To borrow a quote, the current state of UK banking presents a riddle wrapped in a mystery inside an enigma. On the one hand, the economy is growing again, and the major lenders came through the latest stress test from the Bank of England without having to change their capital-raising plans.
Perhaps presciently, the stress test was based on a crisis hitting emerging markets. The Bank of England concluded that the levels of capital forced onto lenders since the financial crisis had made them "more resilient". Fund managers, including Schroders' value team, depict a set of businesses that are getting back to basics, are flush with capital and provide real long-term value as they return to their past life as core income holdings. Consider Lloyds Banking Group (LLOY) as an example of this (our Tip of the Year on this basis), with a ratio of tier-one capital to risk-weighted assets of 13.7 per cent at the end of September, and second only to Nationwide when the stress test was applied.
And yet the UK economic picture is more complicated than all that, with services powering an unbalanced recovery and concerns over the heat of the housing market, while manufacturing continues to fall behind. Expectations on when the UK will follow the US and start to increase interest rates - which should provide an initial benefit to retail banks - have been pushed back with the latest economic data, and the chancellor, George Osborne, warned in January of the "cocktail of threats" ahead. Not to mention the rocky start to the year on global markets.
Meanwhile, the problems of the past continue to dog these companies. For Lloyds, bills for payment protection insurance (PPI) mis-selling refuse to go away, while Royal Bank of Scotland (RBS) prepares for fines from US regulators concerning the sale of mortgage-backed securities ahead of the financial crisis, a bill that could reach $13bn (£9bn), according to the Financial Times. RBS lost its top lawyer, its group general counsel John Collins, in December after less than a year, with banking commentators citing the colossal workload as a factor. For both of these companies there remains a taxpayer stake - while Lloyds is nearly free of this state overhang, RBS presents a much bigger problem, especially given its poor share price performance. All eyes will be on the appetite for Lloyds public share sale this spring.
The problems in emerging markets mean no solace is to be found this time in diversification, as the performance of both Standard Chartered (STAN) and to a lesser extent HSBC (HSBA) last year demonstrated. Standard Chartered announced a long-expected £3.3bn rights issue in November, and set itself a low target of 8 per cent return on equity to be achieved by 2018. But even this negativity was not enough for all investors, with some expecting further capital raising and bad loans provisions in the pipeline, as chief executive Bill Winters continues his clean-up of the business. HSBC is staking a part of its hopes - which in banking terms means its risk-weighted assets - on its 'Asia pivot', hoping the rise of finance consumers in China and elsewhere will provide the return it is struggling to generate elsewhere.
Snapping at the heels of these major lenders are the 'challenger banks', which were an important feature of 2015. TSB was the victim of its own success, demonstrating why Lloyds had to be compelled by regulators to sell it when it was acquired by Spanish banking group Banco de Sabadell. Virgin Money (VM.) made progress, trading a quarter above its float price, as rising house prices and a good environment for consumer credit powered the mortgage market. Its share price is currently up a quarter since its flotation. But the big winner was OneSavings Bank (OSB), powered by the growth in the buy-to-let market. Even factoring in a slight sell-off at the end of the year after the Autumn Statement and other interventions stoked fears of a backlash, its shares are up more than a half over the past year.x`
If the UK economy can keep its show on the road, retail banking at home could again prove a stronger suit as small businesses and housebuyers clamour for credit. But banks will have to demonstrate how they are dealing with the digital consumer, as the old branch-based model is transformed.
| NAME | Price (p) | Market cap (£m) | PE (x) | DY (%) | 1-year change (%) | Last IC view: |
|---|---|---|---|---|---|---|
| ALDERMORE GROUP | 190 | 655 | NA | 0.0 | NA | Buy, 233p, 3 December 2015 |
| BARCLAYS | 190 | 31,912 | 11.2 | 3.4 | -17.4 | Buy, 220p, 18 December 2015 |
| BANK OF GEORGIA | 1,687 | 666 | 8.6 | 3.6 | -14.9 | Sell, 1,941p, 14 October 2015 |
| HSBC | 489 | 96,190 | 9.8 | 6.7 | -18.1 | Hold, 585p, 3 August 2015 |
| LLOYDS BANKING GROUP | 66 | 47,003 | 7.8 | 2.3 | -11.9 | Buy, 72p, 7 January 2016 |
| ONESAVINGS BANK | 313 | 761 | 10.8 | 2.1 | 46.3 | Hold, 344p, 25 November 2015 |
| ROYAL BANK OF SCTL.GP. | 265 | 30,759 | 330.8 | 0.0 | -28.3 | Buy, 253p, 27 Jan 2016 |
| SHAWBROOK GROUP | 303 | 759 | 15.2 | 0.0 | NA | Buy, 336p, 29 July 2015 |
| STANDARD CHARTERED | 491 | 16,096 | 8.2 | 1.9 | -43.4 | Sell, 561p, 25 November 2015 |
| VIRGIN MONEY HOLDINGS | 286 | 1,269 | 17.9 | 0.5 | -3.8 | Buy, 425p, 29 July 2015 |
Favourites
We are optimistic about Lloyds' ability to re-establish itself as a straightforward banking stock with a growing dividend. Virgin Money has also established itself as a strong player in retail banking, having built its distribution relationships with mortgage brokers.
As for RBS and Barclays, although they are following the restructuring paths that we have backed, we need to see further progress on profits if we are to keep faith with our buy tips.
Outsiders
We think there may be more pain to come at Standard Chartered, and the new year tremors in emerging markets only underscore the point. Investors will be keeping an eye on the quality of its loan book. HSBC also has some way to go to demonstrate that its reduction and redeployment of risk-weighted assets can deliver returns for shareholders.
