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Big challenges remain for the banks

Bank shares have enjoyed a remarkable rally in the past three months, but the lenders still face some hefty challenges and those gains could easily be lost
November 5, 2012

Just a few months back - amidst the ongoing eurozone crisis, grim economic conditions, hefty mis-selling provisions and reputational scandals - prospects looked bleak for the banks. Yet bank shares have seen a remarkable rally in the last three months - Barclays ' (BARC) shares are up over 50 per cent since the third week of July, for example - even though lenders' third-quarter figures were hardly pretty. Lloyds Banking (LLOY) and Royal Bank of Scotland (RBS), for example, reported thumping pre-tax losses. So what's changed?

IC TIP: Sell

To begin with, the European Central Bank (ECB) has been at work. In July the ECB said it would do whatever was needed to preserve the euro, which was quickly interpreted as a willingness to buy the bonds of the eurozone's weakest members to cut their borrowing costs and avoid defaults. Sure enough, by early September just such a scheme was announced. It has, according to Barry Norris, fund manager and founding partner of Argonaut Capital, "convinced markets that the threat of a sovereign eurozone default is now minimal". Accordingly, sentiment towards those banks with exposure to peripheral eurozone economies has improved.

Moreover, with the UK economy struggling, regulators quietly relaxed capital and liquidity rules last month to help stimulate lending. Specifically, the Financial Services Authority (FSA) says banks won't need to hold additional capital against new UK loans made that qualify for the Bank of England's funding for lending scheme - designed to bolster credit for corporate borrowers. Regulators have back-tracked from their 'superequivalent' approach to implementing Basel III capital rules, too. Banks are no longer expected by the end of next year to achieve a core tier one capital ratio that's equal to 10 per cent of their assets, adjusted for risk. Liquidity rules have also been softened after the FSA agreed to the inclusion of a broader range of assets for liquidity purposes.

 

 

Persistent problems

But there's plenty that hasn't changed, such as the grim economic backdrop. The UK may have now emerged from its double-dip recession, but the CBI reckons the economy will spend the next two years merely crawling to recovery. A weak economy is bad news for credit demand and credit quality at the banks. That said, overall credit quality does appear to be improving and banks' third-quarter figures revealed generally falling bad debt charges. Barclays, for example, saw its credit impairment charge fall 7 per cent in the first nine months compared with last year, while Lloyds, RBS and HSBC (HSBA) saw their charges fall 40 per cent, 44 per cent and 29 per cent, respectively, in the same period. Both RBS and Lloyds, however, continue to face big credit quality problems in Ireland, reflecting the property market collapse there. And HSBC faces ongoing provisioning pain in the US, where its sub-prime operation, now in run-down, accounted for 44 per cent of the group impairment charge in the nine months so far.

How the banks compare
Share price rise since 23 Julend-Sep pre-tax profit/(loss)Q3 tier one capital ratioQ3 total fines/non-credit chargesProspective dividend yield*Price to forecast net asset value ratio*Q3 peripheral eurozone exposure**
Barclays+53%£712m11.2%£2.74bn2.8%0.61£69.9bn
HSBC+21%$16.2bn11.7%$3.3bn4.6%1.36$36.8bn
Lloyds+48%(£583m)11.5%£5.3bnnil0.76£20.1bn
RBS+44%(£2.76bn)11.1%£1.78bnnil0.61£64.2bn
Standard Chartered+20% (since 7 Aug)£3.95bn†11.6%†$340m†3.5%1.61$1.92bn†

*Based on Investec Securities' full-year estimates **Reflects total exposure to Spain, Italy, Portugal, Ireland and Greece †For end-June 2012

Payment protection insurance (PPI) compensation claims are proving painful as well, with every bank - apart from Standard Chartered (STAN) - having hiked PPI provisions. Lloyds is undoubtedly the market leader in PPI claims and it boosted its provision by another £1bn at the third-quarter stage, bringing its total charge to an eye-watering £5.3bn. Barclays, too, is being hit hard and announced another £700m PPI provision, pushing up its total charge to £2bn. While RBS raised its total charge by £400m to £1.7bn. Unfortunately, Martin Wheatley - who will head up the Financial Conduct Authority - believes that 95 per cent of all PPI products were probably mis-sold, so further charges look likely. "We are assuming £15bn in total PPI costs for the industry," say analysts at JPMorgan Caznove. In fact, growing PPI claims helped contribute to the sliding third-quarter earnings profile of many of the UK banks.

