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UK-listed banks may have improved their capital adequacy, but a series of provisions, low rates and an uncertain credit environment pose a threat to their recovery

One of the defining features of the response to the financial crisis by the UK’s major banks was the desire to simplify their operations. Considering the circumstances leading up to the 2007 crisis, they had good reason. Ferocious growth in securitisation, slack capital adequacy controls and deregulation during the prior two decades had fuelled the rapid expansion of banks. In an increasingly internationalised financial system, setting up offices across the globe to grow the client base even further made sense.

Since the fallout a decade ago, the drive for simplification has been twofold. At a basic level, operating costs are the only lever banks can directly control. The misconduct costs and challengingly-low interest rates that have followed the financial crisis have necessitated a reduction in operating costs. More importantly, stricter capital requirements under Basel III regulations – in addition to impairments for bad debt – have pushed banks towards lower-risk business models.   

The most pronounced consequence of this for many of the banking heavyweights has been a rapid downsizing of their investment banking operations. The requirement to hold more capital for owning riskier assets has taken away some of the attraction of investment banking – just one reason that reducing risk-weighted assets has been at the forefront of all the UK-listed banking majors’ recovery strategies. The Prudential Regulation Authority’s ring-fencing rules, requiring banks to separate retail money from riskier investment banking activity, have also contributed to the shift.  

At Lloyds Banking (LLOY) and Royal Bank of Scotland (RBS), the reduction in investment banking and the move towards lower-risk activities has been most pronounced. Lloyds has focused on UK retail and commercial banking, the former of which accounted for more than two-thirds of its loan book at the end of June. Admittedly, it does carry out activities including currency hedging and asset securitisation. However, it doesn’t do takeover advice, equity capital markets or stock trading. Just 3 per cent of its loans and advances will sit within its non-ring-fenced bank, Lloyds Bank Corporate Markets.     

Similarly, RBS has focused on retail banking, after being burnt by years of overreaching acquisitions. That’s not to mention the fact that asset disposals were a condition of its £45bn state bailout. Its personal and banking business now accounts for 42 per cent of its net loans at the end of June. Meanwhile, NatWest Markets had net loans of £17.7bn, equivalent to just 5 per cent of its total loan book.

In terms of risk reduction, focusing on retail banking has borne fruit. Since 2014, when capital requirements under the Basel III rules came into effect, Lloyds has reduced its risk-weighted assets by 15 per cent to £218bn at the end of June. During the same period RBS has reduced its RWAs by 45 per cent to £215bn. Of these, £27bn were RWAs related to its ‘bad bank’ Capital Resolution – a 43 per cent reduction since 2014. That’s a bigger reduction in its run-off division than expected – management is now flagging RWAs for the end of the year to be at the lower end of its £15bn to £20bn target range.

As a result, the common tier one equity ratio – of equity as a proportion of RWAs – at both banks has improved (see table). However, that’s also where the similarities between the two retail-focused banks end. Where Lloyds has rebuilt its capital position to a level substantial enough to warrant the recommencement of dividend payments, RBS's position is more fragile. RBS has been mired in litigation and conduct disputes, including its 2008 rights issue, for which it has taken sizeable provisions. The bank failed the Bank of England’s most recent stress test, which modelled a UK and global recession. Under the scenario its core capital ratio declined to 5.5 per cent, below a hurdle rate of 6.6 per cent, even after including debt that could be converted into equity. It was forced to submit a revised capital plan to the regulator and issue £2bn-worth of A1 securities. While the bank has settled some of its litigation issues, it is still under investigation by the US Department of Justice over alleged mis-selling of mortgage-backed securities during the run-up to the financial crisis. The bank has already taken a £3.1bn provision for this in 2016, but there could be more to come and eat into the book value. The UK government has also refused to sell down any more of its stake until the matter is resolved. 

