UK banks might look cheap, but pick carefully

UK BANKING stocks rallied last week after the announcement of the Basel III banking reforms. But although the sector has avoided further bank-bashing, much of the detail has yet to emerge and a jumpy market should make for fruitful autumn trading.

New capital ratio requirements made most of the Basel III headlines, with Tier 1 capital ratio requirements rising from 4 per cent to 6 per cent, to be phased in over the next five years. The changes prompted S&P Equity Research to declare: “The European bank sector is heading to a new landscape of lower return on equity.”

But although the relatively lenient timeframe – and the fact that most UK banks already hold capital to these levels or plan to do so – triggered a rally in banking stocks, some of those gains disappeared as the fine print revealed that a change in the definition of the risk-weighted assets (RWA) to which these requirements would apply could make them 30 per cent tougher than they appeared. Both Lloyds Banking Group and Barclays stocks dived 3.5 per cent since the Basel announcement.

This demonstrates that despite the sector’s progress in confronting widespread credit problems and the fact that most UK banks will not actually have to alter their plans in response to Basel, the markets remain sensitive. The full details of the measures have yet to emerge, with vital information – such as the definition of a RWA and therefore the effective change in capital ratio requirements – still undecided until the new rules are presented to a formal meeting of the G7 nations in November. This gives contracts for difference (CFD) traders plenty of leeway to trade on movements as news emerges.

But despite the focus on regulatory shenanigans, traders should still consider the fundamentals. Many analysts still see UK bank shares as offering some of the best deals in Europe over the medium-term. Evolution Securities places Lloyds, RBS and Standard Chartered among its top five picks of European banking equities. Evolution’s Arturo de Frias says: “There’s very little revenue growth across Europe and funding costs are going up. Standard Chartered is one of the few examples of double-digit revenue growth, while both RBS and Lloyds are examples of good value.” Frias is anticipating equity returns of around 14-15 per cent on Lloyds over the next two-to-three years.

Killik & Co’s Jonathan Jackson also puts Lloyds on his “buy” list, citing its cost efficiency drive (currently on-target) as having the potential to make it “one of the most efficient banks in Europe”. Although loans to retail mortgage-holders still dominate its lending profile – at 57 per cent of the bank’s loans – impairments are on a steady downward trend and the government’s 41 per cent stake compares favourably to RBS’s 84 per cent state ownership. In contrast to Frias, Jackson therefore recommends selling RBS shares: aside from the inevitability of a government sell-off at some point, he highlights that the bank still needs to offload many of its toxic assets.

So despite the sector’s progress towards properly pricing risk (as in the widening spreads on low-deposit mortgages – see chart), continuing wobbles in the UK property market coupled with the possibility of further regulation, whether from Basel or potential lending requirements in the UK, make banking stocks an uncertain proposition. With part-state-owned banks not even paying dividends until 2012, traders should be sure that the stocks’ seemingly attractive valuations truly reflect the risk.

FOCUS | STANDARD CHARTERED

Standard Chartered has seen one of the steepest share price rises compared to its peers in the UK banking sector.

Its stock has risen 14.4 per cent over the last month, catching a swell of optimistic sentiment about the sector given many banks’ low valuations. Standard – which avoided being bailed out through government equity buy-in – has continued to expand its operations abroad, avoiding some of the risks associated with its more UK-centric peers.
Overall profit before taxation in the first half of 2010 came to $3.1bn, up 9.8 per cent on the same six months of last year, with consumer banking in Asia Pacific generating an impressive 75.5 per cent rise in net profit. Markets value the stock highly, as demonstrated by a price-to-earnings ratio of 17.63 times.