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No respite for banks

John Adams warns that just because a eurozone break-up now looks less likely, investors shouldn't assume that all is well in the banking sector
December 21, 2012

Following the European Central Bank's (ECB) decision earlier this year to prop up the euro - through buying up the bonds of the eurozone's weakest members - sentiment towards the banks has improved markedly. That decision has, says Barry Norris, founding partner of fund manager Argonaut Capital, "convinced markets that the threat of a sovereign default is now minimal". Indeed, bank shares have recovered strongly since the summer - Lloyds' shares, for example, have soared by over 80 per cent since early June. But just because a eurozone break-up now looks less likely, investors shouldn't assume that all is well in the banking sector - it's far from it.

To begin with there's a fairly hectic regulatory agenda to worry about. Most immediately, moves to make the ECB the eurozone's top bank regulator, as eurozone members press ahead with a banking union, carry risks. Naturally, the UK won't sign up for that union and the government insists that it has won safeguards to protect the City's position - largely through the voting structure of the European Banking Authority, which coordinates EU supervisory policy. But the fear persists that such a powerful bloc would in practice dictate the rules for the EU's single market in financial services, making it easier for eurozone countries to overrule the UK and make rules that favour Frankfurt and Paris at London's expense - potentially leading banks to relocate overseas. The House of Lords EU sub-committee on economic and financial affairs is certainly worried and published a report this month claiming that the government's "confidence that the City of London's pre-eminence may be retained could proved misplaced". Its chairman, Lord Harrison, said of the government's safeguards that "the devil is in the detail".

 

 

Aside from that bigger picture threat, there are plenty of more specific regulatory moves that will worry bankers. Among the more noteworthy, for example, is the Independent Commission on Banking's (ICB) key recommendation - to effectively ring-fence banks' investment banking activities from retail banking. That's estimated by the ICB to mean a £4bn-£7bn cost for the sector, with Goldman Sachs estimating a cost of nearer £10bn.

 

 

Of more significance, perhaps, is the impending implementation of Basel III rules. These will set banks tough liquidity ratios and will require banks to bolster their capital buffers - measures that could constrain lending. The new capital rules, in particular, will force lenders to hold tier one capital (essentially equity) that's equivalent to 4.5 per cent of their risk-weighted assets, plus an additional 2.5 per cent buffer - giving a 7 per cent minimum ratio. Full implementation isn't required until 2019 and, right now, UK banks don't look like they'll struggle to meet this. While, with the UK economy still in a mess, FSA plans for a 'superequivalent' approach to Basel III - to make banks meet a minimum 10 per cent ratio by the end of next year - have been relaxed.

But that doesn't mean capital worries won't plague lenders during 2013. The problem, as the Bank of England points out in its latest Financial Stability Report, is that there are reasons to believe that UK banks' capital buffers "are not as great as headline regulatory capital ratios imply". Significantly, the Bank fears that loan books may be in worse shape than bankers believe. But it also points to the problem of fines and compensation - especially for mis-selling payment protection insurance (PPI) that, according to the Bank, "have also been underestimated and underprovided for". It expects the banks to face "additional sizeable costs" from such reputational issues.

 

 

Lloyds is the clear market leader here and has, so far, provided a painful £5.3bn for PPI mis-selling charges. Next is Barclays, with a £2bn PPI-related charge, followed by RBS - it has set aside £1.7bn. Analysts at JP Morgan estimate that total PPI-related charges for the sector could reach a staggering £15bn. What's more, Standard Chartered has paid up $667m (£412m) to settle fines by US regulators after being accused of having "schemed" to avoid US sanctions against Iran. HSBC, too, has been hit with heavy fines - this month it was forced to cough up $1.92bn in US regulatory fines for money laundering systems failings. Libor rigging fallout is another worry. Barclays suffered a £290m fine, but plenty of other banks are at risk here and it's thought likely that RBS will be hit especially hard. Capital worries are also likely to limit dividend payouts for some time while, for 84 per cent state-owned RBS and 41 per cent state-owned Lloyds, no dividends are likely at all for potentially years to come.

 

 

Then there's the ongoing problem of the weak economic backdrop. The International Monetary Fund believes the UK's economy would have contracted 0.4 per cent during 2012 and next year won't see much growth, either - such conditions mean weak loan demand and potentially rising bad debts, which doesn't bode well for banks' earnings prospects. Indeed, annual household lending growth has averaged just 1 per cent over the past two years, while business lending contracted 3 per cent. Eurozone woe remains an issue, too - despite recent ECB actions - and fears about the scale of UK banks' exposure to the region's weakest economies could easily return. "The eurozone's problems have not been solved and will re-emerge," points out Ed Firth, head of European banks at Macquarie Securities.

 

 

This picture of woe has led the Bank of England to conclude that investor confidence in the banks "remains low" and to point out that the value of major UK banks' shareholder equity, on average, is now equal to around two-thirds of banks' book values. In fact, the only clearly good news appears to be that the cost of bank funding has fallen dramatically since the ECB's decision to pump €500bn (£403m) of liquidity into the sector in February - UK unsecured bank funding costs have fallen about 100 basis points since June.

Against that backdrop, we reiterate our view that the banks are largely worth avoiding in 2013. Indeed, the only UK listed bank with any merit is Standard Chartered - its heavy exposure to fast-growth Asia leaves it as about the only UK bank with a credible growth story. But with the shares trading on a hefty 1.6 times Investec Securities' end-year net tangible assets estimate, even that doesn't add up to a buy recommendation.

 

How the UK banks compare

Market valueQ3 tier-one capital ratioTotal fines/non-credit chargesProspective yield*Price to forecast net tangible assets ratio*Q3 peripheral eurozone exposure**
Barclays£30.8bn11.20%£2.74bn2.60%0.67£69.9bn
HSBC£118bn11.70%$3.62bn4.30%1.35$36.8bn
Lloyds£32.9bn11.50%£5.3bnnil0.83£20.1bn
RBS£18.1bn11.10%£1.78bnnil0.65£64.2bn
Standard Chartered£35.5bn11.6%†$667m3.50%1.64$1.92bn†

*Based on Investec Securities’ end-2012 estimates

**Reflects total exposure to Spain, Italy, Portugal, Ireland and Greece

†As at end-June 2012