Barclays (BARC) has kept a foot in both camps, retaining its investment banking operations, albeit in a downsized guise. Crucially, the bank has simplified its operations considerably. Following the sale of its African operations – for which it took a £1.1bn loss – and Egypt business during the first half of this year, losses associated with its non-core division reduced by around two-thirds. It also helped lift its core tier one equity ratio to 13.1 per cent, from 12.4 per cent the previous year – within management’s target range. However, like Lloyds provisions for payment protection insurance continue to be a thorn in the bank’s side. It £700m in provisions during the first half. However, the Financial Conduct Authority has set a deadline of 29 August 2019 for new PPI claims, which should draw a line under what’s been an incredibly costly hindrance to UK banks’ bottom line.    

Focusing on UK retail banking may help reduce a bank’s risk profile, but it has also presented problems in generating sufficient earnings to restore profitability. Against a backdrop of ultra-low UK interest rates, maintaining a decent net interest margin is a tough job. UK-listed banks have experienced downward pressure on their net interest margins and the return they can make on their equity during recent years.  Admittedly, a lower cost of funding did provide some fillip to margins for most lenders during the first six months of the year.

Asia-focused banks HSBC (HSBA) and Standard Chartered (STAN) have not escaped the pressure of low rates. In November 2015 Standard Chartered chief executive Bill Winters scrapped the final dividend and in August last year pushed out its target of achieving an 8 per cent return on equity by 2018. However, despite failing to reinstate the dividend at the midpoint of the year, the bank has made progress on its capital adequacy. The bank has focused on affluent retail banking customers, instead of investment banking, and has sold-off or reformed capital-intensive businesses.

This strategy has borne fruit. Risk-weighted assets declined 17 per cent to $271bn (£209bn) during the two years to the end of June. It has also taken $2.9bn of the $3bn restructuring charges expected once the overhaul is complete. A recovery in emerging markets sentiment and commodities prices has also meant it has left behind the huge impairments it had been forced to take on commodities loans turned sour during 2015 and 2016. Its common tier one capital stood at 13.8 per cent at the end of June, up from 11.5 per cent two years earlier.   

HSBC has not entirely escaped the pressure of low rates, either – last August it scrapped the timetable for hitting its 10 per cent return on equity target by the end of this year. Nevertheless, as we detailed in our recent ‘Income Majors’ piece, HSBC remains the capital king of the UK-listed banks. It has consistently delivered the highest return on equity of all the banks, partly by continuing to participate in higher-risk investment banking activities. That’s not to say it hasn’t been reducing its risk profile during the past two years. It has been gradually selling down the investment bank’s legacy credit and long-dated rates books, as well as reducing its capital financing activities and redeploying capital away from Turkey and Brazil. 

In 2015 chief executive Stuart Gulliver set a target of reducing the bank’s risk-weighted assets by around a quarter – or $290bn. Last year alone it cut risk-weighted assets by $143bn. By the end of June the bank’s risk-weighted assets stood at $876bn, meaning it had exceeded the 2015 target. HSBC’s core tier one equity ratio stands at 14.7 per cent, comfortably above management’s 12 to 13 per cent target range. At the end of the year the ratio is forecast to be 14 per cent, rising to 14.1 per cent the following year. As well as a reduction in risk, the bank has benefited from an improvement in the quality of revenue, primarily because of its ‘Asia pivot’. The region’s rising middle class and maturing savings and wealth management markets are what HSBC has pinned its hopes on for driving growth. That also leaves the banking group exposed to the waxing and waning of emerging markets fortunes.

Perhaps the largest threat on the horizon for UK banks is a potential reduction in demand for consumer credit. On that front, Lloyds is the most exposed. Its acquisition of HBOS in 2010 granted it the largest share of the UK mortgage market, where it has already suffered a contraction in margins due to competitive pressures. Its purchase of Bank of America’s credit business MBNA earlier this year has increased its vulnerability to a reduction in credit quality. For now, Lloyds' status as a very well-capitalised bank gives us confidence in its ability to withstand moderate pressure here.


How the banks compare

 Share price (p)Leverage (Tangible assets/equity)CET1 ratio (%)Book valueEarnings per share (p)Dividend per share (p)
Standard Chartered76214.113.80.829.50
Source: Companies, at 30 June 2017