Banks after Brexit

Shares in banking groups with global operations, and particularly emerging markets exposure, were hammered last year by the downturn in oil and gas prices and concerns over a slowdown in emerging markets growth. While all of the big five UK-listed banks suffered a devaluation in their share prices last year, sentiment towards Asia-facing HSBC (HSBA) and Standard Chartered (STAN) was particularly poor. Meanwhile, banks such as Lloyds Banking (LLOY), which has been downsizing its operations to focus predominantly on UK retail banking, were not subject to such heavy sell-offs.

Fast forward to post-referendum Britain and roles have been reversed. The financial services sector was one of the worst hit by share sell-offs following the announcement of the leave vote. Yet some banks suffered more than others. In the two weeks following the referendum, shares in Lloyds and Barclays lost a third and a quarter of their value, respectively, while HSBC gained 3 per cent. It is still early days and it will take months for the details and extent of an independent UK’s relationship with the EU, and for that matter the rest of the world, to be hashed out. Even so, ratings agencies Standard & Poor’s and Moody’s cut their outlook for most of the UK’s major banks from stable to negative, citing expectations of lower economic growth and increased uncertainty.

Governor of the Bank of England Mark Carney has scrapped the planned increase to the countercyclical buffer – the rainy day fund banks are required to hold in addition to the minimum capital requirements – in order to free up capital and encourage lending. This was due to be raised to 0.5 per cent of banks’ risk-weighted assets from January, but will now be zero. But not all of the central bank’s remedial actions may be so kind to the banking industry. At the time of going to press, expectations of interest rates being kept lower for longer have flattened the UK government bond yield curve. Domestic 10-year gilts have plummeted to their lowest level on record, tightening the spread between long-term and short-term debt. This is bad news for banks because it means the normally higher rate at which they can charge interest on long-term loans, such as a mortgage, is coming down in comparison to the interest on their short-term borrowings.

European banks are also in a precarious position. Italian banks are being weighed down by €360bn (£304bn) in bad loans, €85bn of which has already been written down. Italian prime minister Matteo Renzi has voiced his support for injecting capital into the country’s banking system, in particular Italy’s oldest bank Monte dei Paschi di Siena. Yet the government is still locked in talks with European officials, who are reluctant to implement more quantitative easing. There are concerns that contagion will set in among the continent’s banks, which in an increasingly international banking system could spread to the UK, even without EU membership.

Events have called into question the wider shift away from the universal banking model – offering retail, commercial and investment banking operations – that had become widespread ahead of the global financial crisis. Many of the issues faced by the likes of Royal Bank of Scotland (RBS), Barclays (BARC) and Lloyds are a hangover from the 2008 financial crisis. The way UK-listed banks have sought to deal with the trauma of that crisis has differed.

While the minority have maintained their commitment to a universal banking model, most UK banks have stripped back their operations geographically and by service offering. The question is whether banks that have chosen to simplify their businesses will suffer a slower recovery as a result of the remedial effects implemented as a result of the country’s withdrawal from the EU, such as lower interest rates. The fact is that while the ‘leave’ vote may have been a shock to the system for investors in UK banks, the ripple effects will be to exacerbate existing pressures on the banking groups.

Cost control

It is worth considering the background. Ferocious growth in securitisation, slack capital adequacy controls and deregulation in the two decades before the financial crisis fuelled the rapid expansion of banks. Cheaper cost of debt meant increased lending by the west to producing countries such as China, and in turn increased the internationalisation of world finance systems in the years leading up to the credit crunch. Banks set up offices internationally in order to service their expanding global client base. What’s more, in a grab for higher returns on equity, banks piled into investment banking as part of a universal model. This was made easier in a time when risky lending by banks went unchecked by regulators and there was less of a restriction on building up risk-weighted assets (RWAs).

However, when the realisation that so many loans were backed by sub-prime mortgages in the US hit the big institutional investors buying the banks’ bonds, the credit bubble burst. The ensuing impairments taken for bad debt charges and beefier capital requirements under Basel III regulations pushed banks to pursue a more low-risk business model. This has meant reducing RWAs and reducing their inflated cost-to-income ratios. As the only lever they can directly control, UK banks have focused on cutting costs. To a certain extent they have been successful in bringing down operating costs (see table). However, provisions taken for the historic mis-selling of payment protection insurance and other misdeeds has slowed progress.

For RBS, particularly, litigation costs also continue to weigh on the bank’s balance sheet. During the final quarter of last year the group incurred £1.5bn in legal costs relating to the mis-selling of mortgage-backed securities in the US, a factor that contributed towards management’s decision to push back dividend payments even further until at least after the first quarter of 2017. A class action brought by investors over its 2008 rights issue is expected to hit the High Court in March.

Keeping the cash coming

Yet for all the talk of cost-cutting, one of the most pressing issues for UK banks is how they keep the money rolling in and how they use it to kick-start returns. As a result of Basel III’s tier one capital ratios – the ratio of a bank’s core equity capital to its total risk-weighted assets – banks are much better capitalised than they were before the financial crisis. This is part of the reason returns on equity are around half the 20-plus percentages being achieved by 2006. However, an increasing reliance on retail banking by banks including Lloyds, RBS and to a lesser extent Barclays, has also subdued returns. This is because, quite apart from the heavy cost weight banks have had to bear, retail banking typically delivers lower margins than services such as investment banking and is also more sensitive to low interest rates.

