When the economy is growing strongly, and there's plenty of demand for credit, then the banks tend to do well. And even though conditions in the UK haven't reached that point yet, recovery is in sight. For example, the IMF expects the UK's economy to grow 1.9 per cent during 2014 and the Bank of England's Credit Conditions Survey for 2013's final quarter, published this month, revealed that momentum is building behind a recovery in credit demand. This signals better times ahead for the lenders.
Specifically, the survey reported that fourth-quarter mortgage demand increased "significantly", following robust third-quarter demand. Unsecured lending bounded ahead, too, and credit demand from medium-sized businesses also rose strongly. Defaults are falling, especially on mortgage and small business loans, which should allow for provision write-backs. Taken together, this should eventually support a sustained earnings recovery.
The improving sentiment that comes with those better conditions could also provide a fillip to bank re-privatisation in 2014. That began in September after the government sold, through an institutional placing, a 6 per cent stake in Lloyds (LLOY). It's thought likely that the government will make a further disposal early this year, which may include a retail investor offering alongside a further placing. At the time of the initial disposal, analyst Ian Gordon at Investec Securities even felt that the government could be "out in full by the election".
But progress with RBS's (RBS) re-privatisation could be slow. Unlike Lloyds', its shares still trade well below the government's average 502p a share buy-in price. And a Treasury report on RBS in November noted that for many RBS businesses "returns, even excluding the non-core run-down division, are below both RBS's cost of equity and the returns generated by the majority of comparable European banks". Business Secretary Vince Cable has said that re-privatisation inside five years is "unrealistic".
Capital-adequacy worries, against the backdrop of the tougher Basel III capital requirements, will probably also persist in 2014, at least for RBS, Lloyds and Barclays (BARC). It was only in June that regulators concluded that the sector faced a combined £27.1bn capital shortfall, £13.8bn of which related to RBS. The affected banks do at least have concrete plans to close the gap. RBS's efforts, supported by such moves as the Direct Line flotation, should have cut its shortfall to around £400m by the end of 2013.
Dividend prospects at these more capital constrained lenders don't look great. RBS isn't set to pay dividends until well into 2015, and while Lloyds may return to the dividend list when it announces its 2013 figures, the payout is likely to be modest. Mercifully, it's a different story at HSBC (HSBA) and Standard Chartered (STAN). Their focus on faster-growing emerging markets leaves them with superior earnings prospects, and they already pay attractive dividends. Capital isn't likely to be a worry for either; they both boast robust Basel III capital ratios.
Business misconduct compensation remains a threat to earnings. PPI-related provisions continue to creep up and interest-rate hedging (IRH) mis-selling could deliver the next big hit. "Average [IRH] redress costs continue to rise, and we suspect that the entire industry has more to come," reckons Mr Gordon. So far the sector has set aside around £3.2bn to cover IRH redress and Mr Gordon reckons RBS is materially underprovided. It has three times as many IRH cases as Barclays, which has double the provision.
Institution-specific issues may also inhibit recovery. For example, both Lloyds and RBS still have significant credit-quality issues in Ireland to tackle. For RBS, Ireland represented 43 per cent of the total bad-debt charge at the half-year point, even though the Irish book accounted for just 10 per cent of total gross lending. Meanwhile, Barclays' heavy reliance on volatile investment banking potentially leaves it relatively less exposed to improving credit conditions.
Bank of Georgia - a special case
Bank of Georgia (BGEO) is a pure play on prospects in Georgia, where conditions can be volatile. For example, the Russian invasion in 2008 saw 20 per cent of its deposits withdrawn, while elections in 2012 caused the shares to slide heavily. The economy has been volatile, too, with growth slowing dramatically in 2013 to about 2.5 per cent. That said, the IMF expects growth to recover to 6 per cent in 2014, which could provide a boost to lending. The shares could also suffer liquidity issues given that the five largest institutional shareholders hold a combined 27 per cent of the bank. Its capital ratio, which is double that of most western banks, is one reason why the shares are highly rated by the market, on over twice forecast net tangible assets.
| FTSE 350 Banks | ||||||
| Company name | Share price (p) | Market value (£m) | PE ratio | Dividend yield (%) | Share price change in 2013 (%) | Last IC View |
| Bank of Georgia Hdg. | 2,362 | 848 | 1119 | 2.4 | 132.5 | Hold, 1,874p, 15 August 2013 |
| Barclays | 278 | 44,827 | 11 | 2.2 | 12.2 | Hold, 287p, 17 January 2014 |
| HSBC Hdg. (Ord $0.50) | 669 | 125,953 | 12 | 3.9 | 2.4 | Buy, 656p, 2 January 2014 |
| Lloyds Banking Group | 83 | 59,257 | 40 | 0.0 | 64.6 | Hold, 83.5p, 17 January 2014 |
| Royal Bank of Scotland | 348 | 21,587 | 17 | 0.0 | 4.2 | Hold, 364p, 17 January 2014 |
| Standard Chartered | 1,357 | 32,927 | 9 | 4.1 | -13.6 | Buy, 1,287p, 10 January 2014 |
Favourites
Out top picks are HSBC and Standard Chartered. They boast exposure to fast-growth emerging markets, are well capitalised and have attractive income characteristics (especially HSBC). The shares are not the most cheaply rated in the sector, but look reasonable compared with those of international peers.
Outsiders
We exited our sell tip on RBS (364p, 26 Sep 2013) this month, reflecting the improving credit backdrop, but the lender still looks like the weakest of the pack. The shares do trade at an undemanding multiple of tangible net assets. But, given the absence of a dividend, ongoing capital adequacy worries, a lack of clarity of re-privatisation and a host of legacy issues, that low rating looks thoroughly deserved.
