Last September, we were in the midst of probably the severest crisis the UK banking sector has ever seen. The casualties have included many banks and building societies including Northern Rock, Bradford and Bingley, Alliance and Leicester, HBOS and the Dunfermline Building Society amongst others.
So where are we now?
We have just seen the interim results from the UK banking names, which have been broadly greeted with a warm response. There is a new confidence in financial markets, both in credit and equities, resulting in credit spreads tightening substantially against government bonds and equity markets rallying. The paralysis in credit markets has been eased by a combination of a stabilisation in the economic downturn and the housing markets and the introduction of Quantitative Easing by the Bank of England.
The good news for the banking sector is that concerns over capital have disappeared... for now...helped by large rights issues and the introduction of the government's Asset Protection Scheme (in the case of Lloyds and Royal Bank of Scotland), which is designed to insure the banks against losses on their riskiest assets. Profitability is still difficult due to the low level of interest rates, low mortgage volumes and impairment, but asset pricing is improving to more normal levels after a period of excessively cheap credit.
There is also more clarity over valuation. Whilst you can look at the glass half full or half empty, it is at least now possible to assess a range of expectations. On the negative view, it is possible to try to assess what the trough tangible book value will be on a post impairment basis over the next 18 months in order to form a base case valuation. And on a more positive tack investors can begin to take a view on what normalised earnings will look like in (say) 2012 and how the market will value the banks on a PE or price to book basis. Clearly the forecasts are very subjective, but with increased confidence in the wider stock market, investors may be inclined to take a more positive view.
The recent domestic bank results can be split into 3 groups. The Asian Banks, Barclays and the quasi-government-owned banks.
The Asian banks (Standard Chartered and HSBC) produced good results. Concerns over capital have been addressed by equity raisings and the banks can move away from worries over capital and liquidity and onto the front foot in terms of growth. Asian GDP has held up better than the bears feared and both banks are satisfied that the worst of impairment is behind them so they can begin to focus on lending to customers. With strong loan to deposits ratios of c80%, both banks are well placed to take market share in any economic recovery.
Barclays' results highlighted the strength of investment banking over retail banking. Investment banking has undergone a surge in profitability as capacity has reduced in the sector and pricing has improved. The new issuance activity in credit and equity markets, combined with market volatility and a flood of liquidity being put into economies by central governments, has meant record profits for investment banking divisions at many banks including the likes of Barclays and Goldmans Sachs. The only question is one of sustainability into the second half of the year. With the bank trading at a modest premium to book value and a discount to its European peers, we are prepared to give it the benefit of the doubt.
The government-owned banks of Lloyds and Royal Bank of Scotland had contrasting statements. Lloyds Banking Group reported results poor underlying results but with an optimistic outlook statement. Net interest margins declined substantially and impairment was disappointing, but this was seen to be on an improving trend and the company feels confident enough about its book of loans to suggest that it may not even need the government's APS scheme.
By contrast, Royal Bank's results were downbeat. As with Lloyds, impairment was poor, the net interest margin fell and the profitability of the bank was dependent in the short term on the profits of the Global Banking and Markets division, which seemed to be on a declining trend quarter on quarter. The outlook statement was gloomy and was a harsh dose of reality which dampened some of the euphoria in the sector. Stephen Hester clearly thinks that recovery is still going to be a long haul.
The future remains uncertain. The economy may ‘double dip', causing further stress in terms of bad debts. We do not know how the banking market will look going forward in terms of regulation of capital, liquidity or remuneration. Will the government try to reduce its funding support for the banks sector at some point? We may not have seen the last of the capital raisings if Lloyds decides to pull out of the Asset Protection Scheme and regulation forces up capital requirements for banks. However, the extreme stress that the sector faced a year ago has abated.
