The future for banks

During that time shares in those banks that are particularly UK-focused have also gone into free-fall. Since Northern Rock was forced to take emergency liquidity from the Bank of England on 14 September 2007, Barclays' shares have fallen 70 per cent, Lloyds' are down 84 per cent and RBS's have dropped a stunning 94 per cent. Only those UK-listed banks that can be considered properly international - HSBC and Standard Chartered - have shown some measure of resilience. HSBC's shares are down just 17 per cent over that period of crisis, while Standard's have dropped 5 per cent. But, compare that with the hefty share price gains seen by the banks in the five years leading up to the crisis, and it's still not much to shout about.

Certainly, the trigger for the 2008-09 crisis - the discovery of the near worthlessness of US sub-prime mortgage-backed securities - is no longer the big issue. But, even though banks have largely cleared their balance sheets of such junk, a raft of new problems have come to prominence that have effectively blocked the lenders’ ability to regain their balance. The new worries stalking the sector, however, certainly have their beginnings in the mortgage-backed securities disaster - often reflecting the fall-out from the solutions that were adopted in order to deal with it.

Sovereign debt fallout

As we now know, Northern Rock's bail-out was just a taster of things to come - stepping in as lender of last resort became the favoured policy solution for governments around the world as the crisis grew. But such hefty interventions required governments to borrow heavily. That state borrowing was further boosted by efforts to protect economic demand - in a fairly typically Keynesian way - as policymakers struggled to avert a 1930s-style economic depression. Such largess helped generate an entirely new problem: the banks may have been saved and mass unemployment averted, but nation states were themselves increasingly perceived by the markets to be in extreme financial distress.

Unfortunately, the world is now only too familiar with the consequences of that - the worst affected nations found themselves unable to affordably borrow anymore, raising the spectre of defaults. Ireland, Greece and Portugal have already needed emergency EU help. Spain has seen its banks bailed out with EU cash, and it - along with Italy - faces soaring borrowing costs. When the banks got into trouble the state effectively nationalised their problems - but when nation states get into financial trouble, the solutions generally involve fairly painful public sector austerity measures. The trouble with austerity, though, is that it can unwind the demand bolstering effects that public spending can generate - hitting economic recovery.

Weak economic conditions mean falling credit demand and weakening credit quality - which is all especially bad news for banks. "Credit growth has remained weak in the United Kingdom over the past few years," says the Bank of England in its latest Financial Stability Report. "Banks have been passing through higher funding costs to the interest rates on both corporate and secured household lending. That highlights the potential for an adverse feedback loop to develop, were the economy to weaken and the quality of banks' assets to deteriorate."

Banks performance versus the FTSE All-Share since Northern Rock's bail-out

True, since the UK emerged from the sharp recession that struck during 2009 - an event that fuelled a painful rise in capital-consuming bad debts at the lenders - bank credit quality has actually been on the mend overall. But, with the UK having re-entered recession during this year - the Bank of England now expects no overall economic growth at all for 2012 - that progress could yet reverse as struggling borrowers default on their loans.

That could leave the UK banks' apparently healthy looking capital ratios under pressure. In short, and despite the big recapitalisations of a few years back, it's far from certain that the banks won't need more capital. "Banks should continue to restrain cash dividends," suggests the Bank of England - as a means of boosting capital.

What's more, lenders still face plenty of uncertainty as a result of their fairly heavy exposures to struggling eurozone countries. Take Lloyds and RBS, for example - they have been hit especially hard by Ireland's painful property market collapse. Even though their loan books there aren't large compared with their total lending, their bad debt charges against Irish lending comprises a hefty proportion of their total bad debt provisions. Lloyds' Irish bad charge, for example, represents 33 per cent of the group total charge yet just 2.3 per cent of the book is in Ireland. Similarly, RBS's stands at 27 per cent of the group charge even though just 7 per cent of its loans are in Ireland. They also have fairly sizeable exposures to Spain and Italy - although it's Barclays that tops the list there, with £28.3bn on loan to Spain and £25.5bn at risk in Italy.

