Having underperformed in 2022, US banks have had another disappointing year, and while last year’s decline was driven more by a pullback after the strong buyback and shareholder payouts of 2021, this year’s weakness was due to concerns over systemic weakness in the wider banking sector.
UK banks have also had a disappointing year, which isn’t altogether that surprising given low expectations that we had entering 2023. We already knew heading into the year rising interest rates are good for bank margins, however the flip side of the coin was that firstly demand for loans and mortgages was likely to slow, and then on top of that competition for savings was also likely to act as a drag on margins.
There was also the fact that banks were expected to come under political scrutiny when it comes to their savings rates at a time when consumers were starting to feel the pinch from the rising cost of living. At the start of this year mortgage approvals were at levels last seen in June 2020 at 40,000, in the aftermath of the LDI bond market turmoil that took place in October 2022. We managed to see a modest recovery during the first part of the year rising to a high of 54,600 in June, however since then we’ve seen a sharp slowdown as demand for houses slides in the shadow of soaring mortgage rates.
The banks themselves also started to batten down the hatches, setting aside funds in respect of loan loss provisions, as the air started to come out of the housing market and valuations fell. The Bank of England was also excessively downbeat, saying it expected the UK to enter a two-year recession, which raised a few eyebrows given that they are rarely right about anything when it comes to their forecasting, a bit like the OBR.
European banks on the other hand have done much better, however that probably isn’t as surprising as it sounds given that over the past decade, they’ve had to undergo significantly more difficult trading conditions, in the form of negative rates, as they looked to repair their balance sheets in the wake of the eurozone debt crisis.
Comparison: UK, US, and EU banks' baskets
Source: CMC Markets
While European banks started to reap the benefits of the return to positive interest rates, US banks continued to come under pressure, only this year the weakness had less to do with an unwinding of the outperformance of 2021 and more to do with concern over systemic weakness in the US regional banking sector.
This bleeding started in March as shown in the graph above and signalled a global sell-off in banking shares in general after the collapse of Silicon Valley Bank due to a combination of exposure to rising interest rates due to over exposure in US long dated treasury bonds, and an over concentration of customer deposits in the tech sector, which was heavily exposed to sharp rises in interest rates.
This combination of factors prompted the bank to sell some of its Treasury holdings at a loss, which spooked some of its customer base prompting a run on the bank, which in turn prompted further sales to pay out those clients. This created a domino effect on similarly exposed banks as Silvergate and Signature Bank also came under pressure from capital outflows, before subsequently failing, with the depositors having to be rescued by a combination of the FDIC, Federal Reserve and a $30bn lifeline from other US banks led by JPMorgan Chase.
In the wake of that First Republic Bank also came under pressure and had to be rescued by JPMorgan Chase, while HSBC took over the UK business of SVB.
The various measures taken by the FDIC, Federal Reserve and the big US banks served to stabilise the US regional banking sector, however despite these rescues there remains some concern over the sector’s exposure to commercial real estate at a time when the US economy could be heading for a slowdown.
The crisis also precipitated a bailout in Europe with the collapse of Credit Suisse and its rescue by UBS for the sum of $3.2bn in an all-share deal that also included extensive Swiss government and SNB guarantees. The wiping out of the AT1 bond holders also created ripples across the entire sector as bond holders across Europe lightened their exposure in that area of the market.
Putting to one side the early year volatility which saw a big sell-off in the sector, we’ve also seen a further slowdown in M&A, SPACs and IPO’s which were very much a feature of 2021 and slowed in 2022 and showed little sign of picking up in 2023.
Investment banking revenues which were also a key factor in the rebound in bank share prices in 2021 have also been subdued with the early year volatility giving way to pockets of low volatility and subdued trading activity.
What has been notable is that despite the greater challenges facing the European economy, rising interest rates and no growth, European bank valuations have improved despite some of the various legacy issues that have faced Italian banks remaining unresolved.
UK banking headwinds
UK banks got off to a good start to the year after a solid 2022 which saw HSBC and Standard Chartered outperform, while NatWest shares managed to push up to their highest levels since May 2018 in early February. The main laggards have been Lloyds and Barclays, which struggled during 2022 and have continued to do so in 2023. The underperformance of Lloyds is even more surprising given that it continues to be more profitable than at any time in the last five years.
As for NatWest, the wheels have come off in spectacular fashion this year in a manner that is entirely self-inflicted, with questions being asked over its governance after CEO Alison Rose was forced to step down for leaking personal information about the account of Nigel Farage to a BBC journalist.
UK banks' performance year-to-date
Source: CMC Markets
As can be seen from the chart above, the best performers have been HSBC, followed by Standard Chartered, while the more domestically-focused banks of Lloyds Banking Group and Barclays have struggled. NatWest Group, on the other hand has had a shocker, being by far the worst performer of them all.
After a solid performance during 2021, followed by a decent 2022, NatWest shares got off to a solid start to the year with the shares getting to within touching distance of their best levels since May 2018, as optimism grew that the bank was on a sustainable turnaround path.
