Banks under siege

Not out of the woods yet

But that doesn't mean all is now well with the banks. The sector is still being buffeted by a host of sentiment-zapping business misconduct issues - ranging from payment protection insurance (PPI) mis-selling to Libor-rate fixing. Capital adequacy is still a worry across the sector, as is the uncertainty created by ongoing regulatory change. The economic backdrop remains stubbornly weak, too - always bad news for credit quality and credit demand at the banks. What's more, as eurozone banks begin to repay the cheap emergency funding made available to them by the ECB in recent years (the Long-term Refinancing Operation) there’s a risk that interbank rates could begin to rise - with implications for banks’ margins and, possibly, even liquidity. It's not even clear that the eurozone sovereign debt crisis won't return at some point to haunt the banks. So, with the world's banks now announcing their third-quarter figures, we take a look at the key issues facing the sector.

A capital problem

Capital adequacy in particular is a worry that just won't seem to go away. Back in June, for example, regulators at the Bank of England's newly-created Prudential Regulatory Authority (PRA) reviewed the capital positions of the five listed UK banks, along with the Co-op, the UK arm of Santander, and building society Nationwide, and concluded there was a big hole to fill.

Based on end-2012 figures, it said that five of these eight institutions were facing a combined £27.1bn capital shortfall - based on a 7 per cent capital ratio using Basel III criteria and incorporating a 3 per cent leverage ratio. The weakest was RBS, with a £13.6bn shortfall, followed by Lloyds (£8.6bn) and Barclays (BARC), with £3bn - Nationwide's was £0.4bn and the Co-op's £1.5bn.

However, those figures aren't quite as worrying as they initially seem. RBS reckons that the shortfall will drop to just £400m by end-2013 - reflecting such capital-generating measures as the planned partial flotation of its US bank unit, Citizen, and the successful flotation of 71.5 per cent of insurer Direct Line. Barclays - helped by its regulatory-driven £5.8bn rights issue back in the summer - expects to be able to exceed the PRA's requirements by the end of this year as does Lloyds. Moreover, HSBC (HSBA) and Standard Chartered (STAN) had no shortfalls at all.

Capital adequacy is potentially a far bigger problem among European banks, however. For example, last month the Basel Committee on Banking Supervision released a report covering 223 global banks that revealed a €115bn (£97bn) capital shortfall - based on implementing the same 7 per cent Basel III capital requirement criteria and using end-2012's figures. Significantly, the European Banking Authority said that €70.4bn of that capital hole - or 61 per cent of the total shortfall identified - related to banks within the EU.

Economic uncertainty

A stubbornly weak economic backdrop isn't helping, either, as a struggling economy traditionally spells weak credit demand at the lenders, accompanied by high levels of capital-consuming bad debts. True, recent newsflow suggests that the UK economy is at last beginning to recover - the IMF this month upgraded its UK economic growth forecasts and now expects 1.4 per cent growth in 2013, rising to 1.9 per cent in 2014. And credit quality at the UK banks has generally been on the mend for some time - at the half-year stage, for example, Lloyds' credit impairment charge was cut by 43 per cent year on year. Bank lending is picking up, too - BBA figures show that UK businesses borrowed £2.5bn more in September than in August, the biggest jump since 2009. But that recovery is far from entrenched and the Bank of England reckons that substantial spare capacity in the economy will limit job creation and delay a rise in the base rate until the second half of 2016.

What's more, some longer-term trouble could be on the cards from the housing market - reflecting the government-sponsored Help to Buy scheme. Dubbed the "help to binge" scheme by banking analyst Ian Gordon of Investec Securities, it allows people to buy homes with only a 5 per cent deposit. But without measures to boost the UK housing stock, it could also unleash another housing bubble and, in the longer term, it could also increase defaults on these relatively riskier mortgage loans.

Right now, however, the economic situation looks rather bleaker elsewhere in Europe - the IMF expects the eurozone economy as a whole to have contracted by 0.4 per cent during 2013, with the Spanish and Italian economies having shrunk by 1.3 per cent and 1.8 per cent, respectively. Even the usually resilient German economy will only grow by 0.5 per cent during this year. And while the IMF reckons the US economy will have grown by 1.6 per cent by the year-end, the recent political cliff-hanger over the budget and the debt ceiling demonstrates that recovery there isn't guaranteed, either.

