of the bank to fund itself, so a lack of what's referred to in the market as liquidity. They were very dependent on raising short-term funds in the financial markets and they found themselves for a variety of reasons unable to do that. People often say that banks fail – when the banks fail, they die of cancer or of a heart attack.

I mean, that's obviously not a very pleasant analogy. But the cancer is this sense that they have made bad loans and they eroded their capital. The heart attack aspect of it is more when they can't fund themselves and there's a liquidity problem. And I think with the Rock you had the one which then triggered and led to the other.

Wall: And how was what happened to Northern Rock indicative or indeed a symptom of what was going on in the banking system, not just in the U.K. but across the U.S. as well, which then did cause the Global Financial Crisis?

Mills: Well, I suppose – I mean, here in the U.K., the Rock was a bit of a canary in the coal mine. It failed in 2007 and it was a huge shock at that time. But in some senses, that helped us to prepare for 2008, which is when it became more apparent that the problems of Northern Rock were actually shared by a lot of institutions. I think for me there was a wider failure in many markets to really view and understand banks' balance sheets as balance sheets.

Banks have become seen more as just a profit machine; they became hugely profitable; they churned out a lot of dividends. I think investors were very focused on that. They weren't really understanding the structure of those balance sheets, very complex, what were the risks that were hidden in there.

Wall: And that was an interesting point because I know certainly for shareholders of companies like Lloyds, they thought these dividends will continue to come forever more. They made a huge part of income portfolios. But obviously, they got themselves into a position where they could no longer honour those dividends. They could no longer pay out to shareholders and therefore had to take some pretty hard medicine, didn't they, in order to get back to sort of in the red, in the black rather?

Mills: Yes. And I suppose – I am not as close to the situation now as I was then, but I think a lot of them clearly have still got a long way to go. Even you got to look at the valuations of banks that are very depressed to see that a lot of investor feel that they are not able on a sustainable basis to really generate much more than their cost of capital. They are not creating value. That's a suspicion often. I mean, not in every case, but that's what the sort of market valuations seems to be telling us.

Wall: So, we had bank failures and banks bailouts. We had a recession. We had extreme stock market volatility. Fast-forward to 2017, things look a lot more positive. We have economic growth. We have ever higher stock markets, both sides of the pond. But I know that you have actually drawn some similarities between what's going on now and what was going on just before the crisis back 10 years ago.

Mills: Yes. Well, I think – I suppose part of the problem for me is, I think, a lot of the situation we are in now, we are still living in the post-crisis world and a lot of the sort of policy environment we are leaving in today, whether you look at regulation or monetary policy, is a reaction to that crisis. So, I suppose, what would concern me is the thought that we may be fighting the last war and the response to that crisis - very well intended and I think often very beneficial - could still be having problematic effects elsewhere. And in particular, for example, bank regulation is tightened.

So, the amount that banks would lend has fallen since the crisis. But overall, the slack has been taken up through non-bank lending or sometimes called market lending. That's really when investors are directly lending to companies through a variety of kind of fund conduits. And this is a risk that regulators are aware of, they are looking at. But for me, I think, they lack the tools to deal with it. Unfortunately, the mechanisms that are there in place to manage that risk may not be quite sufficient.

Wall: Does that mean that we've got another crisis on our hands?

Mills: I don't know. I mean, I couldn't say and no one can tell you for sure. I mean, I would think – I can't imagine that another crisis would be as severe as the one we had before. I mean, there's just much more awareness and there's tighter regulation.

But I also wouldn't want to be complacent. I think the risks are there. They may have shifted. And it's probably more important than ever for investors to be crystal clear what are the risks they are really running. Especially, in this low-yield environment, everyone is looking for yield that they can find. Are they very clear about the risks that may be taking in exchange for the returns that they are getting?

Wall: Andrew, thank you very much.

Mills: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.