As the Co-Op Bank goes on sale, is now the time to buy UK banks?

 
Will Railton
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General Election - Economy
The outlook for the banking sector as a whole has markedly improved since the beginning of 2016, when bonds had negative yields, and there was widespread concern about the risk of a global economic slowdown (Source: Getty)

It wasn't hard to spot the irony when Paul Flowers, chairman of the avowedly ethical Co-Operative Bank and a methodist minister, was arrested for drug possession in 2013. In the same year, the mutual Co-operative Group ceded control of the ailing lender to its bondholders, after a massive £1.5bn hole was discovered in its balance sheet. The bank has struggled to turn itself around ever since. It never succeeded in making enough profit to list publicly.

Another irony is that, on the surface, the reasons that Co-Op Bank has struggled are common to a number of listed UK banks. Burdened with bad or non-performing loans, a Stone Age IT system, the cost of restructuring the business and of cleaning up PPI claims, low interest rates have held down Co-Op Bank’s earnings.

Read more: Red flags raised over Co-op Bank's sale potential

Lloyds, Barclays, RBS and others still face hefty fines for mis-selling financial products years ago. Lloyds sold more PPI policies than any other bank, and has had to set aside around £17bn to cover the costs of customer redress. Last month, RBS added a further $3.8bn to its warchest – which now totals $8.3bn – in anticipation of a fine by the US Department of Justice (DoJ) for mis-selling mortgage-backed securities before the financial crisis. Barclays, another DoJ target, is refusing to settle at all.

Like Co-Op Bank, many UK lenders have felt the squeeze from ultra-low interest rates in recent years, which has held down the interest that they can charge their customers. With Brexit looming over the UK economy and the possible loss of passporting threatening the cross-border operations of investment banking divisions, are UK banks worth holding, and how can you choose between them?

Dealing with it

“A lot of the UK banks have gone a long way to cleaning up their balance sheets,” says Adrian Lowcock, of Architas. Having been bailed out by the UK Treasury during the financial crisis, Lloyds now has a tier one capital ratio of 13.4 per cent, among the highest of the UK’s largest lenders.

RBS has struggled in this area, and is on course for its ninth straight year of losses, which now exceed the £45bn provided by the taxpayer during the financial crisis. However even in the case of RBS, “it has dead loans which aren’t really paying it any income, but they aren’t non-performing either,” says Lowcock.

Fines issued by regulators remain a concern, as Deutsche Bank and other continental lenders know all too well. But in August, the Financial Conduct Authority announced that it was considering a two-year deadline for lodging PPI claims, which would help Lloyds. A decision is expected to be announced later this quarter.

Bank in fashion

The outlook for the banking sector as a whole has markedly improved since the beginning of 2016, when bonds had negative yields, and there was widespread concern about the risk of a global economic slowdown.

“That all changed around July, when the Bank of Japan effectively put a floor on bond yields when it announced it was targeting 0 per cent on 10-year bonds,” says Lowcock. “Rising yield curves are good for banks because they get a better return on their suite of products.”

Further impetus was provided by the Trumpflation trade, which has encouraged investors that economic growth will rise. It has been of particular benefit to bank stocks, which tend to perform well as the economy is growing in the latter stages of the economic cycle. With the post-Brexit economic outlook improving, fears of a recession have subsided, with banks benefitting from robust consumer spending and demand for mortgages.

Low interest rates continue to tether bank profits. The Bank of England cut the benchmark rate to a record 0.25 per cent in the summer and it is unclear when it will decide to either raise or lower them again. The domestically-focused Lloyds, which has a large share of the UK’s mortgage market, would be the most likely to benefit when an interest rate rise comes, though it could also be hit by any significant pick-up in inflation.

Read more: How to protect your portfolio from inflation's rising tide

HSBC, which is more exposed to the US market, is likely to do well in the meantime, with three rate hikes expected from the Federal Reserve this year.

“More than almost any industry, banking is a scale game,” says Alex Wright, manager of the Fidelity Special Situations fund. He thinks that market share is closely tied to a bank’s performance.

“Lloyds has a 25 per cent market share across most lines in personal and business banking in the UK. HSBC and the US-listed Citigroup are dominant in mid-market business transactions given their unique global footprint, which other banks find difficult to replicate,” Wright adds. Lloyds is the largest UK bank holding in his fund. “Lloyds currently trades on around 10.5 times earnings, and its dividend is expected to grow quite a lot from last year’s 3.5 per cent level. At today’s level of interest rates, those are attractive."

Bailout beneficiaries

Annual results will be announced by HSBC, Lloyds, Barclays and RBS next week, with analysts anticipating that Lloyds and RBS, which both received government bailouts, will have continued on very different trajectories.

Lloyds is expected to have tripled its net profits, while RBS is expected to announce a further £2bn in losses. The government has been selling off its stake in Lloyds, and now owns less than 5 per cent, while its holding in RBS is still a massive 72 per cent. Earlier this month, Lloyds announced that it would be paying its staff more in bonuses than RBS, despite having a far smaller investment banking operation.

RBS's pains show little sign of easing. Its share price rose by 0.9 per cent yesterday on reports that it will continue to slash its way to profitability, though it is unclear how sustainable such a strategy is. "The bank has already cut costs at a rate of roughly £1bn a year for the last three, and shed around a third of posts since 2013," pointed out Neil Wilson, senior market analyst at ETX Capital, though Deutsche Bank, he noted, has upgraded its outlook on RBS from "sell" to "hold".

But between the bumper fines, the extra £2bn it needs to meet the Bank of England's capital requirements, and the European Commission's order for it to offload its Williams & Glyn consumer banking unit, RBS's fortunes look unlikely to go the way of Lloyds any time soon.

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