A different problem
But while stability has returned to the banking sector, lenders remain deeply troubled. That's because their freshly-restored capital resources are now under threat from an old-fashioned recession-induced bad debt crisis. The potential scale of that problem was clearly on display this month, when the banks revealed their half-year figures. The worst hike in provisions came from Lloyds Banking Group's need to set aside more cash against HBOS' disastrous book. That acquisition has helped Lloyds' impairment charge rise to a huge £13.4bn at the end of June from last year's £2.5bn. Although the scale of that rise could mean that – uniquely amongst the lenders – Lloyds' bad debt crisis may have peaked. RBS is struggling, too - its impairment charge soared to £8.1bn from £1.7bn a year earlier. And it's not just those that have been bailed out that are hurting. In the same period, Barclays' impairment charge rose 86 per cent, HSBC's jumped 39 per cent, and Standard Chartered's rose 134 per cent.
How much longer the recession goes on will determine how bad the impairments crisis gets. Although there are signs of life, the picture is generally thought to be more bleak in the UK than in many other European countries. UK GDP fell a sharp 5.6 per cent in the year to June, with the OECD forecasting no UK economic growth at all, overall, during 2010.
Investors, clearly, are betting that the scale of capital destruction will be more modest than the worst predictions. That, combined with relief at the fact that further collapses and state bail-outs have been avoided, lit a fire under bank shares in the first half of the year. The sector as a whole is up... and some individual shares by even more.
Easier money
But the reality is that we won't know for some time how much worse the picture will get. There's plenty of evidence for either scenario. The insolvency arm of law firm Freshfields said this month that corporate insolvencies in the second quarter of 2009 were 40 per cent higher than in the same period a year earlier, with company administrations up 9.5 per cent in the same period. Yet other data suggests that in aggregate, companies' returns on capital and profitability are holding up very well. At the individual level, unemployment continues to march higher and most economists expect it to peak at around 3m or more during the course of 2010.
If companies and individuals cannot pay their debts, then banks have to write them off, a process that can go on even after the economy has returned to growth. "Impairments on retail and corporate assets would normally be expected to peak between one to two years after the trough of a recession," said Lloyds' chief executive, Eric Daniels, with the group's half-year figures.
Borrowers suffering too
Generally, borrowers aren't benefiting much from the record low 0.5 per cent base rate either, as banks - keen to defend their earnings and rebuild their capital in such hard times - have tended to avoid passing rate cuts onto their customers.
A recent Moneyfacts survey showed that the margin between the average two-year fixed mortgage (5.18 per cent) and the two year swap rate (2.04 per cent) is the widest on record.
"It would be premature to call an end to rising loan loss provisions in personal and commercial lines," said equity analysts at rating agency Standard & Poor's, when commenting on HSBC's half-year results. Such sentiments can be easily applied to all banks. The trouble is that, as bad debts keep rising, lenders' recently replenished capital resources will come under pressure.
Not only does that raise the prospect of shareholders being asked for yet more cash, but capital weakness will also constrain lenders' ability to lend, and that's a recipe for low growth in the economy generally.
Tmporary boost, permanent albatross
Neither was the unexpectedly decent half-year figures reported by those banks that haven't taken state help necessarily indicative of recovery or their longer-term growth prospects. That's because it largely reflected exceptionally good results at investment banking operations. The trouble is that investment banking has a feast-and-famine earnings profile that leaves repeat performances looking uncertain. "Going forward the environment might not be so supportive," said analyst Nic Clarke of Charles Stanley, commenting on Barclays' performance. Like many other banks, it was boosted by a wave of capital-raising by companies in the second quarter particularly, along with heavy bond issuance by governments. These effects were very positive, but they're by nature temporary.
A more durable feature of banking in the future could be a much tougher regulatory framework, in particular one that could force banks to hold even more capital against future impairments. The government's white paper on financial regulation, published in July, states that "systemically significant firms should be more stringently regulated, which may require such firms to hold capital and maintain liquidity at a level that reflects both the likelihood of their failure and the impact their failure may have on the system as a whole."
That's in addition to the FSA's existing plans to "work with its international counterparts to strengthen capital and liquidity requirements." And while analyst Elisabeth Rudman of Moody's Global Banking sees this as "positive developments for the stability of the banking system," it could eventually bulk up the costs facing lenders. The one positive for banks is that since regulatory change will have to be worked out in accordance with an EU-wide approach, it could be quite a while before any concrete proposals are ready to be implemented.
And not all lenders are equally well placed to handle such increasing capital demands. Barclays, in particular, looking vulnerable, because selling its Barclays Global Investors asset management arm to boost regulatory capital will leave it heavily dependent upon volatile investment banking income and low growth retail banking.
But even the strongest players are unlikely to look like worthy investments until the recession has passed and better trading conditions return. And against the backdrop of rising bad debts, increased capital requirements and reduced demand for credit, dividend prospects don't look great either. There's no chance at all of dividends for years to come from those lenders with big state shareholdings – RBS and Lloyds. By signing up to the government's asset protections schemes - essentially, a state sponsored scheme to insure lenders against their riskiest assets - RBS and Lloyds have also agreed to lend more to recession-hit businesses and struggling mortgage borrowers. There's a good chance that this politically-motivated lending could damage their credit quality even more than those that are free of state influence.
When the state might sell
Recent share price rises mean the government has made a small paper profit on its RBS investment. But an exit from the banking sector is unlikely in the near future. "Our task of returning these investments to the private sector is challenging," admitted Glen Moreno, the former acting chairman. of UK Financial Investments, the body charged with administering the state's holdings. "The amounts involved are very large, and a successful disposal of our holdings will require professionalism and patience."
The IC and the banks
Even before Northern Rock started to get into trouble in the summer of 2007, it became increasingly apparent that the business models of some UK banks were going to come under pressure, especially if house price rises slowed or reversed. For this reason, we recommended selling shares in Bradford & Bingley back in June 2007, when they were 412p each. The bank was nationalised by the government in late 2008, and shareholders received no recompense. We correctly predicted that Northern Rock would end up in government ownership, too, and advised selling HBOS shares in April 2008 when they were over £5 apiece. However, we clearly underestimated the indigestion that the acquisition of ABN Amro would cause to RBS, and – so far at least – the resilience of Barclays in remaining outside government hands.
