Why 'encumbrance' and 'forbearance' are crippling banks and the economy

The City of London

There are two huge and related problems in the global banking system.

First is a growing credit crunch within the eurozone, as weak eurozone banks cut back their cross-border lending and - increasingly - their domestic lending too (there is a chilling analysis today of the so-called Balkanisation of eurozone banking by Morgan Stanley, which is critical of the limited banking union proposed by eurozone leaders as a solution).

This lending constriction worsens a eurozone recession, which in turn exacerbates the weakness of banks: a financing or liquidity crisis morphs into a solvency crisis, as has already happened in Spain and looks set to happen in Italy (yesterday's refinancing of Italy's Banca Monte dei Paschi di Siena augurs ill).

Now that first source of systemic weakness plays into a second source - that the way banks of all developed economies finance themselves has become hideously dysfunctional. Banks in the UK and US, as well as continental Europe, are finding it harder to raise money from conventional, commercial sources and are become excessively dependent on borrowing from central banks.

There are two implications. It is impossible to say when banks, including British banks, will be capable of standing on their own two feet again. And because banks hate being beholden to central banks, they are reluctant to lend as much as the economy needs - even when, as is happening in the UK, the Bank of England and Treasury try to chuck unlimited quantities of cheap money at them.

Forbearance and encumbrance

I am going to introduce you at this stage to two pieces of banking jargon, which help to explain the pernicious trends in finance of our new age of economic stagnation and - in part - why the banking system is in a dire condition. They are "forbearance" and "encumbrance".

Forbearance is when creditors relax their normal lending criteria and conditions, so that their debtors don't go bust. So, for example, up to 8% of all those with mortgages in Britain are enjoying a holiday on payments, or have changed to paying interest only, or are enjoying some other relaxation of normal lending conditions, according to an analysis by the Financial Services Authority for the Bank of England.

And in the commercial property market, the lending terms on some £50bn of troubled loans have been waived.

The idea behind forbearance is a laudable one: if the mortgage borrowers in financial distress had been thrown out of their homes, the social and economic impact would have been nasty. There would have been tens of thousands of people with nowhere to live, house prices would have plunged, losses for banks would have been exacerbated. And if the banks had foreclosed on all the commercial property loans in breach of covenants, there would again have been an acceleration of losses for borrowers and lenders.

But there is a problem with forbearance: it undermines the confidence of those who lend to banks. They fear - rightly - that the banks are not as strong as their accounts would indicate. The point is that forbearance may only defer the pain for the borrower and the losses for the bank, rather than avoid it altogether. So if you are a creditor of a bank, you are legitimately concerned that forbearance is a way for banks to avoid raising the amount of capital the banks need to absorb potential losses.

If you want a bang up-to-date lesson on forbearance as an accident waiting to happen, you only have to look at the £60bn plus capital shortfall at Spain's banks, identified only after independent consultants took a look at the quality of their loans.

Or to put it another way, forbearance is another contributor to the undermining of trust in the integrity and strength of the financial system.

Which brings us on to so-called "asset encumbrance," because it has become the funding trend of this moment precisely because trust in the integrity and strength of the financial system has been wiped.

Asset encumbrance is when a bank has to pledge its assets - the loans and investments it has made - to a creditor when borrowing from that creditor. It is the security or collateral that banks provide to those from whom they borrow.

Dependent on borrowing

Now before the great crash of 2007-8, most banks were able to borrow as much as they liked in an unsecured way. To employ the appropriate lingo, liquidity seemed to be unlimited and cheap. Banks could borrow as much as they needed purely on the strength of their names and reputations from other banks and financial institutions without providing any collateral or security.

But that unsecured interbank market more-or-less closed down in 2007 and 2008, and has never properly recovered. And part of the reason it has never properly recovered is that those who control vast pots of money in Boston, Singapore, Geneva and so on are concerned that big Western banks are weaker then they seem (so a big hello again to "forbearance").

Banks have become increasingly dependent on various forms of secured borrowing, especially in what's known as the repo market, which is where banks swap bonds and other assets for loans from hedge funds and specialist parts of banks (yes there are banks at both ends of this market).

Now you may have worked out there is a fundamental problem when - as is happening - the banking industry moves from a system of unsecured borrowing to one of secured borrowing: we move from a world where there is unlimited money for banks to one in which banks can only borrow up to the value of their unencumbered assets (actually they can borrow rather less than that, since lenders always apply a discount or haircut to the assets they take as security).

