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Brighter outlook for the UK’s banking pariahs

After more than a decade in the investment doghouse, the UK’s unloved high-street banks might finally earn the returns that their market dominance demands
Brighter outlook for the UK’s banking pariahs
  • Net interest margins are set to rise 
  • Government control loosening at NatWest

Years of controversy have dogged the UK’s high-street banks, as the fallout from the 2008 financial crisis cast a long shadow over the operational performance of NatWest (NWG), Barclays (BARC), HSBC (HSBA) and Lloyds (LLOY). It could be the case, though, that investors are finally putting the many doubts about the banks’ collective performance behind them: the shares have outperformed the FTSE 100 so far this year.

While that is clearly welcome news for those investors who have patiently stuck by the sector through hard times, no-one should be fooled into thinking that an improved 2022 will have anything to do with actions taken by the various managements. Rather, as quasi-monopoly businesses, returns this year will be determined by how much slack the government, the regulators, the courts and, most importantly, the Bank of England (BoE) is prepared to give them.

The improvement in overall fortunes is linked to the fact that interest rates are on a clear upward path, with the base rate widely forecast to reach 1 per cent by the end of 2022, as the BoE grapples with spiralling inflation. That gives the banks some headroom on their net interest margin – the gap between the cost of the capital loaned out and what is earned back in interest, which represents a bank’s basic profit. While we are some distance from basic, instant-access current accounts earning 12 per cent annual interest (as was the case in the 1980s), the trend is clearly in the banks’ favour. 

Their balance sheets are groaning with cash after capital set aside for bad loans related to the pandemic is systematically released. In addition, a dividend ban implemented over the past two years has only increased levels of liquidity.

In terms of UK banking, NatWest, now that it has dumped the tarnished RBS brand, seems to be in its best position for years. The main reason for this is that the government has been gradually selling down its stake in the bank, which is soon due to fall below the 50 per cent threshold that meant the bank was effectively a nationalised business. This gives its management, led by chief executive Alison Rose who has been in charge since 2019, the chance to rebuild its returns. Any improvement on its 1.57 per cent net interest margin achieved in 2020 would be a start. According to investment bank Jefferies’ EMEA Banks Dashboard, NatWest scores highly both for its levels of excess capital and sensitivity to changes in interest rates.

 

The black nag trundles on

The UK giants report full-year results next month, and the market will expect to hear more about Lloyds’ apparent reinvention as a landlord and wholesale asset manager. Prior to the results, analysts have been forecasting upgrades in underlying earnings per share of 4 per cent. Importantly for Lloyds’ many income shareholders, Berenberg analysts reckon that the bank’s balance sheet can support a sustainable dividend yield of 5 per cent, rising to 8 per cent when potential buybacks worth up to £1.25bn are taken into account.

The bank is also well-positioned to benefit from rate rises this year and should be able to increase its net interest margin substantially from the 250 basis points it is forecast to achieve for 2021. If a core tier one capital ratio of over 17 per cent is factored in, Lloyds looks in far better shape. The question is whether it can generate top-line growth without resorting to capital releases.

 

HSBC and Barclays differing challenges

The positives for Barclays and HSBC are somewhat harder to pinpoint due to HSBC’s Asian focus, while Barclays' investment banking arm is a moveable feast dependent on what is happening in global markets.

The read-across from the US banks reporting season could have a decisive bearing on how Barclays' performance is perceived. Investment banks of all stripes have witnessed a combination of spiralling costs and lucrative trading conditions, and a potential pick-up in market volatility this year would bring its own benefits. In the meantime, capital releases will boost the bottom line, with analysts pencilling in a £2bn benefit. Barclays' high levels of operational gearing have always been its strength when other, less diversified, banks have struggled with low interest rates and meagre returns. This year, it needs to prove the strength of its business model.  

HSBC’s global reach has proved to be its strength at times when extreme conditions in one market were enough to floor banks that were bigger by assets – see Royal Bank of Scotland in 2008.

However, a willingness to make markets with anyone has also led to numerous legal issues as regulators clamped down on money laundering and price rigging. The other cloud on the horizon concerning investors is what HSBC's ultimate exposure to Evergrande and the faltering Chinese property market will be should a disorderly collapse set in.

The same issue also affects the last of the big UK banks, Standard Chartered (STAN). China and North Asia contributed approximately 84 per cent and 81 per cent of HSBC and Standard’s profits, respectively. Despite this, Standard looks set for modest upgrades this year, according to analysts at Jefferies. However, in a problem that has affected all major banks, the broker warned that cost inflation, particularly in its wealth management division, could double to 4 per cent as the bank scraps for experienced staff and also upgrades its IT.