In the decade since the great financial crisis, the major UK banks have transformed their balance sheets and adapted business models to place less emphasis on riskier lending and investment banking activities. Progress made solidifying capital positions has paved the way for a return to dividends, although the capacity to sustain progressive dividend policies is less certain.
Rationalisation and scaling back of some activities by big players has created an opportunity for smaller lenders, the so-called “challenger banks”, to emerge and take market share in niche areas such as buy-to-let and asset finance. Key questions facing investors in the sector now, are which of the major banks look best placed to re-establish themselves as quality income payers and how to identify the challengers capable of sustaining momentum as they mature.
The major UK lenders have transformed their balance sheets: Stricter capital requirements and the need to rein in sprawling operating structures has encouraged big banks to shift towards simpler business models, focusing more on retail lending. Stronger balance sheets are evidenced by an increase in common equity tier one (CET1) ratios across the board, which has paved the way for the return of dividends.
Generating returns has been tough and it’s likely to stay that way in the medium-term: Low interest rates, domestically and around the world, have made it harder for UK-listed banks – both large and small – to generate a decent margin on loans. The Bank of England is forecasting meagre increases in the bank rate during the next four years. Progress on expanding net interest margins is likely to be slow.
New lenders have flooded higher-risk and specialist markets: Challenger banks have filled the gaps left by larger lenders in buy-to-let and asset finance. Without the legacy issues of the majors, they’ve enjoyed a rapid increase in lending and solid profit growth, delivering high returns on equity. That’s translated into decent, consistent dividends and did afford some shares a premium to the larger players. Margins are now starting to feel the pinch of increased competition and less access to cheap funding, however, causing some shares to de-rate and increasing the likelihood of consolidation.
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