Back in the summer – when the UK’s big banks were reporting half-year results – a definite sense of sectoral recovery started to become noticeable. Against the backdrop of an increasingly well entrenched economic recovery, banks started to look well placed to benefit from improving credit demand and falling bad debts. Indeed, rapidly sliding bad debt provision proved to be a particularly noticeable driver of a recovery in banks’ earnings at the half-year stage. Moreover, after more than half a decade of self-help – winding down legacy loans, selling non-core assets and building capital cushions – banks do appear to simply look healthier.
Inevitably, then, the question arises: are the lenders now worth piling back into? After all, the last time the banking sector was firing on all cylinders – back in 2007 – the banks appeared like fantastic money machines from the perspective of those that had invested in them. Let’s not forget, for example, that in 2007 shares in Lloyds – a good example of a fairly typical big UK lender at the time – were yielding around 10 per cent, while its return on equity stood at an impressive 25 per cent. Given that history, it’s not unreasonable for investors to assume that riding the coat-tails of a banking sector upturn could prove very lucrative indeed.
Back to health?
But investors may need more than just a hunch about recovery before jumping back into the sector, and possibly the best analysis so far of bank health appeared late last month. That comprised the results of the so-called ‘stress-testing’ exercise, carried out on around 130 of Europe’s larger banks, by the European Central Bank (ECB) and the European Banking Authority (EBA).
That mammoth exercise – carried out over more than a year – involved looking at bank asset quality and sought to determine whether lenders were sufficiently well capitalised to cope with various adverse scenarios. These included such extreme events as a painful 5 per cent contraction in EU GDP by 2016, a big hike in unemployment, or a 20 per cent slide in house prices. And while more banks failed the test than expected – 25 compared with the 10-14 banks anticipated – an aggregate capital shortfall of only around €25bn (£19.6bn) was identified. That’s modest compared with €1 trillion of bank equity in the European sector. Moreover, the shortfall is based on lenders’ end-2013 figures – factor in the near-€54bn of capital raised since and the shortfall shrinks to €9.5bn with just 14 banks having failed. The ECB’s review of loan book quality – focused on just the 123 banks within the eurozone – did add a further €136bn of troubled loans to the sector’s total. But analysts at Berenberg point out that this represents a fairly trivial 62 basis points of the assets reviewed. Indeed, on the face of it, it’s understandable that Dutch finance minister JeroenDijsselbloem felt able to conclude that “the banking crisis is behind us”.
But while Mr Dijsselbloem’s enthusiastic conclusion looks fair enough at the bigger picture level, it’s worth bearing in mind that the European banking sector still contains pockets of misery. Of those banks that failed, nine – the largest concentration by far – were in Italy (see below). Three banks failed the tests in Greece, too, along with a further three in Cyprus – all of which serves to remind investors that banks in those southern European economies that were the hardest hit by the financial crisis still face significant issues. Significantly, though, none of Spain’s lenders failed the tests: quite an achievement given how deep the recession was in that country following the financial crisis.
It’s also worth remembering that plenty of banks passed the tests by the skin of their teeth, and that two such laggards are actually here in the UK: RBS (RBS) to an extent and – rather surprisingly – Lloyds Banking (LLOY). Indeed, Lloyds’ capital ratio under the adverse scenario came in at just 6.2 per cent – analysts at Deutsche Bank were expecting its ratio to exceed 8 per cent – which was only a smidgen above the 5.5 per cent minimum level. That seems to reflect both lenders’ relatively high exposure to Ireland as well as elevated assumptions regarding possible loan losses in the pair’s residential mortgage and commercial credit books.
It’s enough, say analysts at Deutsche Bank, to “raise questions around their capacity to return to the dividend list in the near term”. Lloyds, in particular, could be at risk here. It had been expected to at least pay a nominal dividend for 2014, but whether it can now appears to depend on the outcome of the Bank of England’s own stress tests – due for publication on 16 December. The Bank of England’s criteria is considered to be rather tougher than those of the ECB/EBA, too: its adverse scenario envisages such misery as a 30 per cent slide in the trade-weighted value of sterling, a big hike in interest rates and a 35 per cent collapse in residential property prices. The job of modern day bank regulators, it seems, is now focused on imagining the conditions for financial Armageddon!
More regulatory pain?
But, overall, at least, the stress tests do seem to demonstrate that the European banking sector is now better capitalised – and therefore better able to withstand shocks – than at any time since the financial crisis. Indeed, the Bank of England reckons that the UK’s major banks alone have more than £150bn more capital now than they did before the financial crisis began as they stride towards meeting such tough new requirements as the Basel III capital rules. So it’s reasonable for investors to ask whether the regulators are now close to having finished with the banks. Given that the painful capital-building agenda of recent years has played havoc with banks’ returns and dividend prospects, it’s an important question to answer from an investment perspective.