A world of trouble

Other reputational problems persist as well. Barclays is now being investigated by UK's FSA and Serious Fraud Office, as well as the US Department of Justice, over payments to Qatari investors after it raised funds from the Gulf state. It's also facing a possible $470m (£292m) fine from US electricity regulators after being accused of manipulating the Californian energy market. And while Standard Chartered may have agreed a $340m fine with the superintendent of financial services in New York in August - after accusations of having "schemed" to avoid US sanctions against Iran - other regulators are likely to levy fines, too. Its total fines have been estimated at $1bn as the likes of the US Treasury, the Federal Reserve Bank and the US Justice Department negotiate settlements. That takes the shine off the bank's otherwise impressive third-quarter performance - characterised by decent growth and a low bad debt profile, reflecting its focus on still solidly growing Asian markets.

The Libor-fixing scandal hasn't passed yet either. Barclays' role in this may have attracted the most notice - and a £290m fine - but other banks are exposed, too. JPMorgan Caznove think RBS could be in line for Libor-related fines, even though the broker reckons that "these are likely to be manageable in size". There's also a growing problem of compensation claims from mis-sold interest rate products - so far only Barclays has set aside significant amounts for that. "There is a risk that all UK banks could face materially higher provisioning [for interest rate policy mis-selling] once the stance of both the regulator and/or the courts is clearer," says banking analyst Ian Gordon of Investec Securities.

But UK banks are looking reasonably capitalised, with all lenders having reported core tier one capital ratios above 11 per cent. That, however, largely reflects falling loan books rather than increased capital generation. While a need to conserve capital has kept dividends fairly low at those that still pay them, with still no payouts on the horizon for 41 per cent state-owned bank Lloyds or 84 per cent state-owned lender RBS. Nonetheless, imminent pressure to raise further capital is getting harder to spot. "We don't expect any imminent capital raisings from the banks," says JPMorgan Cazenove.

Outsider
Topping the list of outsiders is the heavily loss-making RBS and fellow partly state-owned laggard Lloyds. Both are heavily exposed to weak UK retail banking conditions and are being hit hard by big credit quality problems in Ireland. Neither will pay dividends anytime soon and Lloyds, in particular, is being bled dry with PPI claims. True, even after the recent rally, shares in both don't look demandingly rated compared with net tangible assets. But there are fears that those tangible book value figures aren't robust, while their unique collection of big challenges justifies a big discount. Barclays, too, is worth avoiding - its earnings profile is overly exposed to weak retail banking and volatile investment banking and there could be more reputational pain ahead.

Favourites
The only bank worthy of praise is Standard Chartered. It generates most of its profits in Asia, a region that - despite some slowdown of late - is still growing fast. Bad debts are low and are only rising at all in line with loan-book growth, while earnings are forecast to grow solidly. But that still doesn't add up to a buy recommendation. The shares are already expensively rated compared with those of its international peers and uncertainties over further sanctions-related fines could weigh on sentiment.

IC VIEW:

Admittedly, the recent strong banking rally has left our sell tips on RBS, Lloyds, Barclays and HSBC - written before recent interventions by policymakers - looking poorly timed. But the longer-term challenges facing the sector remain significant. Banks are struggling with big losses, ongoing weak economic conditions, painful hikes in mis-selling charges and wider reputational woe. Moreover, while ECB intervention has helped stabilise the situation in the eurozone, the bloc's deep-seated problems haven't been solved. Against that backdrop, share price gains in recent months could easily be lost - leaving the sector best avoided for the foreseeable future.