Sorting out the UK banking system, part 3/3

1. OK. We assumed a catastrophic house price collapse of 50% and mass bankruptcies - or at least a debt jubilee - in Part 2 earlier today. The resulting consolidated balance sheet of the UK banking system is shown below, and as you can see, the consolidated total assets are still looking positive, albeit down from £873 billion to £36 billion.

2. The next Big Myth is that banks have to refinance £800 billion in bonds in the next few years (the actual figure of £800 billion is correct), and they are unlikely to get this so the government will have to throw another £800 billion of taxpayers' finest at them. Let's assume that the banks really can't afford to repay these loans (which does indeed seem impossible) but similarly that they can't borrow new money either.

So let's turn to our old friend: the debt-for-equity swap. As long as the underlying business has some value and will make more money by continuing under new ownership than it would from being broken up, a debt-for-equity swap is always the most viable option. As to all this Basel-style capital adequacy nonsense, see footnote D.

3. We've also got to show that neither shareholders nor bondholders are somehow being robbed, and that they are no worse off than before - as the balance sheet shows, there is no reason to assume that they would be. See footnotes below:

Footnotes:

A. The total value of all the bonds and shares was £723 billion before the hypothetical house price crash and balance sheet restructuring (see Part 2). For company law/insolvency law reasons, all the bonds would be converted into shares, and the former bondholders would acquire a majority of the issued shares. Twenty five 'new' shares would be issued to bondholders for every eleven 'old' shares (the shares would thereafter be identical, or 'rank pari passu' as they say in the trade).

B. Banks will be charging mortgage interest rates of 4.5% on average - a bit higher than now, but they don't need to worry about house prices crashing any more because they already have done. They'll still be paying a miserly 1.5% interest rate on deposits, and still have typical running costs of 1%, so their maintainable profits from the £1,800 billion average customer balances (deposits or loans) will be about £36 billion per annum. If you don't mind, I'll gloss over corporation tax liabilities and ignore any residual income from the £571 billion worth of 'securities for sale' and the income from their trading or investment banking divisions, which will net off to very little.

C. UK banks' price earnings ratios are currently between 9 and 30. Let's pencil in a price/earnings ratio of 20.1 (it might be higher; it might be lower), which we multiply by the £36 billion maintainable earnings to arrive at a total market capitalisation of £723 billion, which is exactly what is was before we started - this is hardly surprising as the markets have already factored in what will inevitably happen.

In other words, if you own £10,000's worth of UK bank bonds or 'old' shares today, once the dust has settled, you will end up owning about £10,000's worth of shares afterwards. What's not to like?

D. Of course, having shareholder's funds of £36 billion to support total assets of £2,442 billion is far too low. But we are looking at the bottom of the cycle. If we want UK banks to have a ratio of at least 6%, then they'll just have to stop paying dividends for three years, hey presto, job done. Under the circumstances, whether profits are paid out as dividends or retained in the business has relatively little impact, see also 'Berkshire Hathaway' or 'Microsoft'.

Or they can speed up this process by flogging off the 'securities for sale' for £571 billion (they may well get far more than that, of course), which reduces total assets to £1,871 billion - combined with three years' retained profits, they'd have a capital ratio of 10% which is more than adequate.