Will Lloyds Banking Group PLC Overstretch Itself Again?

How long before the next crunch at Lloyds Banking Group PLC (LON: LLOY)?

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Back in more innocent times, economists used to think that it really takes an external shock of some sort to send a growing economy into reverse — like the oil crisis of the seventies, for example.

But that didn’t happen with our banking-led crunch — we just went from everything looking rosy to sudden calamity, and it took everyone by surprise. Well, we should have been paying attention to economist Hyman Minsky, whose work went largely ignored until it was recently rediscovered.

Minsky revisited

CashHis core idea was that “Stability is destabilising“, and he recognised what the overconfidence of the good times can do to bankers. They start out lending prudently, to people who can repay in full — then they move on to interest-only lending, with assets (like houses) as security. And for the final insanity, the banks start to lend more than the value of the assets pledged as security, and the loans can only be repaid if those assets continue to appreciate in value.

And with hindsight, well, it all seems so obviously stupid now, doesn’t it?

New capital requirements

But will it happen again? The Bank of England, through the Prudential Regulation Authority (PRA), has imposed new restrictions on bank lending in the hope that it won’t. I recently looked at the new capital requirements, which mean the banks will need to hold significantly more capital in proportion to their risk-weighted assets (that’s essentially loans reduced in value to allow for possible bad debts).

How’s Lloyds doing?

LLOYSo, will Lloyds Banking Group (LSE: LLOY) (NYSE: LYG.US) make the cut, and are credit crunches a thing of the past?

Looking at the bank’s most recent annual results, for the year ended December 2013, the headline figures suggest things are looking good.

Lloyds gave its Core Tier 1 ratio (which compares its top-quality capital with risk-weight assets) at 14%, which is twice the PRA’s requirement of 7% and well ahead of the 12% the bank recorded a year previously. Back in 2008, Lloyds could only manage a Core Tier 1 ratio of 5.6%, so that shows how much progress there has been in shoring up capital (with a big helping hand from the UK’s taxpayers) and reducing toxic assets.

There’ll be more Minsky Moments

There will be further tightening of the relevant definitions of top-quality capital and rules for assessing asset risk, but we’re quite some way past the crisis now — but that won’t necessarily prevent bankers finding new ways to overstretch themselves the next time they’re buoyed by economic exuberance.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Alan does not own any shares in Lloyds.

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