Liquidity fears

Still, the absolute size of the UK banks' exposure to the eurozone probably isn't big enough on its own to represent a huge danger to them - banks in France and Germany probably have more to fear on that score. But, as the eurozone crisis has grown, banks across Europe have shown signs of becoming fearful of lending to each other because of their potential exposure to troubled eurozone countries. That raises the problem of contagion, whereby - in a crisis - problems can spread well beyond the most affected lenders. It's a worry that the Bank of England highlighted in its latest Financial Stability Report: "if contagion spreads, significant disruption would be likely through secondary channels, such as counterparty risk, funding market stresses and feedback from macroeconomic weakness". The crisis has already made the cost of interbank funding volatile. For example, the three-month sterling Libor rate peaked at about 1.084 per cent in January 2012 as the second half of last year was hit by growing fears of a eurozone crisis - although that rate has since dropped to 0.74 per cent.

Admittedly, that slippage in the Libor rate has reflected robust action on behalf of central banks after liquidity concerns first began to become fairly acute last summer. For example, the European Central Bank pumped over €500bn (£395bn) of liquidity into the sector in February 2012 through its Long Term Refinancing Operation (LTRO). That involved the provision of cheap funding facilities, to more than 800 lenders, with maturities of about three years. But the interbank market remains susceptible to sentiment shifts and any spikes in the cost of funding will hit those UK banks that are relatively less reliant on stable and cheap retail deposits to fund their operations.

Lloyds is a good example - its loan book of £534bn is only partly covered by its retail deposit book of £423bn, with the remainder needing to be made up through interbank funding. But, as its emergency facilities provided by the Bank of England back in the 2008-09 crisis mature, the lender has needed to take up pricier market facilities which has meant margin erosion - as at end-June, the bank's net interest margin (the difference between a bank's borrowing and lending rates) had fallen by 19 basis points to 1.93 per cent in the year to end-June. For such banks as Lloyds, therefore, the price of interbank funding is key to its prospects.

Bank retail funding

Reputational woes

Quite apart from the hefty collection of operational difficulties facing the banks, sentiment has also been continually hit by a stream of scandals. Indeed, it's easy to gain the impression that heads roll regularly at the banks these days. The head of compliance at HSBC, David Bagley, was forced to resign in July, for instance, because of money laundering systems and controls failures - the bank has set aside a painful $700m (£450m) to cover fines related to that.

In fact, banks' slip-ups are proving increasingly costly as the payment protection insurance (PPI) mis-selling scandal has shown. Last year's High Court decision to uphold the application of new FSA rules on PPI mis-selling complaints has unleashed a flood of claims against the banks and forced virtually all of the main lenders to set aside huge provisions. With the exception of Standard Chartered, all of the UK banks have suffered from this but Lloyds has been the hardest hit - it's total estimated cost of redress stands at a painful £4.28bn, after PPI-related provision rose further in the first half of 2012. Lenders are also having to set aside hefty provisions to cover redress for having mis-sold interest rate products to small businesses.

The Libor fixing scandal - whereby the rate at which banks lend to each other was artificially manipulated during the financial crisis - has become another huge reputational threat for the banks. Barclays has been the biggest and most high-profile victim so far and it has cost the bank the scalp of its former chief executive, Bob Diamond.

How the UK banks compare

Indeed, its part in that meant a £290m fine from regulators - £59.5m from the FSA and a further £230m from US regulators - and the shares tumbled 15 per cent between the fine being imposed and Bob Diamond's departure. But other lenders look set to be dragged in with RBS, which has already sacked traders for their part in Libor fixing, as possibly the next most likely target for regulators and politicians. With a raft of investigations under way, which includes overseas regulators, it's conceivable that more heads could yet roll and more fines issued before the matter is laid to rest.

Compensation from this scandal can't be ruled out, either. Last month, analysts at investment bank Morgan Stanley estimated that RBS could face £420m of regulatory fines and a further £680m to settle civil lawsuits. But such fears may turn out to be overdone as proving that Libor manipulation has clearly disadvantaged anyone won't be easy. "Based on Barclays' disclosures, we would conclude that the probability of any litigation being successful... appears to be quite low, meaning that ultimate damages against the banks... might not be very material," thinks banking analyst Andrew Lim of Espirito Santo Investment Bank.

