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The biggest threats to the UK economy

Kathleen Brooks, head of research

If you thought all the bad news about the UK economy was out in the open, think again. The Bank of England’s latest Financial Stability Report added to the list of worries. Four years after the financial crisis in 2008 the banks are, yet again, a major threat to the UK’s economic outlook.

But what makes this more frightening in 2012, is that this time the UK’s taxpayers own some of the most “dangerous” banks, including 83% of RBS and a 40% stake in Lloyds Banking Group.

Bank of England Governor  Mervyn King, who presented the Financial Stability Report, sounded a note of caution about banks’ capital buffers – essentially their cash cushion – which banks have been trying to build since the catastrophic credit crunch in 2008 to protect them against future losses.

King was concerned that the attempts by banks to raise their capital buffers had slowed and that their current capital ratios are misleading. In other words, King said that the banks might be saying they are safer than they actually are.

When the Governor of the most important bank in the land says this, it’s time to take notice. King pointed out a couple of areas of concern. He said that banks’ loan loss ratios may be understating their actual risk. In other words, banks could be caught out if more people default on mortgage, consumer or other loans than currently expected.

The other concern for King is that banks haven’t properly planned for pay outs relating to the mis-selling of loan protection insurance. These pay outs aren’t mere pocket change: Barclays, for example, has pledged to reimburse those miss-sold payment protection insurance to the value of all premiums plus 8% interest. It has already set aside £2 billion to cover these claims. The problem is that other banks haven’t set aside similar sums, which could weigh on their cash reserves in the coming months and years.

If banks aren’t as protected as we thought they were this is worrying on a couple of fronts. Firstly, it means that more economic recession could push banks over the edge if it pushes up bad loan rates.

Secondly, if this happens it may weigh on banks’ share prices, which would reduce the value of taxpayer stakes in some of the UK’s largest lenders. Banks are the fabric that keeps our economy together, if they are weak then the UK is weak.

Not the only problem
There seems to be a dearth of good news when it comes to the UK economy. The Organisation for Economic Co-Operation (OECD) predicts that GDP will contract 0.1% this year and doesn’t see or economy picking up until the end of 2013.

Fiscal consolidation efforts and a reduction in consumer spending are the main risks it sees on the domestic front. These things could keep growth sluggish for some time.

But we also face external risks like the eurozone sovereign debt crisis and the US fiscal cliff. If either of these things blow up in the next few months then grab your hard hat, as the OECD warns they could cause a “major new contraction”.

As we move towards a New Year the economic landscape in the UK is littered with mines – from banks that are under-capitalised to George Osborne’s deficit reduction plan. Which one will blow up first? The trouble is if one goes, the others are likely to follow shortly afterwards.

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