After an uptick in fortunes in 2019, as concerns about Brexit and political uncertainty diminished, hopes were high that UK banks would make further progress in 2020.
The biggest risk to profitability in 2020 was always likely to be the prospect of more Brexit stalemate as well as another Bank of England rate cut, after two policymakers called for a 25bps rate cut at the last meeting of 2019.
Reasons for optimism
The removal of the previous few years’ political gridlock had also fostered optimism at the end of the decade that despite some evidence of a slowing economy, the continued resilience in wages and low unemployment would put the UK economy in a good place for a pickup in economic activity, heading into 2020.
There were plenty of reasons to be optimistic: tensions between the US and China had diminished due to the signing of a phase one trade deal, and the UK election had delivered a landslide majority, which consigned the most radical Labour party manifesto of recent years to the dustbin of history, while the latest economic data from China showed an economy that was starting to pick up speed.
Over in Europe, there had been significant divergence between the manufacturing and services sectors, for most of 2019, however as the year came to a close there was some optimism that this was starting to change for the better.
European banking sector concerns
Despite this optimism, there were lingering concerns about the resilience of the European banking sector, and any vulnerabilities that might come about as a consequence of a sharp downturn. It was still being widely acknowledged that European banks had some way to go to deal with the various legacy issues of non-performing loans, particularly in the weaker regions of Spain, Italy and Greece, where bad loans are a particularly thorny issue.
The problems of the European banking sector aren’t new; the region is overbanked, and needs to shrink or consolidate quite sharply, with investors having very little faith in the ability of the sector to address its underlying structural problems.
The hope was that while the European Central Bank could keep rates low and the financial system functional, the banks and EU regulators could come together and create a bad bank, or winding up mechanism for those banks that are being constrained by the toxicity of their balance sheets.
This was always going to be a tall order, even without the coronavirus pandemic, but now the problem in Europe is even more acute than it was a year ago, not that you’d know it from the way the European banking index has bounced back, after hitting a record low in March this year.
UK vs EU banking sector comparison chartSource: Bloomberg
In terms of overall performance, the European Banks index (green line) has outperformed its UK counterpart despite the problems in Europe, however that’s not as positive as it looks given that the sector traded at record low levels in March. The UK banking sector, on the other hand remains well above its record low levels of the 1980s.
UK banking headwinds
The UK banking sector has nonetheless underperformed this year, not only due to concerns about coronavirus and the amount of bad loans they might have to contend with in the coming months, but also a central bank that seems determined to hollow out its ability to generate income, with speculation about negative rates.
With concerns about a UK-EU trade fissure to deal with as well, it’s perhaps not surprising that we’ve seen much more weakness in the UK banking sector than we have in Europe. This is also borne out when we compare the respective EU and UK banking baskets
Not surprisingly the banking sector has had a dreadful year, not only here in the UK, but the US and Europe as well, however we are starting to reverse some of the worst losses, with the news of a Covid-19 vaccine helping to support the sector, as we head towards 2021.
UK, US & EU banks basket comparison chart
Source: CMC Markets
Looking at the chart above, we can see that the rollover in markets started just after new record highs were posted in the DAX and Stoxx 600 in mid-February, as it soon became apparent that what started out as what was thought to be a localised respiratory flu outbreak, was morphing into a full-blown global pandemic.
Once the sell-off started to gain traction, the banking sector bore the brunt as the prospect of economic lockdowns, and an economic collapse fuelled concerns about solvency, while regulators stepped in to force banks to suspend their dividends and buybacks in order to preserve capital and shore up their balance sheets.
It has been notable that HSBC’s share price has managed to ride out the turbulence this year better than most, not falling anywhere near as much, however its rebound has also been more muted, while Barclays’ share price has bounced back strongly.
UK banks’ share price performance chart
Source: CMC Markets
NatWest share price rebounds
Under the stewardship of new CEO Alison Rose, who took over from Ross McEwan, the rebadged NatWest Group (previously RBS) has had a baptism of fire. While Rose has done a good job of giving the bank a makeover and polished up the paintwork; unless you fix what’s under the bonnet, you’re still left with the same old banger underneath.
In September, the NatWest share price hit fresh record lows, but since then the shares have rebounded strongly, as the prospect of a resumption of dividends and a decent set of quarterly numbers showed that the pessimism priced into NatWest’s share price was probably a little overdone.
Investors’ main concern this year, of all years, has been the banking sector’s resilience with respect to non-performing loans, and it’s the UK and US who have had the most success in improving in this respect.
UK banks set aside billions
The biggest concern for UK investors, and which was arguably a big mistake on the part of UK policymakers, was forcing a lot of UK banks to curtail their trading operations in the wake of the financial crisis, in the mistaken belief that it was everyday so-called ‘casino’ investment banking that caused the crisis, rather than the financial jiggery-pokery of the packaging and repackaging of collateralised debt obligations (CDOs) of mortgages and other risky securities.
