Banks set for a challenging year

While 2010 saw a tentative economic recovery begin to fuel an improvement in credit quality at the UK's lenders, 2011 still looks set to be an uncertain year for the nation's lenders. And the first of those challenges hit the sector at the start of the year after the government's banking levy - designed to raise £2.5bn a year from the sector - came into force.

Despite being an unwanted cost, the main problem with the levy is that it's not being internationally coordinated - potentially leaving those financial centres that don't introduce a levy relatively better placed than the City. This has raised a bigger worry over the UK banking sector's longer-term competitiveness - a concern that could become more acute as 2011 progresses. That’s because the government has also announced a banking commission that will consider whether banks should separate their retail operations from their investment banks. That could force such lenders as , HSBC and into making huge structural changes. We'll know whether that threat is real by the autumn, when the commission reveals its findings. If separation is favoured, though, it's not inconceivable that some banks will relocate overseas.

What's more, the establishment of the banking commission also makes it unlikely that the government will seriously entertain plans to dispose of its stakes in Royal Bank of Scotland (RBS) and Lloyds during 2011 - even though their share prices did exceed the average price paid by the government for its shares on a number of occasions during 2010. Analysts reckon that any bank share issue, either to the public or to institutions - prior to the commission's findings - would carry too many uncertainties. That leaves 2012 as a more likely divestment date.

Then there's the problem of bankers' bonuses. A Financial Services Authority (FSA) code has recently been finalised that largely mirrors tough guidelines from the Committee of European Banking Supervisors. These envisage the cash part of bonuses being capped at as little as 20 per cent of a total award, with the remainder paid in deferred share awards that can be cashed in years later. That's much tougher than in rival centres in Asia or the US - hardly an ideal way to encourage the world's highest flying bankers to remain in the City.

Meanwhile, capital has again become an issue. During 2010 the new Basel III capital adequacy rules were finally agreed requiring banks to hold core tier-one capital that's equivalent to 4.5 per cent of their risk weighted assets. And it's looking like banks may need to raise more funds as a result. That's not because UK bank's don't comfortably meet the new Basel minimum - they do - but because national regulators may implement even tougher local criteria. Indeed, the Swiss regulators set a 10 per cent minimum and it's widely expected that UK regulators will set a 9-10 per cent level. On that basis, Barclays is thought to be especially exposed. Broker Evolution Securities said last year that Barclays may be facing a £7bn capital deficit under Basel III and, after Standard Chartered raised fresh funds last autumn to meet Basel rules, then banks may begin tackling any perceived capital shortages during 2011.

But it's the economy that matters most to banks' prospects and there's plenty there to justify caution. The coalition government's austerity measures will see public spending slashed, and as many as half a million public sector jobs lost, over four years. That could leave too much state-sponsored demand being pulled from the economy too fast, endangering the economic recovery - potentially grim news for banks' credit quality and loan demand.

HSBC HDG. (ORD $0.50)713126,24321.93.1-0.7
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