Unsurprisingly, given the pain inflicted by the financial crisis, the regulators have been busy. To a significant degree, they reacted to the issues raised by that crisis in the traditional way: they tightened up the rules, after the damage was done, and at great cost to the banks. Moreover, a lot of that new rule-based architecture – sometimes EU-driven – is now either in place, or close to being erected: ranging from Basel III capital and liquidity rules to banks’ living wills (which set out how a failing bank can be wound down in a crisis). In Europe, meanwhile, the ECB this month became the eurozone’s main bank regulator, with direct responsibility for regulating the region’s systemically important banks.
But what’s really different with the fallout from this crisis is that the ongoing regulatory approach has fundamentally changed. That was clear from a speech in October given by the Bank of England’s deputy governor, responsible for financial stability – Sir John Cunliffe. He talked of a “macroprudential policy” designed to “act counter-cyclically against the upward spiral of exuberance which can easily set in to the financial system as rising asset values provide additional collateral for more and more lending and weaker lending standards.” Regulators sound determined not to allow banks to ‘let it rip’ ever again – potentially meaning that the fat returns from banks in the pre-2007 world may never be seen again.
The sector isn’t quite finished with rule-based regulatory change, either. Perhaps the most significant item still to come on that agenda relates to new leverage ratios, again dealing with capital levels, that banks must meet from 2019 onwards. Unlike with regulatory capital ratios – where banks are given some leeway with interpreting the relative riskiness of their loans when deciding the capital that must be held – leverage ratios are a far cruder tool. These require banks to hold a certain proportion of capital against loan books, regardless of the riskiness of the assets. In October, the Bank of England announced that the leverage ratio could rise to 4.95 per cent for the biggest banks from 3 per cent now. That means banks must hold almost £1 of capital for every £20 they lend, instead of the current £1/£33 ratio. Sir John is blunt about the implications of tougher leverage requirements for investors: “lower leverage will reduce the returns that banks’ shareholders make, relative to pre-crisis” levels.
Another regulatory shift to watch out for in the UK, and which will carry a clear cost for the banks, is the new rule requiring retail operations to be ring-fenced from investment banking arms. That recommendation came from the independent Commission on Banking (ICB), chaired by Sir John Vickers, and was included in the 2013 Banking Reform Act. Ring-fencing must be completed by 1 January 2019 and the costs of such a major restructuring are far from trivial. The ICB itself estimated the cost at between £4bn-£7bn but, at the time the proposals appeared, Goldman Sachs put the cost at nearer £10bn. So, despite the broadly comforting message from the latest round of stress-testing, investors can expect more regulatory drag ahead.
An economic boost?
than compensate for the capital-zapping activities of the regulators? In the past it has certainly been the case that the rising tide of a recovering economy has been enough to float all of the banking sector’s boats. Moreover, the recent round of third-quarter figures from the UK’s lenders has demonstrated that an improving economic backdrop has continued to drive a robust improvement to credit quality. That in turn has allowed banks to cut, or even write-back, bad debt provisions which has boosted earnings.
But investors might want to think again. To begin with, the UK’s relatively robust economic recovery – the IMF expects the UK’s economy to grow 2.7 per cent in 2015 after more than 3 per cent growth in 2014 – has yet to translate into sectoral growth. Significantly reflecting the fact that banks are still clearing out huge swathes of poorly performing assets, left over from before the financial crisis, bank loan books are generally still shrinking: hardly ideal for earnings growth.
It’s not clear, either, that the better economy is actually translating into significantly stronger demand for credit. The Bank of England’s third-quarter Credit Conditions Survey, for example, revealed that loan demand from small businesses actually fell in the third quarter, while demand for unsecured lending products (excluding credit cards) merely remained flat. And while measures such as the government’s Help to Buy scheme have boosted demand for mortgages, that’s not actually turning into significantly higher mortgage approvals. In fact, the Financial Conduct Authority (FCA) pointed out in its Risk Outlook statement this year that “secured household lending is still subdued compared to pre-crisis growth”.
Moreover, a good portion of that improving credit backdrop reflects today’s ultra-low interest rate environment. As rates begin to rise, as they must eventually amid a recovering economy, any fledgling recovery in credit demand could easily be snuffed out. Meanwhile the FCA warns that some borrowers may be “unable to meet higher debt servicing costs”, suggesting that recent credit quality improvements could yet reverse to some degree. That said, rates rises are hardly imminent. Ben Brettell, senior economist at Hargreaves Lansdown, expects interest rates to “remain on hold until the summer of 2015, and probably even longer”. Moreover, the upside from modestly rising interest rates is that it will boost banks’ generally depressed net interest margins.
For European banks, meanwhile, hopes of a big economically-driven bounty look even more unlikely. Indeed, the IMF expects the eurozone’s economy to have grown by just 0.8 per cent overall during 2014. Some European lenders – as we have seen in Italy – continue to struggle with painfully high levels of bad debts, too. And key performance metrics in the eurozone – such as consumer confidence or business investment – have all struggled to return to pre-crisis levels, which has kept demand for credit weak. Following the release of stress-testing data, for example, bank analyst JakubLichwa of Daiwa Capital Markets observed that “a marked acceleration in bank lending cannot be expected against a backdrop of weak demand growth”.