This has played out in the relative performance of the share prices of NatWest Group, Lloyds Banking Group, Barclays and HSBC, where we’ve also seen enormous provisions in respect of non-performing loans, and where Barclays and HSBC have proved to be the most resilient.
So far this year we’ve seen Lloyds Banking Group set aside £4.1bn in respect of bad loans, with an expectation that this will come in at the lower end of £4.5bn to £5.5bn by the end of this year. NatWest Group’s numbers painted a similar picture; having posted impairments of £801m in Q1, and an attributable profit of £288m, the bank posted Q2 impairments of over £2bn. NatWest said it expects full-year impairments of between £3.5bn and £4.5bn.
As for Barclays, they set aside a Q2 impairment charge of £1.6bn, on top of the £2.1bn it set aside in Q1, making a total of £3.7bn compared to £900m a year ago. In Q3, this was increased by another £608m, taking the total provision to £4.3bn. However, the bank was slightly more optimistic about the future, forecasting that provisions were likely to be much lower in the second half of the year.
While all three of these UK banks are acutely vulnerable to widespread consumer defaults, along with HSBC, at least HSBC and Barclays have other revenue streams from their investment bank and overseas operations. This has certainly helped Barclays, which has seen its investment division start to perform better-than-expected in recent quarters, which in turn has helped it in respect of any underperformance in its domestic retail operations.
As for HSBC, they set aside £5.3bn in the first-half in respect of non-performing loans, and said at the time that this could rise by another £5bn over the rest of the year, as it wrestles with its own restructuring plan, as well as walking a perilous tightrope between its China business, and its UK and US businesses. In its most recent Q3 numbers, HSBC posited a slightly more positive outlook, saying that loan losses could come in at the lower end of expectations for the full year, which is encouraging, however that also assumes no new deterioration in outlook as we head into winter. Given recent events and the direction of travel with respect to the virus, his view looks rather optimistic, which suggests that talk of dividends being resumed at the end of Q4 is rather premature, and could be blocked in any case by the Prudential Regulation Authority.
European banks unprepared for loan losses
As for European banks, their provision for non-performing loans has been pitiful, and while there does seem to be some early signs of consolidation, with the recent deal by Spain’s BBVA to sell off its US operation, its failure to come to an agreement with smaller counterpart Banco Sabadell for €2bn suggests there remains a long way to go to move forward with widespread consolidation, as well as preparing for the tsunami of loan losses that are about to hit the European banking sector next year.
BBVA has also been one of the few European banks to get out in front of potential loan losses by setting aside €4bn so far this year. The remainder of the sector appears to be much more complacent, with the likes of Santander, Société Générale, Deutsche Bank, ING and BNP Paribas appearing to set aside less than €20bn between them.
As if to underline some of the complacency over non-performing loans, Germany’s biggest bank, Deutsche Bank, has set aside a pitiful €761m this year in respect of loan defaults at a time when the German economy has just gone into a one-month partial lockdown, following on from the total lockdown in March and April. Let’s hope this complacency doesn’t come back to bite it hard.
We’ve also had the worrying prospect of Unicredit CEO Jean-Pierre Mustier being forced to step down over political pressure to absorb that perennial Italian basket case bank Monte dei Paschi, due to concerns over wider visibility of some of the problems sitting on its balance sheet. We've already seen the perils of forcing a resilent bank take on the liabilities of a weaker one here in the UK when Lloyds Banking Group was forced to swallow HBOS. Unicredit could well go the same way if forced into absorbing Monte dei Paschi.
A recent survey outlined the scale of the problem in Europe, with estimates that over half of Europe’s small and medium-sized businesses could face bankruptcy next year if revenues don’t pick up. One in five companies in Italy and France anticipate filing for bankruptcy within six months, according to a survey conducted by McKinsey and Co in August of 2,200 SMEs. Coming on top of the problems in the region already, this is likely to be a catastrophe unless EU leaders step up to the plate with a rescue plan.
Banks face uncertain outlook
It’s been an awful year for banks in general, with record lows in a lot of bank share prices here and in Europe. The outlook does appear to be more positive now with the prospect of a vaccine, however while the recent rebound in share prices is welcome, the banks are still likely to be in the front line as loan defaults and bankruptcies start to become apparent in 2021.
Europe remains a key pressure point and a lot will depend on the reaction function of EU policymakers, and their determination to restore confidence in a banking system that is sitting on a bed of nitroglycerine, to coin a phrase that was used in slightly different circumstances.
The rebound from September’s lows looks promising for banking in general, however the sector is likely to face further headwinds into 2021, as the global economy tries to lift itself out of what is likely to be an extended period of subdued recovery.