The Italian banks look especially badly hit by economic distress. For example, the country's third-largest bank by assets - Monte dei Paschi di Siena - faces the threat of nationalisation as non-performing loans there reached an eye-watering 13.8 per cent of its book at the half-year stage. Even UniCredit - Italy's largest bank - revealed that net impaired loans stood at a painful 8.7 per cent of its book. By way of comparison with an international peer, UBS's impaired loans represent just 0.5 per cent of its book. Overall, the Italian banking sector's average non-performing loan ratio has tripled since 2007 and the IMF noted last month that "the lacklustre economic outlook and the large exposure to the highly-leveraged Italian corporate sector" remain significant risk factors for the Italian banking sector.

Latin credit quality misery

The Spanish banking system isn't out of the woods yet, either. In return for €41bn of EU support, considerable banking reforms have been pushed through - including realistic provisioning against the sector's real estate-driven bad debt crisis. But even that may not have gone far enough, and an extra €5bn of provisions is being mooted for the sector against loans that had already been restructured. What's more, lending is still contracting, non-performing loans now stand at 12.12 per cent of total credit extended in Spain and, in June, the Bank of Spain warned lenders to curb dividend payments to preserve capital.

Tarnished reputations

Closer to home, bank investors have had to contend with a long list of business misconduct issues. Take Standard Chartered, for example - in the summer of 2012 it was accused by New York regulators of having "schemed" to avoid US sanctions against Iran - it was forced to cough up $667m (£441m) in fines. Also in 2012, a report compiled for the US Senate found that systems failures at HSCB had allowed the bank to be used as a conduit for "drug kingpins and rogue nations" - leading to a near $2bn fine. Just this month HSBC was back in the news after being ordered to pay $2.5bn by a Chicago court. That's related to complaints by shareholders about the acquisition of Household International in 2002 - HSBC is to appeal against the decision.

Under former chief executive Bob Diamond, meanwhile, Barclays became the first lender to be hit with a hefty fine for its role in rigging the Libor interbank rate (£290m). Even now, the bank is under investigation by the Serious Fraud Office into 2008’s Qatar capital injection. Largely nationalised RBS has been also fined for Libor-fixing - £360m. But for it, and fellow part state-owned lender Lloyds - it's product mis-selling that has hurt most and really tarnished reputations.

Lloyds - the sector leader - has set aside a painful £7.28bn to cover compensation of mis-sold payment protection insurance (PPI), while RBS has set aside £2.4bn for this. Neither has PPI pain clearly come to at an end. Last month the Financial Conduct Authority was reported to have branded the handling of two-thirds of PPI compensation claims as unfair. "In the eyes of the regulator, too few claims are ending up in sufficient redress," observed analyst Shailesh Raikundlia of Espirito Santo Investment Bank.

Interest rate product mis-selling looks set to be the next big thing in the compensation arena and RBS appears especially vulnerable in this respect. The Financial Conduct Authority says that RBS has 10,528 such claims under review, which is more than all of the cases at HSBC, Lloyds and Barclays combined. That leaves the bank's £0.75bn provision looking modest - Barclays' is double that. "If taken at face value, RBS appears the most likely bank to require material additional provisions," reckons Investec's Ian Gordon. Indeed, it's not surprising that the UK banks' third-quarter announcements have revealed more redress charges.

It's not just UK banks that are being hit hard with business misconduct costs, however. In the US, the banking sector is under the cosh to pay compensation for a range of mortgage-related misdemeanours - from having broken rules when seizing homes from customers who defaulted to having sold on loans that breached quality guarantees.

UK bank fines and redress - costs to date

Just this month, JPMorgan agreed to pay a huge $13bn in fines and compensation relating to bad mortgage-backed securities sold to US government-controlled mortgage groups Fannie Mae and Freddie Mac, and Bank of America is rumoured to be in the firing line for another $6bn hit. In January, Bank of America paid out $11.6bn to Fannie Mae, while 10 lenders - including the likes of Wells Fargo, Citigroup and JPMorgan - paid a total of $8.5bn to cover foreclosure failings. What's more, last month Wells Fargo shelled out $869m in compensation to Freddie Mac. More charges for the US banks could well be on the cards - JPMorgan, for example, is rumoured to be nearing a $6bn settlement with institutional investors over mis-sold mortgage-backed securities.

Regulatory upheaval

Some of that misconduct background looks set to spill over into regulation. "We suspect there will be a second wave of regulatory changes, which perhaps focuses on the conduct of business," reckons banking analyst Edmund Salvesen of Brewin Dolphin. "This may look at derivatives/repos and how to look after clients, which seems likely given the amount of mis-selling claims recently."

