Capital adequacy requirements in Britain on the radar. Will leverage be next? Op Ed

London. The world’s institutional FX center. What usually originates within the highly established corporate FX and electronic trading ecosystem in the Square Mile and Canary Wharf becomes part and parcel of the global retail FX industry soon afterwards.

Rather similar to the vast investment that certain motor manufacturers have made over the past 100 years into Formula 1 motor sport, plowing vast sums of corporate capital into the research and development of just one or two cars per team which are finely tuned showcases for the technology which over the years filters its way down and can now be found on many very ordinary road cars, London’s institutional sector is the pioneering proving ground for what is to come.

Want to know what a ‘next generation’ trading platform will look like? A quick visit to the reception area at CMC Markets’ headquarters in Houndsditch is all that is required to see a multi-screen display, mounted on the wall, of the company’s proprietary system which cost over $100 million to develop and has substantial monthly R&D and operating costs. This, in that case, is the cutting edge, of which the cause is advanced by the established and well capitalized.

It is not, however just the technology and trading environment which London can be looked toward in order to gain a glimpse of the future of the mass-market, but also regulatory environment and the commercial structure relating how companies can be operated, and that leads us on to the much-forgotten subject of leverage and capital adequacy requirements.

This week, the entire banking and electronic trading industry reacted to a new ruling from the Bank of England which stipulates stringent criteria with regard to net capital adequacy requirements for banks and building societies in Britain, by letting out a wave of tumultuous silence. Indeed the silence was deafening.

Just a few days ago, a statement issued by the Bank of England confirms that the central bank is to proceed to increase the UK countercyclical buffer rate from zero to 0.5% of risk-weighted assets, with the new capital adequacy requirements set to become effective in one year’s time, specifically March 27, 2017.

What does this really mean?

Whilst the Bank of England’s announcement only relates to banks, it is clear that not only is the British banking sector is now under scrutiny not just for the trades that are executed and the method by which they are executed, but for how well they maintain their capital position, despite the banks being better capitalized now than they were 10 years ago.

This is clearly not a kneejerk reaction to a corporate failure.

If that had been the case, this measure would have been taken in 2008, following the almost complete nationalization of some of Britain’s major banks such as RBS’ Lloyds Banking Group and Barclays, all of which were transferred into the hands of the British taxpayer due to not just factors relating to the 2008 financial crisis, but by ill-fated deals which in the case of RBS was brought about by the expansion policy of the firm under Fred Goodwin.

Mr. Goodwin’s strategy of aggressive expansion primarily through acquisition, including the takeover of ABN Amro, eventually proved disastrous and led to the near-collapse of RBS in the October 2008 liquidity crisis. The €71 billion (£55 billion) ABN Amro deal (of which RBS’s share was £10 billion) in particular stretched the bank’s capital position – £16.8 billion of RBS’s record £24.1 billion loss is attributed to writedowns relating to the takeover of ABN Amro.

Liquidity crisis exposed bank to failure – nobody reacted

It was not, however, the sole source of RBS’s problems, as RBS was exposed to the liquidity crisis in a number of ways, particularly through US subsidiaries including RBS Greenwich Capital. Although the takeover of NatWest launched RBS’s meteoric rise, it came with an investment bank subsidiary, Greenwich NatWest.

RBS was unable to dispose of it as planned as a result of the involvement of the NatWest Three with the collapsed energy trader Enron. [clarification needed] However the business (now RBS Greenwich Capital) started making money, and under pressure of comparison with rapidly growing competitors such as Barclays Capital, saw major expansion in 2005-7, not least in private equity loans and in the sub-prime mortgage market. It became one of the top three underwriters of collateralised debt obligations (CDOs).[26] This increased exposure to the eventual “credit crunch” contributed to RBS’s financial problems.

The third contributor to RBS’s problems was its liquidity position. From a position around 2002 where the bank was essentially ‘fully funded’ (i.e. was funding its lending positions fully from deposits gathered from customers), the rapid growth in lending within the GBM (Global Banking and Markets) division led to a reliance on external wholesale funding. The combination of this, along with the weak equity capital position, and the massive exposure to losses on CDOs via Greenwich, were the factors that destroyed RBS. The bank experienced severe financial problems, and attempted to shore up its balance sheet with a £12 billion share issue in April 2008, one of the largest in UK corporate history.

Why is this relevant?

It has taken until now for the banking authorities to look at this closely, however liquidity, credit risk and counterparty exposure are major factors which the US has sought to mitigate with the Dodd Frank Act since 2010. Four years ago, the US government set in place a rule in which non-bank electronic trading companies in the retail sector had to set aside a capital adequacy minimum of $20 million.

Indeed, many smaller firms exited the market promptly, however those which remained are bastions of stability and corporate flagships of the retail sector.

The possibility that this may expand itself across the Atlantic has gone largely without any consideration, however nowadays with the step by the Bank of England to look at capital adequacy vs risk is an indicator that this may be in its inaugural stages of consideration having been joined by a look at leverage perhaps is more than a modicum of a figment of imagination.

British critics are now beginning to talk about leverage, and in particular with regard to the relationship of capital to assets which is being expressed through leverage. Credit growth requires leverage, and without it, a financial system is not a financial system; however too much of it, and the financial system is precarious.

This is now on the minds of the regulators and the central government, and is certainly a matter that needs to be watched with strict observation. Indeed, the reduction of leverage and increase of capital adequacy may be seen as a wet blanket over a blaze in the short term, but could provide a solid framework for sustainability in the world’s largest financial center which is ready to break free from European fiscal woes this summer.