Just a year ago, conditions looked rosy for the banks. While there had been a minor up-tick in UK consumer lending defaults, the economy remained robust, interest rates were low by historic standards and the UK had seldom experienced such high levels of employment. Against that benign background, few would have expected a banking sector catastrophe.
But catastrophe can originate from the most unexpected sources. Defaults in the US sub-prime mortgage sector raised concerns for those banks which were heavily exposed to securities backed by such assets. And while the UK banking sector's direct exposure to this so called 'toxic waste' looks minimal, the UK banks couldn't avoid the fall-out. Fears of big losses left the banks unwilling to lend to each other and that meant a liquidity crisis in the inter-bank wholesale market with lending rates soaring - especially bad news for banks which are heavily reliant on wholesale funding. Mortgage lender Northern Rock was just such a bank and, as is now well known, it was forced to borrow £25bn from the Bank of England to keep afloat.
And this inter-bank liquidity crisis shows few signs of petering out quickly. True, inter-bank lending rates aren't as high as they were, but wholesale funding remains expensive and that's going to prove to be bad news for some UK lenders during 2008. Analysts think the mortgage banks are most at risk with Alliance & Leicester topping the list. Earlier this year, brokers at Collins Stewart estimated that a 100 basis point hike in wholesale funding would cut the group's net interest margin by a chunky 22 per cent. Weakening housing market conditions, and a potentially slower UK economy, won't help sentiment towards the mortgage lenders, either.
But it's not all bad news. The well diversified clearing banks are still delivering decent growth and look far less exposed to funding concerns - Collins Stewart estimated that a 100 basis point rise in wholesale funding would hit Royal Bank of Scotland's net interest margin by 4 per cent and Barclays' by a mere 0.2 per cent. Add that to the fact that share prices in both have slumped since the crisis began - and now trade on between 6 and 8 times full-year forecast earnings and with yields that are better than what's available from high interest deposit accounts - and the pair look like longer-term bargains.