Even Standard Chartered - which had managed to side-step these toxic reputational threats - has now succumbed. Earlier this month, a New York regulator - Benjamin Lawsky - accused the bank of having "schemed" to avoid US sanctions against Iran. He reckons the bank's actions have left "the US financial system vulnerable to terrorists, weapons dealers, drug kingpins and corrupt regimes".

But while the language used by Mr Lawsky sounded like something from a cheap novel, this saga has proved to be a painful one for Standard - the bank was eventually fined $340m. Matters could have been worse, though, and the loss of the bank's US licence was at least averted. Although it is curious that Mr Lawsky is also responsible for "keeping New York on the cutting edge as the financial capital of the world" - a potentially conflicting role for a regulator to perform.

All of this leaves the problem of excessive bonuses - an ongoing reputational issue - looking like a minor sideshow. However, with UK banks having to compete with institutions in overseas financial centres for skilled staff, the public’s perception of grossly overpaid bankers, being handsomely rewarded for failure, isn't likely to disappear anytime soon.

UK banks' eurozone exposure

Regulatory pressures

Just what the fallout will be from the Libor fixing scandal is hard to judge but, whatever happens, things aren't likely to remain the same. "The days when a small club of bankers could be trusted to act as impartial stewards of a fundamental market mechanism are well and truly over," says Jason Karaian, finance analyst from the Economist Intelligence Unit. It's not inconceivable that it could even lead to further regulation - EU financial services chief, Michel Barnier, is already looking into whether the scandal has exposed "gaps" in current rules.

That's on top of a regulatory regime that is already looking busy. After all, the Independent Commission on Banking's (ICB) key recommendation last year - to effectively ring-fence investment banking activities from retail banking functions - has already been endorsed by the government.

Implementing that could prove costly, with the ICB having estimated a hit to the sector of between £4bn and £7bn - although analysts at Goldman Sachs have put the cost at nearer £10bn. That's going to fall on such lenders as Barclays, HSBC, RBS and Lloyds, which boast decent sized investment banking arms.

This comes on top of the wider international regulatory agenda - especially the Basel III rules - which are largely focused on requiring banks to hold more capital. These will force lenders to hold core tier one capital (essentially equity) that’s equivalent to 4.5 per cent of their risk-weighted assets, plus an additional 2.5 per cent buffer – giving a 7 per cent minimum ratio. Full implementation isn't required until 2019, although UK regulators - like those in Switzerland - are likely to require banks to hold rather more than the 7 per cent minimum.

Charges and fines - the pain so far

Liquidity rules are an issue, too. Basel III will set banks a liquidity coverage ratio, to be implemented by 2015, and a net stable funding ratio, for implementation by 2018. Generally speaking, these require banks to match the duration of their assets more closely to their liabilities, and in the shorter term to ensure banks hold enough liquid assets to cope with sudden high levels of depositor withdrawals.

Admittedly, on the basis of UK bank capital ratios right now, it doesn't look like the lenders will struggle too much to meet the new requirements. But - as already mentioned - that assumes there will be no large capital-consuming shocks, perhaps from eurozone exposure or rising bad debts as economic conditions deteriorate. And holding more capital is costly - it will limit banks' ability to lend and lower returns. Similarly with the liquidity rules, being forced to hold highly liquid but low-yielding assets is hardly the best way to maximise earnings. UK banks' holdings of liquid assets have already trebled since the end of 2008.

Taken together with the hectic EU regulatory reform agenda, the costs look heavy. In fact, a study by the JWG regulatory think-tank has found that the EU financial services industry is on track to spend more than €33bn over the next three years implementing new regulations. That reflects such rules as those establishing ‘living wills’, to help financial players wind-up in a crisis, or those requiring much more frequency and detailed reporting - on such areas as large exposures, counterparty risk and collateral. Taken together with Basel III, and the Solvency II rules (new capital requirements for insurance operations), JWG estimates that cost could even reach €50bn.

Against that dreary backdrop, the lenders face plenty of challenges and, below we've put together snapshots of the UK’s five listed banks.

