Every year since the financial crisis it’s been a familiar story for UK banks, as legacy issues, restructuring costs and a low interest rate environment have combined to shrink margins and weigh on profitability.

2016 initially turned out to be a familiar story though there does appear to be some signs that sentiment surrounding the banks may be starting to take a turn for the better.

For most of this year the FTSE 350 banking index looked to be on course to retest levels last seen at the height of the financial crisis, pushing below the 3,000 level and heading towards those 2009 lows below the 2,000 level, however sentiment around the sector started to show signs of turning rather ironically in the aftermath of the summer Brexit vote, rebounding from the 2,820 level.

Since then the banking sector has embarked on a slow measured rebound and could well finish the year in positive territory above the 4,000 level and close to levels last seen in September 2015.

Source: Bloomberg

The declines at the beginning of the year were primarily driven over concerns about a low interest rate environment, collapsing commodity prices, as well as the financial health of the European banking sector, particularly in Italy as well as Germany’s largest bank Deutsche Bank.

Of the above factors, commodity prices appear to have bottomed out, mitigating concerns about massive bankruptcies in the basic resource sector, while inflation expectations have started to rise, raising expectations that interest rate rises could be on the way, thus pushing yield differentials up and in so doing improving the prospects for bank profitability.

The solvency and profitability of the European banking sector remains the outstanding concern and Italy’s banks in particular, while the level of fines still in the pipeline for Deutsche Bank and Royal Bank of Scotland from the US Department of Justice remains an unresolved question. This is likely to continue to be a concern now that the US has a new President elect, though Mr Trump’s distaste for Dodd Frank could be an offset, if he is successful in rolling back some regulatory rules.

While the level of fines is likely to be an ongoing worry for a number of banks there is some evidence that we could finally be starting to see some light at the end of a very long tunnel, however future solvency and regulatory hurdles will continue to hamper the potential growth path as stress test scenarios become ever more onerous.

The recent stress test results from the Bank of England are a case in point where we saw Royal Bank of Scotland fail to pass them on pretty much every metric.

Source: CMC Markets

While we have seen a continued recovery in the UK economy in 2016, despite being told that a vote to leave the EU would result in an immediate recession, there are signs that we might hit a soft patch in 2017, as higher prices weigh on consumer spending.

What this continued resilience in the UK economy has done, along with a higher inflation outlook has started to feed through into a more positive performance for the UK banking sector, which in the last six months has started to turn higher, despite a further cut in the UK base rate in August to a new record low of 0.25%.

It is no surprise that this year’s best performers have been Asia focussed HSBC and Standard Chartered Bank, though it should be caveated that the outperformance of Standard Chartered is more down to the fact that it was the worst performer in 2015, finishing 38% lower on the year, and down 63% from its 2013 peaks, as the bank embarked on a long overdue restructuring program.

It would appear that the measures taken by new CEO Bill Winters in cutting the dividend in 2015, reducing headcount by 15,000, as well as announcing a $5bn rights issue has gone a long way to stabilising the banks position.

While the performance of HSBC has been slightly better, it still saw its profits fall 29% as a result of the low yield environment, and the turmoil in Chinese markets at the beginning of the year. It still also has to deal with its own share of misfortune setting aside provisions in respect of future potential legal issues. It does remain well ahead of the curve in terms of its cost cutting program than its immediate peer Standard Chartered.

Rising confidence in the resilience of the UK banking sector has certainly improved on where we were a few years ago as the continued improvement in the UK economy has helped in a significant reduction in the amount of non-performing loans on the respective banks loan books, which has helped boost profits as bad loan valuations decline.

In the Brexit vote aftermath Lloyds Banking Group announced a further 1,300 job cuts as the management continued their strategic overhaul of the business. In total the bank intends to cut 12,000 jobs by the end of next year as the bank looks to reposition itself into a more digital operation, and close more and more branches.

On the plus side the government continues to pare down its remaining stake in the bank, which is now at 7.9%, though there was some disappointment that there was no announcement of a discounted share offer to the general public. 

This belief was always likely to be wishful thinking given the weakness in the shares since June and so it has proved, but with the share price looking on course to reverse some of this year’s losses there is a good chance that even at current levels, just above 3 year lows it remains quite cheap.

With a dividend yield of over 4%, and the fact that the worst of its problems could well be behind it, while a rebound in gilt yields in spite of the August rate cut, can only help its net interest margin, (its ability to make a return in the current low interest rate environment), which in July showed an improvement to 2.74% from 2.62% in 2015.

Royal Bank of Scotland continues to be the ugly sister of the UK banking sector, with the UK government writing down the value of its stake in the beleaguered bank for the second time this year, down to £14.8bn, from £21.5bn in March due to the sharp decline in the share price since June.

That sale of £2.1bn worth of shares at 330p a share back in August 2015 seems a long time ago now.

While the bank has put on hold its plans to spin off its 314 Williams and Glyn branches which it was informed it had to sell as a result of its 2008 bailout, it has saved at least £50m a month as a result of this, it still faces a number of regulatory hurdles that it needs to overcome.

First of which is the investigation that it is still facing from the US Department of Justice over mortgage back securities mis-selling. While Deutsche Bank has hogged the headlines this year, and will likely continue to do so, RBS is also likely to face a similarly eye watering fine, in the region of $10bn.

RBS also needs to arrive at a settlement, and that’s before factoring in the controversy surrounding its corporate restructuring group, and its role in shuttering a raft of small businesses after 2008, which could involve further sanctions from UK regulators. The bank has managed to settle with a number of shareholder groups with respect to its 2008 rights issue, for £800m however it has still to settle with the remainder who are demanding up to £4bn in compensation.

The bank has yet to post an annual profit since being bailed out in 2008 with total losses in excess of £50bn already, and the likelihood is that we will see further provisions set aside in lieu of further litigation.

In recent quarters the underlying retail business has been doing ok, posting profits in every quarter this year, unfortunately the bank can’t escape the anchor of its legacy issues, and this is likely to cloud the outlook for investors and keep the prospect of a dividend a far off prospect.

Barclays Bank completes our look at the UK banking sector, and here it is also undergoing a significant restructuring program, while facing the same challenges as its peers.

At its last trading update in July there was a decent performance from its fixed income business and if the continued improvement in US banks profitability is any guide this is somewhere we could well see further gains, particularly if President elect Donald Trump succeeds in rolling back some of the more onerous Dodd Frank regulation that has affected US based banks in recent years.

New CEO Jes Staley appears to be on target to deliver the changes needed and will need to be given that he cut the dividend in half earlier this year, in an attempt to speed up the move away from its non-core operations, including the disposal of its Africa business and the loss of 13,600 jobs so far this year.

Conclusion

There are some early signs that sentiment around the UK banking sector may be turning around however the more domestically focussed banks still remain below their pre Brexit peaks despite the change in inflation expectations starting to mitigate some of the downside risk in respect of margin compression.

The rebound and steepening of the yield curve is a welcome development which also means that the Bank of England will find out particularly difficult to ease monetary policy further in the coming months.

The rebound in commodity prices is also a welcome development removing some of the earlier concerns this year about UK bank exposure to the oil and gas sector, which was in the region of $15bn, with the recovery back above the $40 a barrel level mitigating some of those concerns. 

The next risk events will continue to revolve around new litigation fines, increased regulation as well as new political risk associated with the various elections in Europe next year, and any potential fallout from the repair of the Italian banking sector. The eventual triggering of Article 50 could well trigger some short term uncertainty as well.

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