15 years on, banks hope for a new lease of life

We are now 15 years on from the financial crisis, when the banking system teetered on the brink of collapse and governments had to step in to prevent economy-destroying insolvencies. The British state still owns 47 per cent of NatWest (NWG). Both banks and regulators, as is well known, didn’t cover themselves in glory before, during, and after the crash. And as we look ahead to 2023, there are still systematic risks at play. The UK banking sector still isn't fundamentally safe and secure. While balance sheets have been tidied up, hidden leverage risks – often among counterparties as much as banks themselves – still exist.

But, with earnings performance improving as the era of record-low rates starts to recede, there are now attractive investment options among the banks despite these risks.

The sector has been back in the headlines of late. A range of positive third-quarter trading updates revealed results which were in many cases ahead of analyst expectations, as the rising interest rate environment helped to materially pump up net income lines. On the other hand, Credit Suisse (CH:CSGN) investors have pulled out billions after thinly sourced claims spread like wildfire on social media that the bank was close to financial catastrophe, and in the UK as elsewhere lenders are making larger provisions for future bad debts, in anticipation of the forthcoming recession. It is fair to say that the banks haven't yet recovered their pre-crisis lustre. 

Capitalisation and regulation

Question marks remain around just how resilient bank balance sheets are, despite the Bank of England’s protestations that all is well with capital and liquidity (the Old Lady of Threadneedle Street doesn’t have the best recent track record with such statements). While balance sheets and assets do look a bit more solid than at the time of the financial crisis due to factors such as bigger capital requirements and less risky lending, this remains something to watch.

And so is the closely connected regulatory environment. The 2007-2008 crisis was begotten by failures of in-house and governmental regulation. Banks were investing in (and putting together) extremely risky and ill-understood assets, and the housing market was allowed to spiral out of control. This was a toxic combination: light-touch regulation of complex financial instruments is a recipe for disaster. 

So it might seem surprising that credit crunch-era regulations could soon be removed in a bid to boost UK growth. As part of the Edinburgh reforms, intended to make the City of London more competitive, the UK government is considering relaxing ringfencing rules that splithigh-street banking from investmentbanking and other riskier operations – requiring banks to keep separate pots of capital to absorb potential losses for both sides of the business. The existing rules apply to banks with more than £25bn in retail deposits – the government is to look at increasing the threshold to £35bn, thereby helping smaller lenders, and intends to introduce legislation “to quickly improve the functionality of the existing regime”. Economic secretary to the treasury Andrew Griffith, speaking at a Financial Times event, said last month that reform would “release some of that trapped capital around the ringfence”.

This looks like a questionable approach when there are still concerns over what may lie on bank balance sheets – or rather what may happen when investment bank trading goes wrong.

This looks like a questionable approach when there are still concerns over what may lie on bank balance sheets – or rather what may happen when trading goes wrong.

 A warning sign here comes from the fact that the leading UK and European banks are priced at below book value, including all four big UK banks. Trading at such levels is not uncommon for the sector, but does indicate that investors still harbour concerns about the ultimate value of bank assets, not least those in investment banking arms that have proven prone to big blow-ups. So while valuations may have de-rated and the sector looks cheaper than it has done in recent years – RBC Capital Markets said that forward price-to-book ratios are below their 10-year average – this isn’t necessarily an overwhelming positive.

Lending and bad debt

Then there is the retail banking side of things. Mortgage market machinations are key for the sector as most UK bank lending is for this purpose. Lloyds Banking (LLOY) is far out in front of the rest of the pack in lending terms given its share of the UK mortgage market. The rest of the top-five players are NatWest, Nationwide, Santander (ES:SAN), and Barclays (BARC). A key thing to keep an eye on next year is just what level of provisions and bad debts the commercial banks will continue to make.

Much of the recent narrative about the housing market has been bearish, which is unsurprising given it is being hit by several factors at once. Affordability is being squeezed by higher debt costs after a decade of very low interest rates, with the potential for a significant drop-off in demand from buyers unwilling to take the plunge, and house price declines and payment defaults are risks to the banks in a recessionary environment. 

Berenberg analyst Peter Richardson is bullish on the sector's ability to absorb difficulties around mortgage lending, despite these headwinds. He said that mortgage market concerns are “dwarfed by tailwinds from higher interest margins” and argued that if current mortgage spread levels continue then this could provide a £14bn annual boost to bank revenues. This would cover 30 basis points of mortgage loan losses next year, which would be a very high level in historical terms if it came to pass. Richardson thinks that NatWest and HSBC will take mortgage market share, helped by low deposit funding costs, while smaller banks such as Virgin Money (VMUK) could struggle.

There are also forms of non-mortgage lending – to small- and medium-sized enterprises (SMEs), to individuals, and to corporates – to consider. S&P Global Ratings said that at European banks next year "credit quality will deteriorate, particularly in SME and consumer lending portfolios. The impact will generally be manageable, but uneven by region and economic sector". 

The rates question

There is no question that higher interest rates have pumped up earnings forecasts and interest margins. When the big players across Europe and the UK released their third-quarter updates, deposit banking was a clear winner. Deutsche Bank’s corporate deposit base was up by 11 per cent. There was even some outperformance of US peers, which is a rare occurrence.

But looking ahead, some suggest the benefit of increased rates is the wrong thing on which to focus on for investors. RBC analysts think that “the rates trade is now done, with asset quality and cost control the themes for 2023”. 

The consensus is for UK Bank Rate to surpass 4 per cent next year. Beyond that arguments can be made for further hikes if inflation persists, or even cuts should the economy stumble harder than expected. Either way, the consensus analyst outlook is for a strong revenue performance for the banks in 2023 – even those whose focus is partly on other regions. For example, according to FactSet, net interest income is expected to rise by over a half for both Standard Chartered (STAN) and HSBC (HSBA) between 2021 and 2023.

Our top sector picks

Banks are often derided as Old World stocks when set beside more exciting sectors, but despite the risks involved there are solid prospects on offer. Lloyds Banking and Bank of Ireland (BIRG) are among our recent Buy ideas. We particularly like the former’s balance sheet and market position, and the latter’s recovery story and control of costs. 

Robert Noble, analyst at Deutsche Bank, is also keen on Lloyds. He forecasts that the company will generate a return on total equity of 16 to 17 per cent over its next two financial years and predicts its net interest margin will move from 292 basis points in 2022 to 330 basis points next year. He added that “we see only limited offsets to net interest margin expansion from lower expected growth, higher inflation and deteriorating asset quality”. 

We think that NatWest is well situated too, and like the progress it is now making after its catastrophic fall from grace under the RBS name amid the credit crunch. We have also maintained hold recommendations on several other bank stocks, as the table shows.

So, there are options for investors to delve into for those keen on the sector. But that must come with a caveat in many cases. Few saw the financial crisis coming, and it would be foolish to assume that all material risks have been erased from the banking landscape. We have mentioned capital and bad debt. But there is no doubt that other financial monsters are lurking in the shadows, particularly in investment banking arms.

Return to: Where to invest in 2023