Of course, the first wave of regulation has been heavily focused on boosting capital levels, as well as liquidity levels to absorb losses, and that has led to the to the Basel III rules. Crucially, these will force lenders to hold core 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. The trouble is that holding more capital comes at a cost for banks - it leaves them with low-yielding assets and reduces their capacity to lend. Indeed, rating agency Fitch looked at the world's most systemically important banks last year and estimated that the Basel III regime would "imply an estimated reduction of more than about 20 per cent in these banks' median returns".

There are other regulatory costs on the way. Here in the UK, for example, a key recommendation from Sir John Vickers' Independent Commission on Banking (ICB) was to ring-fence investment banking activities from retail banking functions - that's presently being translated into UK law. But the ICB estimates a hit to the sector of between £4bn and £7bn - while Goldman Sachs has put the cost at nearer £10bn. That's going to fall on lenders such as Barclays, HSBC, RBS and Lloyds, which boast decent-sized investment banking arms.

Meanwhile, the level of regulatory scrutiny looks set to grow further. For example, the Bank of England published a discussion paper this month proposing annual stress tests for banks to explore whether they are robust enough to withstand market turmoil. "Our intention is that stress testing evolves into an essential component of our prudential framework," remarked the Bank's new governor, Mark Carney. That could even evolve to cover foreign subsidiaries and systemically important non-banks. Meanwhile, in preparation for the EU's banking union, the ECB this month set out tough new stress tests that it will apply to lenders before supervision is centralised under its roof in November 2014. That could identify yet more risks in banks' loans books, potentially requiring more capital to be set aside.

Regulators don't always sound confident that existing reforms have covered all the bases, either. For example, outgoing Bank of England deputy governor Paul Tucker warned this month that big risks to stability remain from the non-bank financial arena - such as hedge funds. "It is hard to guess what is going to happen but what we suspect is that there are another five or six years of regulatory change to come," says Mr Salvesen. He reckons a likely area of focus will be on so-called living wills - recovery and resolution plans to allow for an orderly wind-up of troubled banks.

Limited competition

Still, at least the big banks don't appear to facing any serious competitive threats - good for banks' earnings, less so for bank consumers. In the UK, Sir John Vickers' report argued for more banking sector competition and that line has also been championed by the Parliamentary Commission on Banking Standards. And the creation of two new banking entities - reflecting the EU's enforced branch disposals at RBS and Lloyds - should help to boost competition.

But the barriers to entry make it hard going for new players to get established. That's significantly down to regulatory requirements - such as tough capital rules, certainly, but also the need to be able to demonstrate a long-standing banking track record. A glance at the various failed efforts to buy the RBS and Lloyds branches demonstrates just how tough it is for new players to establish themselves.

For example, the 300 or so branches RBS is selling - to be branded as Williams & Glyn - have been linked to multiple bidders. Originally, they were to be sold to Santander but that deal fell through. Such varied names as Virgin Money and private equity company JC Flowers then emerged as potential bidders - none were successful. A deal was eventually agreed last month to sell the branches for £600m to a consortium including Corsair Capital, Centerbridge Partners and the Church Commissioners.

It has also proven tough going trying to off-load Lloyds' 630 or so branches. They were originally to be sold to the Co-op, but that deal fell through - regulators were concerned about the Co-op's capacity to absorb such a major deal, and rightly so, given the problems that organisation is facing. After failing to find an appropriate new buyer, the branches will instead be floated off as a stand-alone entity - branded as TSB - probably in the middle of next year.

Indeed, the City is littered with failed banking wannabes. Look at 2010's so call 'project new bank', for example - an effort to impress regulators by stuffing a start-up with City grandees. It was intended as a vehicle to snap-up Lloyds' branches and involved the former Lloyd's of London chairman Lord Levene teaming up with former Bank of England director Sir David Walker, former Treasury Select Committee chairman John McFall and former European Commissioner Charlie McCreevy - all to no avail. Meanwhile, progress at such new players as Metrobank remains fairly limited - it only has about 20 branches.

But even though a radical boost in competition isn't likely, don't expect a reduction, either - which leaves serious M&A in the sector looking increasingly like a concept from history. True, last month there were some M&A rumours circulating in the European baking sector - such as those linking Danske to SEB and BNP to Commerzbank. But such rumours probably have "zero credibility", according to analysts at Berenberg.

In fact, in a world where there are already too many banks that are too big to fail, the systemic implications of allowing yet more banks to join that category through mergers isn't likely to be tolerated by regulators. "If banks are too big to fail, prompting growing concerns among regulators/politicians, they are also too big to control for management and too big to understand for investors," reckons Berenberg. "Further M&A only compounds these problems."