Following its acquisition of Halifax/Bank of Scotland in 2008, Lloyds has the largest share of the UK retail banking market, at around 30 per cent. This gives the banking group a competitive advantage. Last year net interest income grew 5 per cent to £11.5bn. Yet this was not driven by an improvement in customer loans and advances but was driven by its net interest margin, which grew 23 basis points to 2.63 per cent. During the first quarter of the year this was up to 2.74 per cent and management expects it to stick at around 2.7 per cent for the full year. A positive effect of lower interest rates for Lloyds during this time is that wholesale funding and deposit costs also reduced, helping offset the reduction in average interest earning banking asset prices.

However, with growth in customer loans and advances so sluggish – flat in 2015 on the previous year – any further reduction in interest rates by the Bank of England could squeeze net interest margins for Lloyds and other UK banks even further. Shore Capital analyst Gary Greenwood says: “Increased fear and uncertainty will typically push up the cost of borrowing [for banks] as spreads widen relative to the risk-free rate.” However, banks have larger stores of liquid assets than they did prior to the financial crisis, which could act as a backstop should short-term wholesale funding markets freeze up, he adds.

However, Lloyds and RBS potentially face a double-pronged attack to their net interest income post-Brexit. Since Lloyds has the largest exposure to the UK retail mortgage market it is particularly vulnerable to a potential downturn in the property market post-Brexit. It grew its open mortgage book by 1 per cent last year, below the market average of 2.5 per cent, as management focused on protecting its margin in such a highly competitive environment. Similarly, competition is already snapping at the heels of RBS’s mortgage business. Combined with an increasing number of customers switching to lower-margin fixed-rate products, this eroded its net interest margin marginally to 2.12 per cent last year. If interest rates are cut further, the normally higher rate at which banks can lend mortgages is also likely to fall as spreads between long-term lending and short-term borrowing tighten.

There could be further problems. At the time of writing, a number of commercial property funds run by asset managers including Standard Life (SL.), Aberdeen Asset Management (ADN) and Aviva (AV.) had decided to temporarily stop investors taking out or putting in money, following a surge in withdrawal requests after the referendum result. Plus Standard Life, Henderson and M&G all reduced the valuations of their underlying portfolios by 5 per cent. Whether this fall-away in demand is long-lasting or even evidence-based remains to be seen. There is the risk due to the illiquid nature of the commercial property market, a wave of sellers could rip the bottom out of prices. RBS and Lloyds would be most affected, with RBS having the largest exposure of the big five banking giants to commercial property.

Spreading your bets?

While the more domestically-focused banks have been subject to harsher investor reaction following the leave vote, it would be foolish to think that banks such as Standard Chartered and HSBC in particular are not vulnerable to any post-Brexit fallout. After all, a quarter of HSBC’s net operating income last year came via its UK operations. The bank demonstrated its susceptibility to competitive pricing pressures in the UK mortgage market last year when falling yields, coupled with lower yields on new lending to consumers and companies, forced down its overall net interest margin to 1.88 per cent from 1.94 per cent the previous year.

However, the group’s so-called ‘Asia pivot’ could be its saving grace. Around 83 per cent of HSBC’s profits came via Asia last year. Management is focusing capital on Asia, and China in particular, as it seeks to exploit its competitive strength in the region. Last year this seemed to pay off as pre-tax profit in Asia grew 8 per cent to £15.8bn. Yet the bank experienced rockier trading during the first quarter of this year as its retail banking and wealth management and investment banking businesses suffered a decline in sales. In volatile markets corporate M&A, debt and equity-raising activity typically declines. Yet analysts at RBC Capital Markets expect a £50bn increase in quantitative easing in August. They reckon such a policy would push investment banks to outperform retail due to higher bond issuance and increased bond valuations.

Plummeting share prices in the banking sector means UK-listed banks are trading at significantly lower valuation multiples than they were prior to the referendum (see table). However, it is harder to separate those that are good value from companies that are cheap for a reason. Even without the risk of a further cut in interest rates, the majority of UK banks are still being weighed down by legacy provisions and restructuring costs.

We stand behind our Recovery Tip of the Year, Lloyds, with a buy recommendation. The shares received a kicking after the leave vote and are now down almost a quarter since our original buy tip. However, we reckon the risk of a decline in net interest income has already been priced in. Unlike RBS and Barclays, Lloyds paid out a solid dividend at the start of the year.

It has a solid balance sheet and we think, even if management decides against increasing the dividend, this will enable it to continue with its capital distribution. We also upgrade HSBC to hold from sell, primarily for the yield. This is forecast to be around 8 per cent this year, according to Bloomberg consensus forecasts. We remain cautious on RBS. Admittedly, the bank is a lot better capitalised following its sale of US bank Citizens. However, with the potential for litigation costs hanging over the bank still, plus uncertainty on when it will return to paying dividends, we stick to hold.

Taking a more retail UK-centric approach has delivered rewards for RBS, Barclays and Lloyds to differing degrees. However, the leave vote has highlighted the potential shortcomings of having an income stream that is more geographically and operationally concentrated. That’s not to say that we reckon the universal banking model will experience a resurgence because of Brexit. Investment banking fees are also under pressure as voltile conditions dissuade companies from capital raising and M&A. The higher regulatory cost of capital involved does not help, either. The fact is that these trends were present before Brexit became a reality, albeit potentially not as amplified. What will be important in the coming months and/or years is how the big banks leverage their huge market share to deal with competition to keep the cash coming in. Capital strength still counts for a hell of a lot – it maintains dividends. For this reason we keep our faith in banks such as Lloyds that have already demonstrated their ability to improve returns in tough market conditions and keep paying out dividends.

How the banks compare