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Brexit blues for UK banks

Earlier this year UK banks were showing some encouraging signs of putting the past behind them with respect to provisions for past misdeeds, though once again the biggest causes for concern were declines in profits as a result of the new lower for longer interest rate environment.

These concerns have been exacerbated in recent weeks with the outcome of the June “Brexit” vote and the slide in UK gilt yields to record lows, though at least here in the UK yields are still largely in positive territory.

This month’s numbers from US banks do appear to point to a pickup in profitability, particularly on the back of better than expected trading activity in terms of bond trading as well as loan growth, on a slowly improving US economy.

As far as UK banks are concerned as they look ahead to the end of H1 there is little optimism that they can repeat the performance of their US counterparts, particularly since the share prices of all of them have fallen sharply in the wake of the June referendum vote with Lloyds Banking Group being hit particularly hard as a result of its more domestic focus.

At the end of its first quarter, three months ago Lloyds Banking Group reported a sharp drop in profits due to its decision to buy back £800m of bonds. Its net interest margin was still fairly healthy and would have continued but for the recent fall in gilt yields post Brexit, which will in all likelihood impact its future profitability.

This appears to have been borne about by this morning’s announcement of a further 3,000 job losses and 200 branch closures as the bank continues to push forward on its cost cutting drive, in an attempt to cut a further £400m off its cost base by the end of 2017.

Pre-tax profits, improved from the same period last year at £2.45bn, but more importantly its net interest margin actually improved from 2.74% from 2.62% a year ago. Given recent drops in yields in the wake of the Brexit vote the bank is likely to find the rest of the year challenging in this regard to maintain that ratio.

The bank announced a dividend of 0.85p per share and also reaffirmed its full year guidance, despite the expectation that we could see a base rate cut in the next week or so.

Even allowing for all of the Brexit concerns as we come to the end of the first half of the year the balance sheet is in probably the best shape relative to its peers and with the prospect of further government share sales off the table for the time being the downside should be fairly limited given a dividend cover of over 3.5 and a dividend yield of 4%.

The picture for Barclays shouldn’t be too dissimilar given that is also saw a similar drop in profits in the first quarter of this year dragged down by underperformance in divisions it plans to get rid of with plans to offload the Egyptian already in progress, on top of the recent decision to pare down its Africa stake.

In March the bank said it would split itself into two divisions, UK and International as it looks to restructure its operations in order to operate in a rapidly changing global banking environment, and while we in Q1 the investment bank produced some better than expected numbers the lower yield environment of recent weeks is likely to produce similar contractions in profit expectations, which are likely to be more pronounced given its larger international exposure.

Like Lloyds, Barclays has a decent dividend cover in excess of 2.5 with a dividend yield of 4.3%, though its profit expectations are for an increase in profits for the full year at £3.33bn on lower revenues of £20.2bn. Again here we should be looking for the lower rate environment impacting on its profits and revenue expectations, which in turn could well see the bank looking to cut costs further.

Royal Bank of Scotland continues to be the most vulnerable of all the UK banks as new CEO Ross McEwan looks to turn the bank around after years of losses.

Earlier this year the bank posted a Q1 loss of £968m, slightly higher than was expected largely as a result of a £1.1bn payment to the UK treasury in respect of a golden share agreement that gave the UK government first dibs on any dividend payments. On the plus side restructuring costs were slightly lower at £238m, and litigation costs were also down to £31m from £856m previously.

The block on dividend payments was put in as a pre-condition of the bailout agreement in 2008 that prevented RBS making pay-outs to shareholders before the government had been repaid.

Even so this isn’t the end of the banks troubles though the recent Brexit vote may mean it now won’t have to abide by the deadline of December 2017 to dispose of 300 of its Williams and Glyns branches.

The logistics of this process are proving more challenging than previously expected and are as a result of EU state aid rules that were the price of being able to implement the 2008 £45bn bailout.

It is estimated that the costs of this ongoing process are also acting as a drag on profits, with current costs already estimated at £1.5bn, though if it formalises the suspension of the sales process permanently it will probably save about £50m a month.

This will leave the bank more able to concentrate on the process of overhauling and streamlining its outdated and complex IT systems and draw a line under a number of recent high profile failures.

The underlying business has been performing quite well managing to post an operating profit of £421m in Q1 so a decent performance in Q2 could signal the start of some form of stability, though of course the main concerns are likely to be around the recent market volatility and low interest rate environment and the impact of that over the course of the next few months.

The big question is whether there is light at the end of the tunnel, and whether RBS has turned the corner, or whether the days of over promising and under delivering are set to continue.

Given the current regulatory environment and a continued era of low interest rates, anyone expecting a speedy turnaround is likely to be waiting a while; however with the shares already near their all-time lows expectations are already fairly low.

That being said the Bank of England could well also have a part to play when it meets for its latest meeting in early August. A further cut in interest rates could do further damage to UK banks profitability already under pressure from shrinking margins, not only here in the UK but also more globally. More importantly will the Bank of England heed the warning from RBS earlier this week that lower rates could well bring closer the day when banks charge customers for credit balances.

The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.