Is Monzo at risk of a capital crunch?

A traditional bank takes in deposits and lends them back out in the real economy. Monzo, which has a sleek app that has helped it attract 3.9m users, does things differently. It prefers to stash its deposits at the central bank, or invest them in short dated government bonds.

This means that although it does not receive the revenue stream other banks do from lending (although it has made a start with this activity), it keeps down its risk-weighted assets (RWAs), the amount of assets on its books multiplied by a factor related to how risky they are.

Analysts look at the ratio between a bank’s amount of capital and its RWAs to work out how easily it could absorb losses on those assets. Monzo’s common equity tier one (CET1) ratio, measuring the most solid form of capital, has historically been very high: 104% as of the end of February 2019. That number fell to 70% at of the end of February this year, the latest figure available.

The drop reflects the fact it has been lending more to customers. At the end of February 2019, £16m of its assets were in the form of loans and advances to customers; a year later this was £124m.

Still, 70% is a high number for a bank. NatWest Group, Barclays and Lloyds Banking Group reported second quarter CET1 ratios of 17.2%, 14.2% and 14.6% respectively.

Yet Monzo’s annual report released last week presented the capital outlook for the bank as uncertain, even though just five months have passed since February.

Ernst & Young warns in the independent auditor’s section of the report: “The group is loss making and its revenue streams and expected credit losses have been significantly impacted by Covid-19. There is a risk that the group will not be able to execute its business plan, which could adversely impact its ability to generate profits or raise capital to meet future regulatory capital requirements.”

EY adds that a slower recovery “would lead to lower than expected results against [the business] plan, at levels which may cause the Group’s capital resources to fall below the minimum... requirements”.

This slower recovery, to be exact, is “the extension of a six month recovery to a nine-month or 12 month period instead”, something that hardly seems like a black swan event.

The bank itself outlines plans to mitigate the risk of a capital shortfall: closing funding rounds and raising tier two debt (a less pure form of capital than CET1) before the end of February. It also says it has restricted access to borrowing “as we strengthen our control environment and our capital, in response to our high rate of growth”.

The gloominess of the report, and particularly a line about “material uncertainties that cast significant doubt upon the Group’s ability to continue as a going concern”, resulted in dire headlines.

The question is how did Monzo end up here? And how bad is it?

Let’s look at the figures. In May, Monzo’s capital requirements increased. This looks to have been by about £42m in nominal terms (see Table 1), when incorporating a fall in the countercyclical capital buffer that applies to the whole industry.  

The calculation relies on the end of February balance sheet, and one part of the capital requirement, the Pillar 2B buffer, is undisclosed.

This still would have left the bank with £89m of headroom before breaching the requirements based on the February balance sheets, more than it had a year previously.

Emma Dunkley, a reporter at The Sunday Times, said that the rise in requirements prompted Monzo’s fundraising round in June, where it raised an extra £58m, although this supposed rationale is disputed.

Regardless, a slight rise in capital requirements is not really the issue.

As already noted, EY instead talks about expected credit losses and risks to revenue due to the coronavirus crisis. 

Monzo’s absolute reserves of capital could have deteriorated since the end of February due to losses and a lack of revenue.

But GlobalCapital understands it has at least £175m of capital currently. This is £32m more than the £143m reported at the end of February.

So maybe the concern over capital is because the bank is set to run at such a great loss that it will erode even a hefty level of capital.

Can we estimate the level of losses the bank is running at? If we add June’s £58m raise to the end-of-February capital level of £143m, we get £201m, up to £26m more than the actual capital level currently.

This suggests up to £5.1m of capital attrition per month. This actually seems rather modest, given that the bank made a loss over the 12 months to the end of February that averaged £9.5m per month.

This level of loss would be unsustainable in the short-term, from the perspective of capital requirements, only if Monzo does not have much headroom between its £175m-plus level of capital and its minimum requirement. 

GlobalCapital ran a basic model of Monzo’s headroom above the requirements, and it suggests that for that headroom to be slim, RWAs must have shot up (see table 2).

If Monzo had just £50m of headroom before meeting the buffer, that would mean RWAs have almost tripled since the end of February. If it had £100m spare, RWAs would still have grown by 50%.

Monzo wouldn’t comment on its level of RWAs. However, it’s worth noting that if RWAs had increased from the end of February to the end of July at the same rate they did in the 12 months before, they would be just shy of £250m, and the bank says it has restricted access to borrowing.

There is no certain way to tell without more information, but perhaps the biggest capital concern is less about breaching requirements in the next few months, and more about the medium to longer term funding environment, whenever it does need to raise capital. The June fundraising round reportedly valued Monzo at a 40% discount to the previous round.

EY warns there is material uncertainty “whether the group will be able to access new funds available at the levels required either through future equity capital raising or tier two debt”.

Until Monzo starts turning a profit, it will always need to rely on external investors to help it stay above its capital requirements, and if they are growing wary or impatient, it risks running into trouble.