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Banks outperform despite a year of shame

CMC Markets

At the beginning of 2012 the main worries surrounding the UK banking sector where the effects of the Vickers report, Basel 3 requirements, and a further deterioration in the European sovereign debt crisis. We'd just seen the ECB launch the first of two LTRO's in an attempt to breathe some life and unlock the European banking credit channels. Unfortunately all these did was reinforce the negative feedback loop between banks and sovereigns as largely insolvent banks were forced to buy the bonds of their increasingly insolvent sovereigns. While I felt that we had probably seen the lows as far as share price valuations were concerned I felt that upside was probably going to remain fairly limited against a backdrop of a weak economic outlook and persistently sticky inflation. As it turns out after an initially rocky six months for the banks we have seen some stabilisation in share price values, but as far as news flow it has been a year of shame and a very bumpy road with lots of negative publicity as the banks bring their own annus horribilis to a close. Virtually every major bank worldwide has been caught up in a range of scandals from mis-selling PPI insurance, Libor rate manipulation, and money laundering and energy market manipulation, as banks fall foul of regulators at every turn. Even after all this the banking sector has had a fairly positive few months since August since the announcement by the ECB of the new OMT bond buying program, the Spanish banking bailout, and moves towards a European banking union which to all intents and purposes appears to have removed the short term risks of a messy disintegration of the euro, and collapse of the European banking system. Concerns remain around the sector though especially given the warning in November by the Bank of England in its Financial Stability report that UK banks face a potential £60bn black hole in 2013 as a result of further bad debt provisions, customer compensation and further regulatory fines. This could well see further asset disposals over the coming months as well as other capital raising measures including job losses and the paring back of investment banking activities. The sector started 2012 at 3,335 and is currently trading near 4,400, up over 30% and the highs for this year, however it still remains well below the highs of 2011. While the short term risks appear contained the outlook remains full of potential pitfalls with further regulatory fines in the pipeline for all four of the big UK banks as regulators dig through the activities of the past few years. This morning's findings of the UK parliamentary commission could also add an extra layer of uncertainty over a sector still reeling from the fall-out of this year's scandals. The report urges the government to put in place safeguards to ensure that banks don't try and circumvent the ring fence around the retail activities by putting in place a form of electrified partition which would give regulators the means to split up banks that are found in material breach of the rules. This report therefore increases the risk of the government coming under pressure to break up some of the larger banks, especially if we see further fines on large institutions over the Libor scandal in the wake of the recent fine on UBS and Royal Bank of Scotland negotiating another fine ahead of next year's quarterly results. Continued balance sheet rebuilding is likely to continue apace as banks wrestle with higher capital adequacy requirements, while facing pressures to lend by governments desperately trying to kick start their debt strapped economies. There also remains the risk of continued uncertainty in the euro area in 2013 which could see bank share prices remain choppy especially if economic conditions remain difficult, particularly in Spain and Italy. One thing seems certain given the tight funding problems set to face sovereigns as well as banks in 2012, it remains likely that financials will continue to remain volatile, with share prices remaining volatile, as Europe acts as a cloud, while a recovery in Asia is more likely to help HSBC and Standard Chartered than the others, further regulatory scandals notwithstanding. Royal Bank of ScotlandThe state owned bank has endured a turbulent year but nonetheless has managed to make some healthy gains in the wake of significant negative news flow, with the shares up over 50% on the year. The direction of travel with respect to its profitability continues to go in the right direction mis-selling costs not withstanding with hopes high that the bank will return to profitability in 2013. The bank will also be hoping to rebuild a new deal to sell the branches it was set to sell to Santander until the deal fell through a couple of months ago. Barclays A volatile year for the bank that has seen the departure of its Chairman, CEO and COO over a host of scandals including PPI mis-selling, Libor and other market manipulation, the shares opened the year around the 180p level and initially pushed to a high of 260p in March before crashing back to earth, with a bump in August to hit a low of 148p, before bouncing back strongly, and are once again approaching the March highs at 260p, despite concerns about further fines from US regulators over alleged energy market price manipulation . A move above 260p could well be the precursor to further gains towards the highs seen in 2011 above 330p but given the bank's exposure to Spain and Italy further shocks can't be ruled out in 2013, with a break below 235p potentially triggering further losses. HSBC Opening the year at 492p HSBC had, by and large navigated the worst of the financial crisis with some ease, however the bank fell foul of US regulators this year as it become implicated in a Mexican money laundering scandal that would ultimately cost it $1.9bn to settle US regulatory concerns. Given that the bank has also set aside £1.2bn to set aside PPI mis-selling claims and the possibility that banks globally may well have to settle further sums with overseas regulators for local infractions Trading just below its highest levels this year the share price still remains below its 2011 highs at 739p. The sustained up trend that has been in place since the end of July currently has support at the 620p level, and any pullbacks need to hold above this trend line for upward momentum to be sustained. Lloyds Banking GroupThe other government owned bank has also outperformed in the last few months as the situation in Europe has stabilised, after opening the year above 25.70p, its 2011 close. Like its UK peers the bank has continued to set aside provisions for PPI mis-selling and potentially other regulatory surprises. With the bank less exposed than its peers to the problems in Europe the potential for further upside remains much higher and has been reflected in the share price movement in the last few months, breaking above its March highs and hitting its highest levels since July 2011. The current uptrend should remain in place while trend line support from the August lows remains intact at 44.75p. Standard Chartered BankThe underperformer of the year in the UK banking sector, who would have thought that at the beginning of 2012, a large part of this can be put down this summer's broadside by the New York regulator on the bank accusing it of being a rogue institution. Since those sharp falls at the back end of the summer the share price has recovered somewhat and should remain well positioned for any recovery in its core Asia markets. It has struggled to recover its highest levels of this year, however if growth prospects continue to show signs of stabilisation we could see the share price recover back to these levels. The past twelve months has been an extremely positive one for the UK's banks and as long as economic conditions don't deteriorate much further in Europe and elsewhere then the share price performance over the past months could well be sustained. We have to add an enormous caveat though in that there remains a great deal of opaqueness with respect to the bad loans on the books of the banking sector in Europe. While the UK's banks have taken great strides in paring down their exposure to the peripheral economies in Europe the fact remains that Barclays in particular has some significant exposure to Spain and Italy, and further deterioration there could well impact on the quality of their loan book. The recent decision by Barclays to take a small stake in the Spanish bad bank also seems rather questionable given the continued deterioration in the Spanish banking sector and the rising nature of bad loans, now at 11.2%, a record high.