FTSE 350: Misconduct costs haunt the banks

Unfortunately, it's not that simple. A range of issues - from tougher regulatory requirements to the costs of past misconduct - continue to hurt the lenders. And those pressures look set to persist.

Perhaps the most significant conduct-related threat ahead is posed by forthcoming settlements in the US for mis-selling mortgage-backed securities (MBS) prior to the financial crisis. The US banks have already been hit hard, but their pain is now behind them. It's a different story for the UK lenders. Inevitably, forecasting fines and settlements involves a huge amount of guesswork, but research issued in July by Macquarie Bank suggests that HSBC (HSBA), RBS (RBS) and Barclays (BARC) could be facing a combined $10bn (£6.6bn) hit. Only Lloyds (LLOY) appears set to escape.

RBS is the bank most exposed - to the tune of $5.6bn, according to Macquarie. But the costs are hardly imminent. America's Federal Housing Finance Agency, which acts for the US government-backed secondary mortgage operations Fannie Mae and Freddie Mac, has yet to initiate any settlement discussion with RBS, for instance.

Other fines and settlements - from big misconduct issues such as forex market manipulation and Libor-rigging - are also still hanging over the banks. Macquarie estimates that the big four UK banks could be stung with a combined misconduct-related cost of nearly $41bn. And that doesn't include the ongoing costs of provisions to cover compensation for having mis-sold payment protection insurance (PPI). While the worst is probably over, PPI costs continue to creep up: the big four again hiked provisions at the third-quarter stage. Lloyds remains the hardest hit by far. It has set aside an eye-watering cumulative total of over £10bn since the PPI scandal first emerged.

Tough investment banking conditions are another drag on banks' performances. Low levels of market volatility - leading to less trading activity - are hitting revenues. Barclays, for instance, reported that pre-tax profit at its investment bank had slumped 38 per cent year on year in the nine months to end-September. Significantly, Barclays' restructuring plan involves drastically hacking back the investment bank, which is where most of its non-core assets sit.

Those lenders with investment banks also face the cost of implementing rules to ringfence them from their retail banking operations. The Treasury thinks the cost to the sector of running such a system could exceed £4bn a year, and lenders have this month submitted plans to regulators setting out how they intend to achieve the ringfencing requirements. Should Labour win the next election, the banks face a competition probe, too. That could lead to bank break-ups for those with market shares perceived to be excessive.

Capital adequacy worries haven't been entirely extinguished, either. The UK banks did all pass last year's stress-testing exercises - which modelled the impact of various adverse economic and market conditions - undertaken by the ECB/EBA and, a few months later, the Bank of England. But Lloyds and RBS passed by only slender margins. Capital worries also continue to haunt Asia-focused lender Standard Chartered (STAN). These reflect fears that Standard could be facing heavy losses on commodity loans as the prices of oil and iron ore slump. Mercifully, there are no such concerns for HSBC: cost-cutting and the disposal of non-core operations have left it generating more capital than it can employ. That explains its healthy capital ratios and attractive dividend yield.

Privatisation is another theme that refuses to disappear. While the government has made considerable progress with selling its stake in Lloyds, the legacy issues still facing RBS leave its reprivatisation looking like a distant prospect. The shares also still trade well below the government's average 502p-a-share buy-in price, which poses a political barrier to progress.

In fact, the only FSTE 350 UK bank with neither legacy issues to tackle nor the prospect of painful misconduct-related costs ahead is newcomer TSB (TSB). Lloyds' vehicle for hiving off the 631 branches demanded by the EU competition regulators in 2009 was finally floated in June. It's very well capitalised, which leaves it nicely positioned to support expansion within its low-risk residential mortgage book.

Favourites

Our top pick is Barclays. It's focusing on the decently performing retail, corporate and African operations and ditching those businesses where returns are weak. Add to that cost savings and a solid dividend yield and the shares - trading at a significant discount to analysts' forecasts for net tangible assets (NTA) - look churlishly cheap. RBS's shares are also cheaply rated for the sector, which may not do justice to its long-term recovery potential. HSBC's strength, income characteristics and fairly undemanding share rating leave it looking as attractive as ever.

Outsiders

Bank of Georgia (BGEO) - which is entirely focused on Georgia - faces none of the same issues as its UK-focused peers, but that doesn't make it any more attractive. Strong economic growth in the former Soviet state is driving decent earnings growth, but the Ukraine crisis and the fallout from Russia's current economic woes have made the shares very volatile. Meanwhile, Lloyds' shares trade on the punchiest multiple of NTA in the sector. It has made progress with tackling legacy issues, but we don't think that premium is sustainable for a bank that has yet to return to the dividend list.