The broad challenges facing the major UK lenders could be placed under the following banners: redress, regulation and returns. After the halfway stage, any evaluation of the prospects for the Big Five has to address these factors.
The good news is that the sector's rebuilding job is under way, but bank shares are still a long way from the staple income stocks that they were in the past - only HSBC (HSBA), on a dividend yield of 5 per cent, might feature in a fund manager's income bucket. Most likely to rejoin the lion of banking there is the black horse: Lloyds (LLOY) is forecast to achieve a similar yield by the 2016 financial year, having reinstated its interim dividend. The question for private investors is when they will remount, given the discount that the sector is running - on a price to forward net tangible assets basis - to the young upstarts at the challenger banks. Indeed, there is still a case for 'Bargain banks', but the recovery has proved more stubborn than most could have predicted.
Redress
Ratings agency Standard & Poor's has said that 2015 is set to be the worst year on record for banks' misconduct costs, and that these fines have become a "way of life" for the institutions. There are only so many times bank-watchers can argue that the fines for past misconduct are going to fall away, only to be surprised by the size of provisions set aside in the lenders' results.
Sticking with Lloyds, the further £1.4bn set aside for payment protection insurance (PPI) in the first half was one such example. The bear case argues that there is much more to come, depending on the outcome of the Financial Conduct Authority's current review. Cenkos analyst Sandy Chen argues that could add a further £10bn of PPI charges if people are given another avenue through which to process their claims via the Consumer Credit Act, following a recent Supreme Court reading. Of course, it could go the other way, if a time limit is placed on PPI claims.
| Share price (£) | Market cap (£bn) | Year-to-date performance (%) | NTM PE ratio | Cost:income ratio | Price/2015e tangible NAV* | tier one capital ratio (%) | |
|---|---|---|---|---|---|---|---|
| HSBC Holdings | 5.62 | 109.2 | -7.7 | 10.3 | 58% | 1.13 | 11.6 |
| Lloyds Banking Group | 0.80 | 56.7 | 5.8 | 9.7 | 48% | 1.39 | 13.3 |
| Barclays | 2.76 | 46.2 | 13.4 | 10.7 | 64% | 0.99 | 11.1 |
| The Royal Bank of Scotland Group | 3.42 | 38.7 | -13.2 | 12.6 | 95% | 0.93 | 12.3 |
| Standard Chartered | 8.70 | 22.1 | -9.7 | 11.6 | 59% | 0.87 | 11.5 |
*Based on Investec forecasts £1=$1.55 | |||||||
And, just as one mole is hammered down, another pops up. The latest is packaged bank accounts, which held a fee for embedded insurance products, of which customers may not have been aware. Barclays (BARC) has set aside £250m for any future issues with these products, while Lloyds and Royal Bank of Scotland (RBS) set aside £175m and £157m respectively in the first half. HSBC has also reportedly suspended sales of these products, but has yet to set any money aside. In both this case and of that uglier elder sibling, PPI, there is a great deal of uncertainty as to how accurate the current estimates of future costs will be.
For RBS, the major outstanding question is the past sales of mortgage-backed securities, where group companies are currently ensnared in more than 25 lawsuits brought by past purchasers of these products. The bank is not yet even in settlement talks with regulators, and it could be the best part of a year before that process gets under way. Then there are settlements over foreign exchange dealing, with HSBC and Barclays reported to be part of a $2bn settlement with regulators.
Regulation
While juggling the IOUs for regrettable past endeavours, the UK banking sector is being forced to lop off its limbs in the form of ringfencing legislation. These rules will force lenders, from 2019, to hold retail and investment banking as separate subsidiaries below a holding company.
For a UK-focused largely retail operation like Lloyds this should be straightforward, given most of the bank sits within the ringfence. But for Barclays, where the investment bank remains an important part of the organisation, this is more difficult. Unlike rivals HSBC or RBS, which already have a separate licence for a UK banking arm, Barclays has had to apply for a licence - according to reports, it was even looking to acquire an entity with such a licence. Then there is the larger challenge of how to split capital between the two entities, another core requirement of the reform.
The major lenders do not have it all bad, though. Following a fair amount of lobbying and sabre-rattling, the first majority Conservative Budget decided to dial down the bank levy, as well as restricting it to banks' UK assets, and phase in a corporation tax surcharge. If policymakers had wanted to encourage the smaller lenders to challenge the larger players, this was a thoroughly regressive step: challenger banks were hit hard on the markets, as the regulatory costs switched from balance sheets to profits.
The sector is also responding well, on the whole, to the increased demands for improving their capital ratios: each of the big five improved their capital ratio from end-December to end-June, with Lloyds sitting at the head of the pack.
Returns
The wider challenge facing the major lenders is where they can find decent returns in a low-rate environment. Cost-cutting is one major focus for all the banks, and management teams are falling over themselves to pull on the one return lever that they can directly control. HSBC in particular has a big battle here - its adjusted costs were up 7 per cent in the first half to $1.2bn (£774m). RBS has an awful cost:income ratio, but is at least moving in the right direction, with its operating costs excluding restructuring litigation and conduct costs - which cost a fair amount themselves - down 14 per cent at £5.5bn.
The other side of the coin is using risk-weighted assets wisely. HSBC's much-vaunted 'Asia pivot' will employ around half of RWAs that are moved out of worse-performing businesses. The mantra for the banking giant, and its emerging markets-focused rival Standard Chartered (STAN), is now returns over growth. These strategies are at the early stages, but it is worth pointing out that HSBC and Standard Chartered are both delivering a return on average total equity above their peers, on S&P Capital IQ figures, with Lloyds close behind.
Favourites
Our Recovery Tip of the Year, Barclays, is demonstrating exactly the kind of recovery that we had expected, even if it was not enough to keep Antony Jenkins in the top job. The company has improved its capital base and reduced its costs, as promised, while it has also been helped out in its personal and corporate banking divisions by a strengthening UK economy. It is still good value, its shares trading in line with forecast net tangible assets.
The latter is a big part of Lloyds' improving story, while the reduction of the taxpayer shareholding has also encouraged more buyers than sellers. The government is hoping the same trick will work for RBS, which we have on a recovery buy tip. "The overhang of the shares will become less of an issue," argues Laith Khalaf, senior analyst at Hargreaves Lansdown. "[But] we are still some way off from that."
Outsiders
We are less excited about the prospects for the non-UK-focused lenders, given the economic challenges facing emerging markets. Both HSBC and Standard Chartered are currently on a hold. For HSBC, we need to see more proof of the restructure, and more specifically to see the increase in returns outstripping the increase in operating expenses - so-called positive 'jaws'. Whereas in the case of Standard Chartered, we are cautious about what else new boss Bill Winters will find in his clear-up.
