Q3s preview: not so great expectations for Lloyds, NatWest, Barclays & HSBC

Last month, the value of the FTSE 350 Bank Index fell below the nadir reached in the 2008-09 banking crisis. That marks a decline of more than four-fifths over 15 years, during which time the total shareholder return looks scarcely better: reinvesting dividends in the sector would still have resulted in a near two-thirds decline.

Against this backdrop, it’s safe to say the market isn’t holding out for many positive surprises when the UK’s largest listed banks begin to publish their third-quarter numbers next week. So far in 2020, the trajectory for lenders has been almost entirely downhill.

The latest portents hardly inspire, either. This week, the International Monetary Fund said it now expects UK gross domestic product to fall by 10 per cent in 2020. The Office for National Statistics says unemployment rose from 4.1 to 4.5 per cent in the three months to August. At the time of writing, a breakthrough in the Brexit negotiation stalemate has proved elusive.

None of this is good news for domestic banks, whose income-generating prospects are tightly tied to the outlook for the economy. Consequently, some pretty miserable assumptions have already been baked into lenders’ share prices. Together, the five bank constituents in the FTSE 100 – Barclays (BARC), HSBC (HSBA), Lloyds Banking (LLOY), NatWest (NWG) and Standard Chartered (STAN) – are expected to book £26bn of provisions this year, all but erasing net income and helping to cement an average 55 per cent discount to tangible book value.

This, as we have previously detailed, reflects macroeconomic assumptions that have now caught up with consensus estimates. Of course, some discrepancies remain. Barclays, for example, expects house prices to rise until the end of 2021, during which time both Lloyds and NatWest expect major contractions. But under IFRS 9 rules, lenders have already had to book big provisions against possible loan losses sparked by the pandemic's economic effects. Although each bank has flagged these could rise further, consensus forecasts since half-year results were published suggest analysts are not bracing for further negative surprises in either the third or fourth quarters (see chart).

This might help to explain why the City remains resolutely positive on the sector, at least judging by the breakdown of analyst ‘buy’ ratings on the largest five banks. The one exception to this is HSBC, whose position at the eye of a geopolitical storm has meant it is now definitively out of favour with the sell-side, not to mention both Asian institutional and retail investors.

Forewarned is forearmed?

Does this mean the sector is now prepared for a loan book deterioration? At this stage, it is very hard to say, although it’s worth noting that domestic lenders’ huge exposure to mortgage lending has proved an asset in the past. According to analysts at Berenberg, mortgages have accounted for only 9 per cent of losses on UK household loans since 2008, despite making up £9 out of every £10 borrowed.

This means investors should pay particular attention to losses on other personal borrowing lines, such as car finance or credit cards. On this front, Berenberg thinks Lloyds looks the most exposed of the large UK banks, given its more modest provisions for consumer credit to date.

More broadly, despite rising confidence in the adequacy of banks provisions, the next binds might not be far off. Already, there is mounting concern that many of the state-backed emergency loans to businesses being administered by the banks could suffer default, even with the generous payback terms and interest rates on offer. According to one government estimate, insolvencies and fraud could mean up to £26bn of the £58bn-worth of coronavirus funding is unrecoverable.

The threat here for banks is not to their asset bases, given the loans are state-sponsored, but that their reputations could be badly damaged from the mammoth task of debt collection. At the same time, the government has called on banks to turbo-charge high loan-to-value mortgage lending, as part of the prime minister’s plans for a “revolution” in home ownership among young people.

An industry pushback here – on the grounds that loosening underwriting standards could raise credit risk – is risky, and once again underlines the quasi-political role banks now find themselves in.

Pinch points

Another pinch point is lending to commercial landlords, many of whom have suffered steep falls in rental income and could soon start failing borrowing covenants related to property values and interest coverage. Heather Powell, head of property at tax advisory group Blick Rothenberg, singled out Metro Bank (MTRO), for its “big push on lending to smaller property investors, at very competitive rates” in recent years. “It is these investors, who do not have the capital behind them, who are going to cause an issue in 2021,” she cautioned.

Early signs suggest this could indeed be a problem. In the first half of the year, Metro increased its expected credit losses from £34m to £145m, the majority of which were booked against commercial lending, even though the segment makes up just 30 per cent of the total loan book. Despite booking chunky provisions themselves, NatWest and Lloyds appeared to enter the crisis better prepared than the challenger.

Might deal-making offer hope?

Although dividends are unlikely to restart until the Prudential Regulation Authority (PRA) gives the green light, this has at least had the effect of buttressing banks’ capital levels. Unfortunately, stressed loan books and economic recession pose severe constraints on efforts to lift net interest margins and returns on equity.

Could deal-making provide one diversion from this bleak path ahead?

Two developments outside the UK suggest this is possible. The first is to be found in Europe, where the banking sector is finally starting to consolidate. Since Spanish lenders CaixaBank (Sp:CABK) and Bankia (Sp:BKIA) agreed to combine, reports suggest Sabadell (Sp:SAB) is next. In Italy, Intesa Sanpaolo (It:ISP) has just bought UBI, while pressure is mounting on UniCredit (It:UCG) to acquire Monte dei Paschi di Siena (It:BMPS). Deutsche Bank (Ger:DBK) and Commerzbank (Ger:CBK) of Germany, along with SocGen (Fr:GLE) of France, are all said to be open to M&A.

Despite their inherent complexity, there is some logic behind these deals. For one, eurozone banking markets are more fragmented than the UK; plenty of tie-ups are therefore possible without drawing the ire of competition authorities. Second, European lenders’ income has been severely hampered by negative interest rates, exacerbating the need to both cut overheads and scale up to help them make large investments in technology.

Third – and no doubt conscious of the effects its monetary policy has had on the sector – the ECB has signalled acquirers can book targets’ sharp discounts to book value as so-called ‘badwill’, which has the arguably perverse effect of boosting capital rather than precipitating a write-down.

Could this pattern spread to the UK? Although it insists zero or negative interest rates are not imminent, the Bank of England recently began surveying City executives about their “operational readiness” if negative rates were introduced. One big driver of European consolidation is therefore in play. However, it’s questionable whether the PRA would agree to the badwill accounting trickery, while the big four high-street lenders’ dominance is likely to frustrate attempts at large-scale M&A.

Aside from sharper cost-cutting, a better use of spare capital might be through diversification.

Last week, just days after completing its acquisition of retail trading platform ETrade, Wall Street giant Morgan Stanley (US:MS) announced it was buying asset manager Eaton Vance (US:EV) for $7bn (£5.4bn). The logic here is compelling: with revenue from securities trading moving sideways in recent years, the investment bank sees wealth management as an increasingly important driver of future profits.

Assuming compelling deals exist, a splash in the asset gathering space might make sense to UK lenders. Even after accounting for a rise in its minimum regulatory capital requirements, Lloyds has a surplus of £7.4bn. For NatWest, the figure is a whopping £15bn. If bank executives want to change the narrative, they could do worse than looking at financial firms with the luxury of growth.