FSA acts to let banks cut their capital ratios

Regulator's guidance now in line with Government's demands for bank lending

The Financial Services Authority said yesterday that it would let banks reduce their capital ratios in a move that brings the regulator's guidance in line with the Government's demands that the banks should lend to support the economy.

The City watchdog said that the capital ratios it demanded of the banks in October's sector bailout – about 8 per cent for "tier one" capital – were not set in stone as new minimums. Instead, they were designed to restore confidence in the financial system by giving banks big enough cushions to absorb recession-level losses.

Some banking analysts have attack-ed lenders whose capital ratios app-eared light compared with the apparent new benchmark, raising fears that they would need to raise more funds. The FSA said tier one ratios could fall to between 6 and 7 per cent.

The Governor of the Bank of England has voiced his frustration at banks hoarding capital and not lending to businesses and households because they fear being punished for reduced ratios. The Government has repeatedly said it wants the banks to lend to prevent the recession bankrupting otherwise healthy businesses.

Mike Trippitt, a banking analyst at Oriel Securities, said: "I think the Government and the FSA have been talking with forked tongues on this. The Government wants the banks to lend and the FSA seems to want the banks to deleverage. There was an apparent conflict between what the two organisations wanted and I think this closes the gap."

The FSA clarified its position as the Government announced its latest bailout plan for the sector, including insuring assets against future losses, an extension of the liquidity plan that lets banks swap illiquid assets for Treasury bills, and guarantees to get the securitisation markets moving again.

The watchdog said its decision marked the introduction of "counter-cyclical" capital rules that will require banks to build up capital during times of growth so they can withstand losses when the economy slows and customers cannot repay. The current international capital regime has been criticised for letting banks reduce their capital in good times and requiring them to take up-front losses against future impairments.

HSBC and Barclays have faced pressure in recent weeks over their capital positions as banking analysts have questioned the strength of their buffers. HSBC, which has not raised new capital, has insisted that its tier one ratio of 8.9 per cent at the end of September is strong enough. Barclays issued a statement on Friday after its shares lost a quarter of their value, saying it had a 9.5 per cent tier one ratio at the end of last year.

Another vital change of direction buried in the Government's second banking package is the asset purchase programme to be led by the Bank of England through a specially created fund. Financed by Treasury bills, the Bank will be authorised to buy up to £50bn-worth of "high-quality private-sector assets", including corporate bonds, commercial paper and syndicated loans. Further details of how the scheme will work will be set out by the Governor of the Bank of England today and will be the subject of open letters between the Governor and the Chancellor. A key detail, with significant implications, is that the Bank's Monetary Policy Committee – which is responsible for managing inflation – will have the authority to expand the scheme if it proves useful as an instrument of monetary policy.

The biggest difference is that the Bank will be directly involved in the market for the first time, according to Simon Ward, an economist at New Star Asset Management. "The asset purchase scheme is much more important than the insurance element of the package," Mr Ward said. "Everything else that has been announced has depended on the banks themselves starting to lend more, but now the Bank of England is stepping in directly and supplying credit, which will have an impact on the broad money supply."

The only danger is that not enough money is poured into the system. An equivalent scheme being run by the US Federal Reserve has successfully produced a sharp acceleration in the money supply, but has around four times the available funding, relative to the size of the economy. Unless the MPC pushes the ceiling up to around £200bn, the effects could be limited.

The monetary implications of the asset purchase scheme raise the possibility of quantitative easing officially for the first time. But the Government could go further. "The focus is on credit but if the Government boosted the money supply it would remove some of the liquidity pressure and the issue of credit availability would not be as serious," Mr Ward said. "This package is skewed towards the credit side of things and could be doing more in terms of boosting the money supply – they are complementary."