Bankers face new year uncertainty

Tory bank attack

Indeed, the first item on a growing agenda of banking change will make itself felt in January, which is when the Tory-led government's decision to enforce a hefty levy on the sector will take effect. That's expected to raise £2.5bn a year. Presumably driven by a desire to placate an angry electorate over the last government's decision to throw huge quantities of public money at the banks, the new government announced its levy proposal in July.

Inevitably, it didn't go down well in the City, with Standard Chartered, Barclays and HSBC implying that they might even quit the UK. That backlash was heightened by the government's decision to also establish an independent banking commission to look into whether the banks' retail operations should be separated from their investment banking operations – an approach that would have big implications for the same three lenders.

Taken together, these measures drew some angry responses: "It is a matter of great concern to us, as a truly international bank, that regulations and taxes are not being introduced equivalently on an international basis and that UK banks could be put at a disadvantage," remarked Standard's chairman John Peace with his bank's half-year figures in August. The British Bankers' Association – which represents the sector as a whole – put matters more simply: "It is essential that the international banks do not find themselves taxed multiple times for the same thing."

Bankers' warnings about relocating overseas appear to have had some effect and the spending review in October seemed to backtrack a little on the levy. Specifically, the government proposed that half of a bank's non-guaranteed deposit base (that portion not covered by the UK Financial Services Compensation Scheme) could be taken into account to reduce the overall bill. This approach will be a big help to both HSBC and Standard Chartered, both of which boast big Asian and other overseas deposit books that are outside that scheme.

But the unilateral application of a banking tax, without international coordination, still carries competitive implications for the UK as a financial centre. "The levy is based on a proposal by the IMF [International Monetary Fund], but unless it is adopted, or something similar, by the key international centres then it is possible that the UK financial centre could be disadvantaged over time," explained banking analyst Nic Clarke back in October. What's more, the issue of whether banks should have to split their retail and investment banking operations is potentially an even bigger competitive issue and the sector won't get to hear the commission's views on that until it reports in September 2011.

Capital worries

Quite apart from the new government's assault on the banks, the UK's lenders also have to tackle the machinations of international banking regulators. During 2010 the new Basel III capital adequacy rules were finally agreed – these require banks to hold core tier one capital that's equivalent to 4.5 per cent of their risk weighted assets, plus an additional 2.5 per cent buffer. The current tier one requirement stands at just 2 per cent.

Being forced to hold more capital will hit banks' earnings – it constrains lending and forces them to hold funds in forms that don't generate much of a return. But at least the UK's lenders looked like they had enough cash to meet the new criteria. The trouble is that national regulators are likely to require more than that – Switzerland, for example, has set a 10 per cent ratio. And banking analysts reckon the UK is likely to do something similar, perhaps setting a 9-10 per cent minimum ratio.

If that's the case then UK lenders might need to raise yet more funds, with Barclays looking like the weakest link. Indeed, banking analysts at broker Evolution Securities said in a recent research note that they are "more convinced than ever that Barclays will have a £7bn deficit under Basel III".

Admittedly, the new Basel rules won't be fully implemented until 2019, but if more capital is required, then banks could begin tapping shareholders during the course of next year. Standard Chartered has already begun that process by raising £3.3bn via a rights issue precisely for this purpose.

State banks to remain

What's more, hopes that the government might begin unloading its unwanted stakes in RBS and Lloyds during 2011 could prove to be premature.

The state owns a hefty 84 per cent of RBS and has a 41 per cent slice of Lloyds. But, predictably, any sale of those shares would have to generate a profit, as no government could afford the political hit from losing taxpayers' money on bank shares – especially not as the US government booked a profit on the sale of bank shares it bought during the crisis. However, as bank share prices slowly recover, that objective has started to look achievable. The government bought its stake in RBS at an average price of 50p a share, and it took shares in Lloyds at an average price of 73.6p a share. Admittedly, shares in both remain below these levels – in early December, RBS traded at 39p and Lloyds traded at 61p. But, during the course of the past year, shares in the pair have exceeded the government's average purchase price on a number of occasions (as the chart below shows). As the economy continues to slowly recover, and prospects for the banks improve, it's conceivable that next year could see share prices recover to trade sustainably above those buy-in prices.