Reprivatisation gets under way

But in the UK the government has, at least, made a cautious start on bank reprivatisation after selling a 6 per cent stake in Lloyds last month - it now owns 32.7 per cent of the lender. This involved an institutional placing at 75p a share - comfortably above the 61p a share at which the stake is valued by the government in the national accounts. A further disposal is anticipated next year and is thought likely to include a retail offering along with another institutional placing.

Unfortunately, however, RBS's share price remains well below the government's 502p average buy-in price and no real progress has been made in disposing of the government's 81 per cent stake. In fact, business secretary Vince Cable said in August that an RBS sale wasn't likely "for at least five years" and strategic clarity towards RBS remains in short supply. In June, for example, the government ordered a review of whether RBS should be split into a 'good bank', containing the best assets, and a 'bad bank', containing the dross. But such a split isn't thought likely - it would almost certainly require the full nationalisation of RBS's worst assets.

Against that mixed backdrop, and with the third-quarter reporting season upon us, we've put together snapshots and recommendations of the UK's big five listed banks.

Royal Bank of Scotland (367p)

As already mentioned, RBS faces plenty of strategic uncertainty and capital adequacy remains a worry. Its recovery from recession hasn't been impressive, either. The UK retail arm grew half-year operating profit by just 4 per cent year on year, despite a firming UK economic recovery. And investment bank downsizing meant half-year profits at the markets business slumped by two-thirds. Broker Investec expects a zero return on equity (RoE) for 2013 and doesn't expect RBS's RoE to exceed its cost of equity before 2017. There's no dividend, either, and unlikely to be one for years to come. True, rated on under 0.9 times Investec's forecast end-2013 net tangible assets, the shares aren't pricey - but that's roughly in line with Barclays' share rating; a bank with arguably better prospects and which pays dividends. Sell.

Lloyds Banking (78p)

True, Lloyds Banking looks in better shape than RBS and, at the half-year stage, a big improvement in credit quality at the bank's Irish operation helped drive down the impairment charge. Underlying profit at the retail arm rose 11 per cent, too, and its Basel III capital ratio improved to a healthy 9.6 per cent. The government has begun to sell its shares in the bank and the group booked gains from selling shares in wealth management company St James’s Place Capital. Management have even flagged the possibility of a return to the dividend list. But the shares, trading on about 1.4 times Investec's end-2013 net tangible assets (NTA) estimate, are no bargain - that's in line with those of HSBC, which boasts rather better growth prospects and a fat prospective yield. Hold.

Barclays (274p)

Even after its rights issue, Barclays' Basel III capital ratio reached just 9.3 per cent. And while Barclays does at least pay a dividend, raising capital at the same time as promising to hike next year's dividend has, at the very least, sent confused messages. Meanwhile, trading has been mixed. At the half-year stage, investment banking profits rose 7 per cent, but the UK arm saw a flat performance and Barclays also substantially hiked PPI-related compensations provisions. And, with an ongoing SFO investigation into the bank's 2008 Qatar capital injection, there's always the risk that sentiment could suddenly take a hit on the back of new reputation-related revelations. So, even though a rating of 0.9 times Investec's end-2013 NTA estimate isn't pricey, it's about right. Hold.

HSBC (689p)

HSBC's exposure to fast-growth emerging markets in places such as Asia and Latin America leave this bank with the kind of growth profile that its UK-focused peers must lust after. Half-year profits from the bank's Hong Kong operation, for example, jumped 12 per cent to $4.2bn. What's more, the US credit-quality nightmare at the bank's former Household International sub-prime unit appears to be over - the half-year bad debt charge there slumped 68 per cent year on year. There's also a prospective yield of about 4.8 per cent - one of the tastiest in the global banking sector. And with a Basel III-basis capital ratio of 10.1 per cent, capital adequacy isn’t a worry, either. Meanwhile the shares, trading on about 1.4 times Investec's end-2013 NTA estimate, aren't pricey for its international peer group. Buy.

Standard Chartered (1,518p)

As with HSBC, Standard's emerging markets exposure that leaves it among the best growth plays in the sector. It also boasts the most comfortable capital cushion of the UK-listed banks, with a Basel III ratio of 10.6 per cent. Credit quality looks strong, too, and the lender's core Hong Kong business saw profit (after combing wholesale and consumer results) rise 16 per cent at the half-year stage. True, the bank has its share of challenges - weak conditions and rising bad debts in South Korea, for example, hit performance hard there in first half. But, overall, growth is robust and the shares trade on a not overly demanding 1.5 times Investec's end-2013 forecast NTA. There's a 3.7 per cent prospective dividend yield, too – not as fat as HSBC's, but attractive nonetheless. Buy.

UK banks compared