Ten years on, is the banking sector a wise investment?
It was 10 years ago this week that large queues of people started to form outside branches of Northern Rock, the first visible sign in the UK of the crisis that was to engulf markets over the coming months. Poor credit assessment by banks and sloppy regulation on both sides of the Atlantic led to the worst banking crisis since the depression – resulting in massive bailouts of financial institutions and global economic grief. Now, one decade later, how are banks shaping up from an investor’s point of view?
In the UK, the end of PPI payments is now in sight. The Government has returned Lloyds Banking Group to private hands, and dividends in the sector are already high and on the rise. So, can we now draw a line under the Great Financial Crisis and look forward to a confident and profitable future for UK banks?
Well, not exactly. Although substantial fines and compensation have already been paid, not all legacy issues are over. Barclays, RBS and HSBC have yet to settle with the US Department of Justice over the sale of mortgage-backed securities in the lead up to the credit crunch. The fines could easily be $3bn (£2.25bn) – and even as much as $10bn judging by those banks that have settled. This is a massive amount for Barclays and RBS, potentially wiping out one year’s dividend payments. It should be easier to swallow at HSBC, which appears to be the more attractive of the UK banks due to its significant operations elsewhere.
Bank profitability is probably never going to hit the heady heights of where it was before the financial crisis, mainly because of increased regulation. Before things started to deteriorate, banks could aspire to generate returns on shareholders’ equity of at least 15pc. But capital requirements following the crisis have more than doubled – and low interest rates have reduced profits from the banks’ own assets. UK banks are, in general, now targeting a lower return on equity of 10pc, which most have so far failed to meet.
Growth in loans has also plummeted, especially for mortgages. High house prices have reduced affordability for many younger customers, and banks have become wary of lending to higher-risk customers. Home loan growth has gone from mid-teens per year precrisis to around 2pc to 3pc now. Low interest rates – which are likely to be around for some time in the UK – also crimp banks’ profitability. Indeed, earnings growth is unlikely to become interesting until interest rates are raised substantially.
Lending to businesses has also been subdued. Some say this is because the banks are unnecessarily restrictive, while others say that businesses do not want to borrow because they do not want to expose themselves to funding risks. The only positive recent macro trend for the banks has been the rise in consumer credit, but, for most, this is a small part of their activities and can’t make up for declines elsewhere.
There are also competition issues that are likely to continue to drag. Regulators are keen to encourage challenger banks, with the focus of their attention on current accounts, mortgages and small business lending. One of the most interesting and innovative proposed remedies is the introduction of “open banking”. This would require UK banks, with their customers’ approval, to make customer data available to other financial companies who could then bid for the customers’ business. It is expected that knowledge of a customer’s credit history will improve competition in lending to those customers, especially to small and medium-sized enterprises.
UK-listed challenger banks such as Aldermore, Shawbrook, Metro Bank and Virgin Money have their own problems. The big banks have significant economies of scale and are much more able to cope with regulatory requirements than institutions with smaller balance sheets. This means that these smaller players are likely to be restricted to a narrow part of the market that is underserved by the major banks, which could result in riskier lending portfolios. If more competition is to be encouraged, then regulators may need to take a look at the impact of new rules on these up-and-coming lenders.
One under-discussed risk for banks is disruption from fintech companies. Banks are increasingly using digital processes to lower costs and interact with their customers, but digital expertise is not a traditional core skill of a UK bank and there is a suspicion that fintech companies will be better able to exploit the opportunities. Traditional banks are responding by using smartphones and digital technology to distribute and process business, but their focus is more on lowering costs than on radically changing the way business is done.
UK banks may give good dividend yields paid out of current profits, but investors should be wary that bank profitability could fall sharply if margins come under more pressure and loan losses start to pick up. This could put dividends at risk, and the investment also comes with an opportunity cost – as more money could potentially be made in other sectors. Indeed, US financials look more attractive as interest rates are likely to be raised sooner, loan books are growing, the economy appears to be in great shape and, following a recent period of dollar weakness, they are attractive in currency terms too. Investors seeking banking exposure may do better by heading west.
‘Investment in UK banks comes with an opportunity cost – as more money could potentially be made in other sectors’