A lot of this was down to the hard work of CEO Alison Rose who had been doing a decent job of giving the bank a makeover and polishing up the paintwork; with the bank posting its best set of full year numbers since the financial crisis at the start of 2022.
Sadly, the makeover appeared to have only been skin deep and while there was little likelihood that the bank would be able to match its results from 2021, at least management gave the perception of a high level of competence.
This perception imploded in the wake of the treatment of Nigel Farage and his banking arrangements which gave the appearance of being motivated more by his politics than his finances, sending the shares to their lowest levels since February 2021, and the worst performer this year.
While the focus should have been on its banking business when the bank published its Q3 numbers it was also hard to escape the perception that the bank was also performing a damage limitation exercise on the way it treats its customers, although the rot in the share price started slightly before Q3.
This began in Q2 when NatWest downgraded its full year guidance even as attributable profits to shareholders came in at just over £1bn pushing H1 profits up to £2.3bn. Net interest margin slipped back in Q2 to 3.13%, from 3.27% in Q1, with the bank cutting its full year forecast to 3.15% from 3.2%.
Things didn’t improve in Q3 either with another downgrade to NIM to 2.94%, with the bank downgrading its full year forecasts from 3.15% to just above 3%, which is a sizeable downgrade from where we were in Q1, although this shouldn’t have come as too much of a surprise given that at the time NIM was being priced on a UK base rate of 5.5%, with the new forecasts now based on the new rate of 5.25%.
Sadly, this isn’t the only problem facing NatWest given the fallout from CEO Alison Rose’s departure when it was revealed she was the source of a leak over the details of the bank’s relationship with Nigel Farage. From a reputational standpoint this is hugely damaging, and even accounting for the increased competition for customer deposits the revelations of unprofessionalism amongst its staff could prompt some customers to take their business elsewhere.
On profits the bank reported profit after tax of £924m, pushing profits year to date up to £3.3bn. On impairments the bank set aside another £229m, pushing the total for the year to £452m. As far as the wider business is concerned net loans rose by £1.8bn to £354.5bn, while customer deposits also increased by £2.4bn to £423.5bn, however this appears to have been achieved at the expense of a fall in NIM.
On the topic of departing CEO Alison Rose remuneration, the bank said that a decision on that would be made as soon as possible with the likelihood she would have to forego her unvested share rewards. The bank also revealed some of the findings of the Travers Smith independent reviews covering the decision to close the account of Nigel Farage, as well as the conduct of Alison Rose, and while the report said that the decision to close the accounts was lawful, it still doesn’t make for comfortable reading for NatWest or Coutts.
The report highlighted several potential regulatory breaches, in the governance, systems and controls, all of which are now being reviewed by the FCA. On the conduct of Alison Rose the report said that her disclosures “probably” amounted to a Personal Data Breach for the purposes of GDPR, as well as a possible regulatory breach by members of NatWest Group, although it added this was a matter for the regulator.
Barclays had a shocker last year, and this year has been little better, despite getting off to a solid start to 2023 along with the rest of the sector.
In 2022 the banks governance was called into question after it was revealed that the bank was facing a multimillion US dollar hit, and a regulatory investigation over some of its trading products in the US, at a time when current CEO Venkat oversaw the banks risk environment. The mistake appears to have come about after it was realised that the bank sold nearly £28bn of exchange traded notes that track commodity prices over a three-year period and only registered £16bn of them with the SEC.
When the bank reported in October its Q3 results only served to deepen the gloom further with the shares sliding to 6-month lows, and close to the lows in March, after Q3 revenues came in at £6.26bn which was slightly below expectations.
Key among the reason was its corporate and investment banking arm delivering a 6% decline in revenue to £3.08bn. Profits before tax also came in lower at £1.89bn, with the bank setting aside £433m in respect of impairment charges.
Like its US counterparts the equities division managed to put in a solid quarter, with revenues of £675m, however FICC underperformed expectations with £1.15bn.
When Barclays reported in Q2 their expectations for net interest margin were for a number in the region of 3.15%. This came in line with expectations, however Barclays said that this was expected to slow to between 3.05% and 3.1% for the full year, suggesting that we could well be at the high point of the margin cycle, with the bank suggesting the scope for cost cuts by year end.
In a sign of further weak demand for the UK economy, the fall in customer deposits, which fell to £243.2bn either suggests that customers are cutting into their savings, or going elsewhere, while whole loans remained steady at £205bn.
Lloyds Banking Group
Lloyds Banking Group shares slipped to one-year lows in the aftermath of their Q3 numbers, which on the face of it weren’t particularly bad, however sentiment around the UK banking sector as well as the problems being faced by NatWest don’t provide a particularly constructive backdrop.
On the numbers themselves there is plenty to be positive about even as the shares languish well below their peaks of this year at 54p. October’s Q3 trading statement saw the bank report statutory profit before tax of £1.86bn, a sizeable improvement on last year’s £576m, pushing year to date profits up to £5.73bn.
Underlying net interest income rose 1% to £3.44bn with net interest margin coming in as expected at 3.08%, up 10bps from a year ago, but down from 3.14% in Q2. For the year-to-date underlying net interest income is up 10% to £10.45bn. Impairments came in below forecasts at £187m, a sharp drop from the £668m the bank set aside in the same quarter last year. This pushed total impairments for the year up to £849m.
