UK bank stocks are attractive but precarious

COMPARED to some of the financial institutions in continental Europe, Britain’s banks, even the part-nationalised ones, are managing to exude an air of respectability and even strength.

While French and German financial institutions – banks and insurers – are estimated by Barclays Capital to hold just under €80bn of Greek debt, British banks have minimal exposure in comparison.

RBS says it holds only £1.5bn of Greek debt and £1.4bn of Portuguese government bonds, HSBC reports having €1.5bn of exposure to Greek debt, Barclays has just £200m of exposure to Greek government debt and Lloyds Banking Group has said that its exposure to both Greece and Portugal is not material.

Although they have limited exposure to the debt of the Club Med countries, the share prices of UK banks have still been hit by the ongoing sovereign debt crisis and the fear that it could spread throughout the still-fragile banking sector.

The FTSE 350 Banks index has fallen some 12 per cent since the end of April. In terms of the individual banks, RBS has been the most resilient with its share price only down 5.3 per cent since mid-April compared to an 18.3 per cent drop in Lloyds’ share price. The stronger banks, HSBC and Barclays, have lost 11 per cent and 26 per cent respectively.

Indeed, bank share prices have fallen so much that some analysts are starting to think that this represents an ideal buying opportunity. And if you are an investor with nerves of steel, yesterday’s closing share prices of 55.89p and 45.14p for Lloyds and RBS certainly appear attractive.

Some analysts are becoming more positive on the two banks. For example, Standard & Poor’s credit analyst Nigel Greenwood last week raised his rating on the two banks’ core UK bank subsidiaries to BBB+ from BBB because he believes that they have had a promising start to their turnaround plans.

“Although we consider that Lloyds and RBS Group have much more to achieve and that the external environment continues to pose challenges, they have in our view laid the foundations to improve their performance and further strengthen their balance sheets,” he said.

Lloyds was particularly upbeat in its trading update at the end of April when it raised its profit outlook for 2010 and said it expected to be in profit both at the time of its first half and full-year results. This was ahead of analysts’ expectations and has added to the optimism that surrounds the fundamentals of the stock.

Greenwood was not the only analyst to raise his rating on Lloyds and RBS last week – Credit Suisse’s banking analysts Jonathan Pierce and Robert Self raised Lloyds, Barclays and RBS to outperform – all three are trading below their tangible net asset values (TNAV) at the moment. “We don’t see TNAV as a floor for share prices but we are comfortable on the ability of the balance sheet to withstand further dislocation in markets and impairment charges,” they say. And, happily, the three banks’ reliance on short-term funding has been going down, say Pierce and Self.

But while the outlook for these banks is looking better, there are still plenty of downside risks that could shake the share price.

First, a full-blown banking crisis in Europe is unlikely to leave the UK banks unscathed. Second, unless the new coalition government takes credible steps to bring the budget deficit under control at the emergency Budget later this month, the UK’s AAA rating could be under pressure. A downgrade would not only scare investors in UK equities, it would also raise debt-servicing costs and make it much harder for financial institutions to raise money in the capital markets.

As a result, investors looking to take advantage of the banks’ current low share prices should consider investment products that protect them from the downside such as covered warrants. With these products you know from the outset exactly how much you could lose if the market moves against you. In a volatile stock where there is plenty of downside risk, this is ideal for the risk averse investor.

What’s more, because they are effectively options packaged up for individual trader, you can bet on a bank’s share price that will rise over a certain period of time by choosing a strike price and expiry date that suits you.

It might be a risky bet but the UK banks could provide sufficient upside for you to end up in the money.