Barclays (BARC)

Barclays' current woes over the Libor fixing scandal have revealed concerns regarding the internal management culture and, with the chief executive's seat now empty, the lender is set to strategically drift. Moreover, after having sold its asset management arm in 2009 to bolster its capital position, the bank now looks overly reliant on volatile investment banking and low-growth retail banking - hardly a recipe for decent earnings growth.

True, Barclays avoided needing state bail-out cash and has, therefore, steered clear of a government shareholding. And, unlike some of its UK peers, it does pay a dividend - although the yield is nothing special. The bank is also the most heavily exposed to weak eurozone economies, such as Spain and Italy. Add that to the grim economic outlook and, even though the shares are cheap - rated at 0.5 times estimated end-year net tangible assets - they could easily get cheaper. Sell.

Lloyds Banking Group (LLOY)

The bad debt crisis unleashed upon Lloyds after buying HBOS at the height of the 2008-09 financial crisis left a state bail-out unavoidable and the government still has a 41 per cent stake. And, while much progress has been made since, bad debts in Ireland remain painfully high, there's no dividend in sight and the bank is heavily exposed to the UK's grim economic conditions. Its eurozone exposure is chunky, too - £21bn for the five weakest eurozone economies.

A relatively high reliance on pricey interbank funding - as already mentioned - is also eating into the bank's net interest margin. And the bank's painful looking PPI-related compensation claims haven't helped sentiment. The shares look cheap - rated on about 0.6 times forecast net tangible assets - but are worth avoiding. Sell.

Royal Bank of Scotland (RBS)

Half-year figures from RBS revealed a miserable picture - grim trading and a plethora of charges meant a painful £1.5bn pre-tax loss. There's going to be no dividend for years, either, and RBS boasts a chunky peripheral eurozone exposure. Indeed, RBS has the largest UK bank exposure to Ireland and its Ulster Bank operation looks troubled. Meanwhile, the investment banking arm is struggling amidst uncertain financial market conditions and the UK retail side isn't finding life easy, either.

There are also rumours that RBS could even be nationalised. While the government already owns 84 per cent of the bank, some ministers - concerned that banks aren't lending enough to businesses - want to buy the rest so that RBS can be used as a lending vehicle.

Like Lloyds, RBS's shares - rated on 0.47 times expected net tangible assets - are hardly pricey. But the long list of risks facing the bank mean they could get cheaper yet. Sell.

HSBC (HSBA)

HSBC is the UK's only major international bank and it boasts robust operations in fast-growth Asia, as well as other promising emerging markets such as Latin America. The bank has a healthy capital cushion, too, and - unlike lenders such as Lloyds or RBS - it's profitable. Also unlike that pair, it pays a decent dividend - a prospective yield of over 5 per cent - and it avoided any kind of state hand-out during the financial crisis.

But HSBC faces challenges. Its US sub-prime operation is being run down but it still generates painful bad debt charges.

Operations in Europe and the UK aren't exactly booming, either, and it has a fairly hefty $37bn (£24bn) exposure to the weaker eurozone states. Yet its shares trade on a demanding 1.2 times forecast end-year net tangible assets - and look vulnerable to sentiment shifts. Sell.

Standard Chartered (STAN)

Until recently, Standard Chartered was the smartest play in the UK banking sector. It generates 80 per cent of its earnings in fast-growth Asia, is well capitalised, boasts a tiny impairment charge and virtually no eurozone exposure. Unfortunately, that good news story took a big punch after Benjamin Lawsky - superintendent of financial services in New York State - issued a statement this month accusing Standard of having "schemed with the government of Iran" to avoid US sanctions.

While Standard insists the charges were trumped-up, the bank eventually agreed to pay a hefty $340m fine. And while that's better than the loss of its New York banking licence - potentially disastrous for a global trade finance bank - it's not inconceivable that more pain could be on the way. Indeed, regulatory lawyers at CMS Cameron McKenna estimate that the bank could eventually pay fines that total $1bn as other regulators, including the US Treasury, the Federal Reserve Bank and the US Justice Department, negotiate settlements.

Sure, Standard boasts a great growth story, but it too has now been dragged into the reputational scandals that have hit peers. While the shares, which have bounced somewhat after news of the settlement, trade on a punchy 1.49 times forecast net tangible assets. Hold.