The past 12 months have seen UK banks start to show signs of a turnaround in sentiment as the majority attempt to put previous mistakes behind them.

For quite some time 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.

Even though 2016 initially turned out to be a familiar story, despite enough evidence that a change in sentiment was starting to take hold, there is still a significant divergence between the better performers and the underperformers.

There is no better indicator of this change in fortunes than the performance in the FTSE 350 banking index, which at one stage last year looked to be on course to retest levels last seen at the height of the financial crisis. The turning point turned out to be, ironically, the aftermath of the summer Brexit vote, when the sector rebounded from the 2,820 level.

Since then the banking sector has embarked on a slow, measured rebound as it looks to close in on levels last seen in the summer of 2015, but there does remain some concern as to how the sector will do once the process of the triggering of Article 50 takes place.

For now the sector has been able to shrug off a lot of the concerns about what a “Brexit” might do to their business models, in the expectation that pragmatism will win out over political posturing. While that remains a big ask, the fact is politicians have rarely been possessed of good sense when it comes to financial markets.

The admission by Bank of England governor Mark Carney that a messy divorce from the EU will be risky for the EU’s financial system, appears to have been lost in translation by some central bankers and politicians in Europe.

Whatever Mr Carney’s motives, if the EU thinks that there aren’t significant systemic risks given the fragility of its banking system then they are surely in complete denial. The amount of non- or under-performing loans in the European banking system amounts to billions of euros, with Italy’s banks holding the largest amount at €350bn, French banks, around €170bn and Spanish banks €130bn.

At the beginning of 2016, the banking sector was under immense pressure as a result of 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 all the above factors, commodity prices appear to have bottomed out, mitigating concerns about massive bankruptcies in the basic resource sector, while inflation expectations continue to rise, along with a steepening yield curve, which has raised 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, for Italy’s banks in particular, and while we’ve finally got clarity on the level of the US Department of Justice fine for Deutsche Bank, Royal Bank of Scotland still has to settle its own case. This is likely to continue to be a concern now that the US has a new president, though Mr Trump’s distaste for Dodd-Frank could be 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.

The UK economy continues to hold up well despite disaster being predicted in the aftermath of the Brexit vote; however, 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%.

The continued improvement in the UK economy has also helped in a significant reduction in the amount of non-performing loans on the respective banks' loan books, and this has helped boost profits as bad loan valuations decline.

It is no surprise that the best performers have been Asia-focused HSBC and Standard Chartered, though it should be caveated that the outperformance of Standard Chartered is more down to the fact that it had a shocking three-year period from 2013 to 2016, losing over half its market cap as the share price declined from peaks near 1,700p to lows below 400p.

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 share price performance of HSBC has been similarly positive, the bank still saw its profits fall 86% in the third quarter as a result of losses from the sales of its Brazilian business, while the low yield environment, and turmoil in Chinese markets at the beginning of last year didn’t help its cause.

The financial environment has been slightly better since then with the election of Donald Trump as US President as well as the emergence of rising inflationary pressure which has seen the yield curve take off and volatility increase, and the upcoming full year numbers need to reflect that.

US banks have shown the way forward here with improved performance in their fixed income and investment banking business, and HSBC will be expected to replicate this.  

Investors will also be looking for an update about who will replace Chairman Douglas Flint and CEO Stuart Gulliver who are both due to step down later this year.

In the Brexit vote aftermath and the sharp drop in the share price Lloyds Banking Group announced a further 1,300 job cuts as the management continued the 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 below 5%, and while there was some disappointment about the lack of a discounted share offer the government appears to be on course to recoup most of the money used to bail out the bank.

The shares haven’t quite recovered their post Brexit peaks despite the resilience of the UK economy but the outlook still remains positive when compared to say Royal Bank of Scotland which continues to take two steps forward and three steps back. The bank recently announced the purchase of the MBNA credit card business for £1.9bn boosting its position in the UK credit card market to 26% as it looks to take on Barclaycard.   

The only cloud on the horizon remains legacy issues with the risk of further exposure to litigation claims as a result of the HBOS fraud scandal, where two HBOS executives were jailed for defrauding business clients, and we may see some provision made for that.

Lloyds currently has a dividend yield of over 3.4%, with a dividend cover of 3.8% and while there remains uncertainty with respect to some of its legacy issues the 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 problem child of the UK banking sector, and remains the worst performer in the UK banking sector.

Last year the UK government wrote down the value of its stake in the beleaguered bank last year to £14.8bn, acknowledging the fact that the UK taxpayer will never get its money back, on the over £50bn worth of losses seen so far. That sale of £2.1bn worth of shares by the government at 330p a share way back in August 2015 seems a long time ago now.

Reports of further job losses have been doing the rounds recently as the bank looks to invest heavily in its IT systems against a backdrop of another loss for the fiscal year 2016. Expectations are for a loss of £2.3bn, a ninth consecutive year of losses.

Since its peak in 2007 RBS has cut over 145,000 jobs bringing the headcount down to around 80,000.

The bank still needs to decide what to do with its 314 Williams and Glyn branches which it was informed it had to sell as a result of its 2008 bailout, but it has saved at least £50m a month as a result of stopping work on this, as it still needs to focus on a number of other 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. Management set aside another £3.1bn provision in January in respect of this.

While Deutsche Bank has settled its dispute for $7.2bn and hogged the headlines last year, and could well continue to do so this year given Europe’s basket case banking system, RBS is also likely to face a similarly eye watering fine, in the region of a similar amount.

Putting to one side this settlement RBS may also have to factor 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.

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

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

At its last trading update in October there was a decent performance from its fixed income business in Q3 as a result of post Brexit volatility returning £1.4bn, which helped boost its international operations.

Since then we’ve seen further volatility which should augur well for Q4, 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 last 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.

Conclusion

There are some early signs that sentiment around the UK banking sector may be turning around, however the more domestically focused 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 it particularly difficult to ease monetary policy further in the coming months. The rebound in commodity prices is also welcome, removing some of the earlier concerns last year about UK bank exposure to the oil and gas sector, which was in the region of $15bn, with the recovery back above the $50 a barrel level mitigating a lot of those concerns.  

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

 

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