Downgraded UK banks, bonuses and Bank of England support

Mervyn King painted a gloomy picture for UK banks in his Mansion House speech

Most British banks deny that it is an especially "stressful" time for them - in the technical sense that, all but one to whom I've spoken in the past 24 hours insist they have the cash or liquidity they need right now.

The one bank that was a bit more frank that access to liquidity is an issue insists that the Bank of England's new and unconventional scheme to provide cash - the Extended Collateral Term Repo - will rectify things.

However, all the big banks will tomorrow apply for some of the six-month loans, because the Bank of England is instructing them they have to do so (this afternoon they'll be told how much will be on offer; we already know it's a minimum of £5bn).

"It is what the Bank always does on this sort of occasion," said a banker.

The Bank of England wants its ECTR - which provides relatively cheap loans, at a minimum interest rate of 0.75%, in return for pretty much any old assets or collateral the banks can provide - to be seen as mainstream funding, not stigmatised emergency funding. And the best way to remove the stigma is to force all the banks to take the money.

As it happens, some of the banks may turn out to be more grateful for its existence than they currently claim to be, for two reasons.

First, some time in the coming days - and the banks think probably this week - Moody's will announce downgrades of most of them. For the European banks, Moody's and the other credit rating agencies are seen as grim reapers, going from country to country pronouncing in more-or-less all of them that the banks are less strong than they once were.

Bankers concede to me that - in these more anxious times - they can't be certain that the downgrades will have zero effect on their ability to borrow. Which gives a clue as to why the Bank of England has launched the insurance scheme of the ECTR at this juncture and in a bit of a hurry.

Increased risk

All that said, the reasons for the downgrades in the UK are a bit different from what is transpiring in the eurozone.

In Spain, for example, part of the recent downgrades of its banks was because the Spanish government, with its overstretched finances, is perceived to be less able to bail out its banks in a crisis than it used to be.

By contrast, in the UK it is Treasury policy to be less willing to bail out banks in those ghastly circumstances (the whole point of the Treasury's recent white paper on banking reform is to restructure banking so that in future crises more of the losses will fall on creditors and less on taxpayers).

But British banks and Spanish and Italian banks have other bad things in common. The economies of Spain, Italy and the UK are all in recession, which increases the risk that more borrowers will be unable to repay debts; and even if you think (rightly) that the economies of Italy and Spain are weaker than the UK's, the Bank of England has helpfully pointed out that British banks have quite big exposures to these countries.

The Bank of England's Financial Stability Review shows that Barclays' retail banking loans in Spain, Italy and bailed-out Portugal are equivalent to a bit more than its core equity capital - its buffer against losses. And, of course, Lloyds and Royal Bank of Scotland retain substantial retail and corporate exposures in the hideously loss-generating economy of the Republic of Ireland.

This is how the analyst Sandy Chen of Cenkos recently described UK banks exposures to Spain: "Amongst the UK banks, we note again that Barclays has £27bn of Spanish exposures, including £14.3bn of gross residential mortgages with only £77m in provisions; RBS had £17bn of exposures, including £6.1bn of lending; and Lloyds has £6.5bn of exposures."

None of this is life threatening for the banks. But it is not pleasant, when the eyes of the world are on the financial instability and economic weakness of the eurozone.

And, as I have pointed out here many times, part of the vulnerability of British banks is through their loans to other eurozone banks. Thus, according to a Bank-of-England analysis, British banks have collectively lent just under £100bn to French banks, which in turn have lent just under £450bn into the eurozone's weaker economies.

So you can see why the Governor of the Bank of England was a touch gloomy about the outlook for British and European banks in his speech to bankers last week at the Mansion House.

Bank bonuses

All that said, the banks that regard themselves as strongest have a particular incentive to resist pressure from the Bank of England and the Treasury not to take too much of the money on offer in tomorrow's auction and in the so-called Funding for Lending scheme that will be launched next month.

That is because the loans will not only be cheap, but they will be subsidised - the Bank of England, a state institution, will be charging less than is warranted by the risks it is taking.

Here is what Barclays said when it took €8.2bn ($10.3bn; £6.7bn) of similar subsidised loans from the European Central Bank's long-term refinancing operation: "Any funding benefit that might arise as a result of Barclays use of this facility - versus Barclays' cost of funding - will be ring-fenced... and will not contribute to the remuneration of any personnel".

Or to put it another way, the banks are acutely aware that the more they are perceived to be dependent on special cheap credit from the Bank of England, from the state, the more criticism they will face if they continue to pay substantial bonuses.

Conflicts of interest in commercial banking? Um yes, there are a few.