FTSE 350: Banks set for further margin pressure

Capital ratios among the major lenders look sturdier. Lloyds (LLOY) was much quicker than UK-focused peer Barclays (BARC) in executing its simplification strategy. However, the latter is catching up. After selling off its majority stake in Barclays Africa in the third quarter, it reduced risk-weighted assets by £28.5bn, helping boost its common tier-one equity (CET1) ratio – calculated as a proportion of risk-weighted assets – to 13.1 per cent, up from 11.6 per cent a year ago. That sale, along with that of its Egypt operations, has pushed down the losses suffered by its non-core segment. Investec analyst Ian Gordon believes this will lead to an improvement in the cost-to-income ratio from 2017, down to 59 per cent by 2020. He thinks that progress made on capital levels may mean 2018 becomes the year Barclays makes a meaningful increase to its dividend payments.

Even Royal Bank of Scotland (RBS), whose balance sheet was left in dire straits following the credit crunch, has made solid progress in reducing its risk-weighted assets. Importantly, management expects risk-weighted assets at ‘bad bank’ Capital Resolution to be at the lower end of the guided range of £15bn-£20bn at the end of 2017. A jump in its CET1 ratio to 15.5 per cent during the third quarter has also stoked hopes that it could even pay a dividend again in 2018.

With the deadline for PPI claims set for 29 August 2019, the end is also in sight for the hefty charges that have set back profitability. Lloyds had an outstanding balance sheet provision for PPI of £2.3bn at the end of September, although claims had surpassed its assumed weekly run rate in the third quarter, so there’s every chance that the actual cost could rise.

The much harder task facing the UK’s banks is driving returns against such low interest rates. The Bank of England may have raised rates back above an all-time low, but returns available on longer-term loans are still historically weak. Lower wholesale funding costs have started to alleviate some of the pressure on net interest margins for some banks, notably Lloyds, which has the largest exposure to the UK mortgage market. Barclays set a target of making a return on equity of 9 per cent in 2019 and upwards of 10 per cent by 2020. However, a lacklustre returns-generating performance of 4.4 per cent during the first nine months of last year makes us sceptical about whether it will achieve these longer-term goals. 

HSBC (HSBA) has stood out among the major lenders since the financial crisis for its superior income status. The Asia-focused bank has managed to at the very least maintain its dividend since it was last cut in 2009. That’s not to say it has been immune to low UK interest rates, as well as volatility in emerging markets, which resulted in substantial loan impairments during 2015 and 2016. However, dividend cover was expected to have recovered to around 1.2 times earnings on an adjusted basis in 2017, rising to 1.3 times in 2018. HSBC has been benefiting from its ‘Asia pivot’. The region’s rising middle class and a maturing savings and wealth management market are the long-term growth trends HSBC hopes will drive earnings. 

Standard Chartered (STAN), may also be exposed to the same macro drivers as HSBC, but it has far more work to go until it can recommence paying dividends. Its CET1 ratio is expected to decline to 13.5 per cent in 2017 – with a return on equity of just 2.6 per cent – and 13.3 per cent in 2018, according to Investec.

For the FTSE 350’s burgeoning roster of challenger banks, including Virgin Money (VM.), Close Brothers (CBG) and Aldermore (ALD), there is some uncertainty over whether they can sustain such rapid loan book growth, given increasing competition in consumer lending and heavy gearing towards the UK property market. Margin erosion has dogged Virgin Money during the past two years, as it accelerated growth in its credit card business in the hope of closing in on its £3bn balance target. Admittedly, at the end of June last year balances were £2.8bn, but the net interest margin for this business declined by 65 basis points. What’s more, management expects the net interest margin at the group level to be at the bottom end of its guided range of 3-3.5 per cent for 2017.

Virgin is trying to broaden its customer base by launching a current account for small- and medium-sized enterprises (SMEs) this year, targeting £5bn of deposits within the first year of its introduction. However, given the likely persistence of low rates this year, it is hard to see how this will boost margins. The Bank of England’s term funding scheme – which allows lenders to draw money at reduced rates, thereby reducing their cost of funding – is also set to close in February this year; this could hurt margins for challenger banks, which have typically drawn a greater proportion of their funding from it. In this respect Metro Bank, which is rapidly growing its retail customer base, looks better positioned – but it’s a high-cost growth model, and its shares are expensive.