Misconduct misery
As explored in some depth in our recent feature – ‘Bleeding the Banks’ (31 October 2014) – banks also face considerable pain from fines and redress costs for past misconduct. It’s an ongoing problem that looks set to drag on bank earnings for some considerable time to come. Analysts at Macquarie Securities have estimated that HSBC (HSBA), Barclays (BARC), Lloyds and RBS could still be facing a combined near-$41bn (£26bn) of misconduct-related costs – and that excludes PPI provisions which are still hurting the lenders. Lloyd’s alone has set aside an eye-watering £11.3bn in cumulative provisions for this since the issue emerged.
Some of the most significant pain to come for UK and European lenders includes settlements and fines in the US for having mis-sold mortgage-backed securities prior to the financial crisis. There are also fines to come from having manipulated foreign-exchange markets – at the third-quarter stage, HSBC, RBS and Barclays – announced large provisions for this before being fined a collective £2bn this week. And more fallout from the Libor-rigging scandal can’t be ruled out, either. Essentially, the benefits of any economic recovery look set to be significantly offset by conduct-related costs and ongoing regulatory costs.
Investment bank pain
The investment banking arms of the big lenders are struggling, too. The problem is that banks’ fixed-income, commodities and currencies (FICC) trading businesses are still under pressure. That’s largely down to lower trading volumes, reflecting such factors as interest rate uncertainty or regulatory limitations to discourage risk-taking. That has been enough at many lenders to offset the growth seen at investment banks during much of this year from their equity-related businesses.
For example, FICC-related revenue at RBS at the third quarter stage fell a third year on year, while Barclays saw investment bank pre-tax profit in the nine months to the end of September slide 38 per cent – a performance described as “disappointing” by chief executive Antony Jenkins. Such pressures are leading some banks to downsize their investment banking arms. Barclays, for example, announced in May that it’s axing 7,000 jobs at its investment bank, while UBS (SW:UBSN) has been shrinking its investment bank arm since 2012.
The challenger threat
What’s more – and after the outcry following the ICB’s conclusions that the UK’s banking market wasn’t competitive enough – Britain’s big lenders face a growing number of new entrants. Indeed, the FCA and the Bank of England’s Prudential Regulatory Authority have been tasked with looking into how the substantial barriers to entry for a new bank – especially, capital requirements – can be lessened in the case of smaller and less systemically important lenders.
There has certainly been plenty of activity this year from challenger banks. In June, for example, OneSavings Bank (OSB) – formed from the purchase of Kent Reliance Building Society’s mortgage assets in 2013 – floated. So did TSB (TSB), which comprises the branches that Lloyds was forced to divest by EU competition regulators as the price for state support during the financial crisis. Specialist banks Aldermore and Virgin Money also announced their intention to float – Aldermore subsequently changed its mind amid this autumn’s market volatility, while Virgin Money has postponed its flotation to the end of November. RBS will also spin out Williams & Glynn by 2016 – as with Lloyds and TSB, that’s also required by EU competition regulators. Meanwhile, Metro Bank, which is growing fast organically, has IPO plans for 2016.
There’s a raft of long-established specialist lenders as well. These include such well-known names as Close Brothers (CBG), which has done very well in such areas as motor finance, as well as strongly performing buy-to-let mortgage specialist Paragon (PAG). Aim-traded Secure Trust (STB) (53 per cent owned by specialist lender Arbuthnot) is also growing fast on the back of strong demand for motor finance and it’s preparing to enter the small and medium enterprises (SME)-lending market.
But don’t expect the big banks to lose much sleep over this competitive threat just yet. To begin with, the alternative lenders are generally growing by filling the gaps left by the withdrawal of the big banks following the financial crisis. That’s largely down to regulatory pressures, such as tougher capital requirements and the ongoing need to tackle legacy loan books, which has helped reduce risk appetites. Analyst Justin Bates at broker Liberum isn’t expecting the rise of the challengers to deliver a notable drop in the price of banking products for consumers. He reckons that the banking sector was actually far more competitive at its market peak in 2006-07 than it is now, despite being dominated by a small number of big banks. “We’re still some way below the capacity seen in 2006-07 and the challengers are starting from a low base,” notes Mr Bates.
UK banks in bargain territory (mostly)
It’s clear, then, that enough banking headwinds persist for investors to remain profoundly cautious of the sector overall. That said, it’s hard to ignore the fact that bank share prices are undemandingly rated by historic standards – most trade at not far above analysts’ estimates of net tangible assets (NTA) compared with multiples of between two and three times prior to the financial crisis. So progress such as improving credit quality and better balance sheet health could leave those share price multiples looking too cheap, despite that long list of headwinds. We have therefore put together snapshots and recommendations on the UK’s main listed banks – we’re actually fairly bullish on most of them.