What is more, the increasing use of secured borrowing by banks becomes self-reinforcing: as any bank pledges more and more of its assets to creditors, so it has fewer free assets, which means it looks weaker, which in turn means that anyone thinking of providing an unsecured loan to that bank will charge a penal rate; so, in effect, the growth of the secured lending market militates against any recovery in the unsecured lending market.

Here are the trends, according to the latest annual report from the central bank's central bank, the Bank for International Settlements: a fifth of all European banks' assets were encumbered, or pledged to borrowers, in 2011.

Please don't take any great comfort from the fact that "only" a fifth of European bank's assets are pledged to borrowers. First that understates the true position, because the statistic is months out of date. Second, some assets can't be converted into a form suitable for secured borrowing. Third, and most important, it would be a disaster if banks pledge massively more than that, because there would be nothing left over to underpin the savings of European citizens.

Here is the thing: we haven't talked about the ginormous elephant in the room, which is that banks borrow most of their money in the form of deposits provided by you and me. And if the banks pledge all their assets to institutional lenders of various sorts, we might worry whether there is anything left to pay us back with.

As you would expect, in stressed parts of the eurozone the growth in secured borrowing has been exceptionally rapid: between 2005 and 2011, the ratio of encumbered assets to total assets increased tenfold for Greek banks, to one third of the total.

That implies Greek banks have almost no spare assets to pledge for secured loans, if they are to keep anything back to cover the money they have borrowed in the form of deposits from ordinary Greek citizens. The pledging of all these assets by Greek banks is a tragedy waiting to happen to Greek savers.

'Potentially lethal consequences'

To state the bloomin' obvious, encumbrance has potentially lethal consequences.

Now this vicious contraction of banks' capacity to borrow or fund themselves is exacerbated by the downgrading of their credit-worthiness by ratings agencies.

These downgrades are a treble whammy:

1) when banks' credit ratings fall below a certain threshold, it becomes impossible for them to borrow from certain non-financial lenders, such as some local authorities, sovereign wealth funds, companies and so on (Royal Bank of Scotland, for example, has already fallen through this threshold);

2) after a downgrade, lenders demand that banks pledge even more of their assets for a specified value of loan, so downgrades accelerate the rate at which assets become encumbered;

3) banks that engage in what are known as over-the-counter derivatives transactions have to put up more of their assets as margin or security in these deals.

Here are two indications of the damaging impact of downgrades.

First, Royal Bank of Scotland has disclosed that it will have to pledge an additional £9bn of assets as collateral following its downgrade last week by Moody's (and I'll return to the position of British banks in the coming days).

Second, the European Central Bank took action on Friday in advance of the shocking downgrades on Monday of Spain's banks by Moody's, by relaxing the criteria for the loans that it and Spain's central bank make to Spanish banks.

Or to put it another way, the ECB exercised forbearance on Spanish banks: Moody's downgraded large numbers of Spanish banks to junk; so the response of the central bank was to soften the lending terms on the loans it makes to Spain's banks.

You will have gathered by now that there is a final chapter in this encumbrance story, which is that when banks can no longer raise money by pledging assets to commercial lenders they are forced to raise what they need by pledging assets to central banks in return for loans.

This is when banks go on life support, and it accurately describes the parlous condition of a large number of banks in Spain and others scattered throughout the eurozone.

However, so long as these banks retain assets of sufficient quality, they can continue to claim to be viable, or at least potentially viable - even if they are only alive because of credit they've received from the European Central Bank, for example, or from their national central banks.

But the assessment of requisite quality is tricky. As we have seen in the case of Spain, in response to a verdict by Moody's that the quality of Spanish banks' collateral had deteriorated, the response of the ECB was to lower the quality threshold for lending to those banks - which, in theory, significantly increases the risks for all eurozone taxpayers from the finance provided by the ECB and the Bank of Spain to Spanish banks.

Here is the big imponderable: what will the ECB do at the moment that a big bank runs out of unencumbered assets? This is a very real possibility, according to regulators and bankers. And they simple don't know how the ECB would react - whether it would do something that central banks are never supposed to do, which is provide unsecured loans, or whether it would allow the bank to fall over, and risk a chain reaction of collapsing banks.

All of which is a very long-winded explanation of why many - including the governor of the Bank of England - argue that the fundamental problem of the eurozone banking system is that it is seriously insolvent in parts. And until the requisite capital is raised, the eurozone will continue to live dangerously on the brink of potential catastrophe.

Robert Peston Article written by Robert Peston Robert Peston Economics editor

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  • rate this

    Comment number 249.

    The quicker we let the Banks Go Bust the quicker we all get out of this mess.


    It will not be pretty but Economic Spring will be around the corner the quicker we let Banks Fail

  • rate this

    Comment number 248.