It has been notable from most UK banks that we’ve seen customer deposits decline, over the year, and this continued in Q3 for Lloyds and a 3% fall from the same quarter last year, to £470.3bn, although most of that appears to have come about at the end of last year, given that the figure at the end of 2022 was £475.3bn. It would therefore appear that the outflow has slowed in the last 9 months, while we saw a modest pickup in Q3.
Loans and advances to customers have also slowed, falling to £452.1bn, although there was a modest pickup in Q3, while lending to small and medium businesses also slowed. Despite the gradual slowdown in NIM over the last 3 quarters Lloyds maintained its full year guidance of NIM of 3.1%. Despite maintaining its guidance here, unlike Barclays, the shares struggled to rebound from their October lows, probably on the basis that we’ve hit peak NIM, and that the line of least resistance is down. This appears to be borne out in the quarterly numbers for NIM, 3.22% in Q1, 3.14% in Q2 and 3.08% in Q3. Operating costs in Q3 remained steady at £2.24bn, the same as in Q2, with full year guidance of £9.1bn maintained.
HSBC has been notable by managing to outperform its peers this year, helped in some part by the reopening of the Chinese economy at the end of last year, while it also stepped into save the UK operations of Silicon Valley Bank.
In the wake of their Q2 and H1 results the shares popped above 660p and a 4-year high before slipping back to their current levels on concern over the resilience of the Chinese economy, as well as the banks’ exposure to the struggling property sector.
When the bank reported in Q2, pre-tax profits came in at $8.8bn, on the back of a 36% increase in revenues to $16.7bn, driven by a strong performance in both commercial banking, as well as in wealth services.
The bank also set aside a further $0.5bn in respect of non-performing loans. In a sign that higher interest rates are influencing loan demand, customer lending decreased by $9bn in Q2, with $6bn of that coming from the UK bank.
Customer account balances in Europe also fell by about $13bn, while net interest margin improved to 1.72%. On guidance HSBC raised their outlook for annual net interest income to above $35bn.
Like its peers the bank saw a slowdown in NIM although Q3 profits before tax rose to $7.7bn, a sizeable increase on the same period a year ago, however the numbers last year were depressed by a $2.3bn impairment related to the sale of its French operations.
The profits compared to the previous quarter were $1.1bn lower, and missed expectations, while revenue increased to $16.2bn. NIM came in at 1.7%, down slightly from Q2, but 19bps higher from the same period a year ago.
Impairments or ECL’s rose by $1.1bn during the quarter, with $500m of that related to the Chinese property sector, with HSBC claiming that the problems in this area of the economy could be near a bottom, although any recovery could well take a while. There was a big drop in net loans and customers of $23.8bn, while the balances in customer accounts fell by $32.6bn over the quarter and were also lower than the same period last year.
The UK bank performed well with $1.78bn in profits, up from $1.66bn in Q2, as the integration of SVB UK continues apace.
When it reported back in Q2 HSBC said it expected to see annual net interest income of $35bn, and appears to be on course for that, with a year-to-date NII of $27.5bn.
The bank also added another $3bn to its share buyback program for the year, bringing total buybacks year to date to $7bn, as well as announcing a dividend of 10c a share.
One other area of concern was a 5% increase in costs which was higher than an expected 3% increase, with the bank saying that they hoped to be able to reduce this to a 4% increase by year end. The bank has continued to focus on its Asia business, buying Citigroup’s retail wealth management portfolio in October and adding another $3.6bn in assets in that area.
Banks' resilience faces key test in 2024
The last 12 months have seen mixed fortunes for the UK banking sector with the reopening of the Chinese economy helping the likes of HSBC and Standard Chartered while the overarching pessimism over the UK economy has hurt the fortunes of Barclays, Lloyds and NatWest, although a lot of NatWest’s problems have been self-inflicted by incompetent management, who should have been focussing on the business, and not indulging in politically correct nonsense.
Not for nothing did we see the NatWest share slide to 2-year lows, although we have seen a modest recovery since then as new CEO Paul Thwaite looks to draw a line under the fallout from Alison Rose departure, although the slate won’t be wiped completely clean until Chairman Howard Davies has departed to be replaced by Richard Haythornwaite in April 2024.
As for Lloyds Banking Group the underperformance here continues to surprise given the resilience we’ve seen in the bank’s profitability, and the fact that unlike its peers it has thus far managed to avoid the negative headlines that have to some extent dogged its peers.
Looking ahead to 2024, the main challenges for the sector will be an increase in mortgage arrears as the various interest rate increases continue to bite on consumer finances.
A lot of householders will continue to see their fixed rate deals expire over the course of the next 6-12 months and while we appear to have seen the top in the interest rate cycle that doesn’t mean that budgets won’t feel the squeeze when these deals rollover and are refinanced at higher rates.
Nationwide has already reported that it is seeing an increase in arrears, and while the number appears manageable for now that number is only likely to increase even as gilt yields continue to drift down from the highs of the year.
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