Almost there...

Sadly for investors, though, and even if that happens, the government isn't likely to rush to sell its stakes – despite the grim state of the public finances. That comes down to the government's decision to establish a banking commission to look at the fundamental structure of the UK's banking sector. The trouble is, according to banking analysts, that any bank share issue – either to the public or to institutions – prior to the release of the commission's findings in the autumn of 2011, would carry too many uncertainties. On that basis, 2012 rather than 2011, seems a more likely year for the state to begin exiting the banks.

What competition?

Still, the big and established high-street banking names probably don't have much to fear from chatter about opening the sector up to more competition. True, there have been quite a few players to emerge in the past year or so with high hopes of grabbing a tasty slice of the UK banking market's assets – many are eyeing Northern Rock's – and entire branch networks could go under the hammer.

These include Virgin Money, which bought tiny Somerset lender Church House Trust in order to gain its banking licence. Back in the summer, a group of City grandees – including Lord Levene, former European Commissioner Charlie McCreevy and former Treasury Select Committee member John McFall – got together to explore the possibility of establishing a vehicle to buy up banking assets. There's also overseas entrants, such as Blackstone-backed lender Home & Savings Bank, as well as Metro Bank, the vehicle of US entrepreneur Vernon Hill. That has one branch so far, in Holborn, but wants to open eight in the next year and then float in late 2012. Tesco Bank is focused on growing organically, too.

The trouble is that bank regulators are very cautious people. Even when they are prepared to grant new banking licences – which isn't very often – they usually insist that a company has a long track record before being allowed to expand through big acquisitions. Add that to the fact that regulation is getting tougher – hardly ideal for small players with limited capital resources – and breaking into UK banking's big league is a truly ambitious objective. Indeed, one such new banking scheme already appears to have stalled. Former Panmure banking analyst Sandy Chen had hoped to launch a new retail bank, called Walton & Co, but the planned £200m Alternative Investment Market (Aim) float was pulled back in February.

In fact, when assets have come up for sale, it's not the new entrants that look set to benefit. Take the 318 RBS branches that EU competition regulators forced the bank to sell earlier this year, for example. Spanish giant Santander, which already boasts a big UK presence through Abbey, Alliance & Leicester and Bradford & Bingley, won that particular race. In short, it could be years before any newly established banking wannabe seriously gets close to challenging the existing high-street lenders and it's quite conceivable that it may not happen at all.

It's the economy that matters

Ultimately, it's economic conditions that matter most to the lenders. When times are bad, borrowers default, bad debts rise, loan demand dries up and bank earnings collapse. During 2010, however, the UK's cautious economic recovery has helped lenders get back on their feet. Credit quality has improved in the past year, as conditions appeared to stabilise, which has been good news for a recovery in bank earnings. The big question facing the banks in 2011, however, is whether that gradual recovery can continue.

There are certainly good reasons to remain doubtful on that point. After all, the new government's austerity measures will see public spending slashed with perhaps half a million public sector jobs lost in the next four years. Indeed, the knock-on effect in the private sector has led the Institute of Personnel & Development to predict a total of 1.6m job losses over the next five years – potentially very bad news indeed for banks' credit quality and loan demand.

Essentially, the gamble that the new government is taking by removing so much state-sponsored demand from the economy so quickly could yet hit the economic recovery hard and, therefore, undermine prospects for the banks. On that basis, investors might like to steer clear of those listed banks that are heavily UK-focused during 2011 altogether. Indeed, the Investors Chronicle's only buy tip in the sector is Standard Chartered, precisely because it has no UK exposure – it's largely a play on fast-growth Asian markets.

Comparing the banks