    Sorry pesto, this is tosh.

    1991 property crash left UK banks with no unencumbered assets, BOE relaxed capital requirements, let the normal profit drag carry on and all was fine.

    Let's not over dramatise this.

  • rate this

    Comment number 247.

    I gave up after the first para, but it really is quite simple:
    When the world economy is based on the availability of credit, do not remove the availability of credit, otherwise we are beggared.Oh look, that's what happened
    The "banks" were trading cr@p (technical term) in the form of CDOs, the plug was pulled instantly by the "banks" when it became clear that the CDOs were - in fact - cr@p.

  • rate this

    Comment number 246.

    So if the answer is to raise the requisite capital so that the eurozone does not have to live on the brink, why don't they do that, who's decision is it and where does the money come from.

    By the way...Great article Robert.

  • rate this

    Comment number 245.

    The Peoples Bonk

    No more Banks, the new is Bonks.

    A trusted & more sustainable way of keeping things on the up !

    The Peoples Bonk, for lifes ups & downs.

  • rate this

    Comment number 244.

    What a day eh?

    Who would have thought it?

    Was the road fuel tax holiday announced to take the edge off today's revelations?

    Are we supposed to revere these bankers?

    How can they show their faces?

  • rate this

    Comment number 243.

    This has always been a crisis of insolvency

    Continually telling us its a liquidity issue doesn't make the real issue of insolvency go away

    To paraphrase Clinton, "it's the derivatives, stupid"

  • rate this

    Comment number 242.

    I am looking to buy a house. I bowed out of the market 7 years ago thinking it was all about to crash. Everything else did but not house prices. Probably as a direct result of forbearance! Can forbearance be extended in perpetuity? Would I be mad to buy now? Are we about to follow the Eurozone into the abyss, or will we decide none of it matters and carry on as before?

  • rate this

    Comment number 241.


    Probably the central banks (BofE, IMF, Fed, etc), leading to the question: who owns the central banks?

  • rate this

    Comment number 240.

    Can someone tell me to whom all the struggling banks and countries are in debt?

  • rate this

    Comment number 239.

    Anywhere else Barclays would be run out of town and the BBC would be accused of censorship.

    Instead Robert tells us about how the eurozone is in difficulty because of obscure instruments.

    "forbearance" and "encumbrance"

    But those instruments will cost us all dear.

    Spot a trend here?

    Everything costs us all dear.

    And can we do anything about it?

    Write to your betters. They know best.

  • rate this

    Comment number 238.

    This's where terrorists waste their time blowing people up.

    Ditto governments.

    Why not instead declare a financial jihad against their enemies and encumbrance them to destruction?

    But if they did that it'd be seen as criminal extortion and people'd fight back.

    But even if it's currently motivated by greed it's still criminal extortion anyway so why DON'T people fight back?

  • rate this

    Comment number 237.

    It's a bust system run by spivs that manipulate flawed and criminal monetary 'accounting' for personal gain.
    The 'bonuses' are the only 'real' money and that is paid into their bank accounts and to hell with the rest of us.
    The only talent they have is the the same talent as AL Capone.

  • rate this

    Comment number 236.

    this does not effect the ability of banks to lend to credit worthy customers these loans will always be profitable
    the problem is not liquidity to business and customers
    the problem is insolvency
    banks wave repayments because they do not want unsellable assets
    banks will not lend to each other for derivative trading because THEY are not credit worthy
    it was never a liquidity crisis

  • rate this

    Comment number 235.

    I struggle to see where the best talent in the world got so deep in the mire without realising it.

    It's going to happen again with type of system that we have & the best brains in the World will once again lead us into it, mainly because it pays either in votes or bonuses.

    We need to wake up & share before some event forces us to behave.

  • rate this

    Comment number 234.


    Most potential problems can be overcome, including the prospect of collapse. A new system could be created, but until the political will is there it won't happen. Up to us all to organise and help ourselves instead of remaining divided.

    Easter islanders didn't disappear (the fabled last tree was never cut down), the reduced population got its act together when forced.

  • rate this

    Comment number 233.

    223-Transport would be needed for food - to get it to the cities. People could pile out of the cities but then any food production even small scale would be taken or destroyed – Easter Island comes to mind. If this is not an option then resolving the current financial/economy issues is the only solution.

  • Comment number 232.

    This comment was removed because the moderators found it broke the house rules. Explain.

  • Comment number 231.

    All this user's posts have been removed.Why?

  • rate this

    Comment number 230.

    I do not like being disrespectful to our fellow monetary professionals but for a few hundred billion reasons I just cant help it.


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