Is now the time to invest in banks?

The share price performance of the five UK-listed banks over the last three months has been exceptional. Most of their share prices have risen by more than 10%, and the strongest performer Lloyds rallied more than 40%. Please remember past performance is not an indicator of future performance.

It should be remembered that some of the share prices were starting from an extraordinarily low base. The longer-term chart tells a different story - whilst HSBC and Standard Chartered have recovered well from the sharp drops seen in 2008/9, Lloyds and RBS languish in the doldrums, despite their recent strong performance.

Over the last week Lloyds, Barclays, RBS, HSBC and Standard Chartered have all released their third-quarter updates. What clues did they give as to the banks' future prospects?

Most of the headlines were taken by many of the banks increasing their provisions for Payment Protection Insurance (PPI) compensation, but this was only part of the story. Encouragement can be drawn from a strengthening of the banks' capital cushions, whilst there was also a widespread reduction in impairments, or bad loans.

Specific highlights included RBS's exit from the Asset Protection Scheme, underlining its success to date in executing its turnaround plan. Barclays' "universal banking model" of commercial banking, investment banking, retail banking etc. was one example of the benefits of product diversification. Such strength also applied to HSBC, where there were strong showings in its Global and Commercial Banking operations.

Unfortunately, doubts on the sector remain.

Although many of the issues surrounding the banks are historic, there is a concern that further problems could arise. As we have pointed out many times, the market hates uncertainty and many investors are unsure whether to enter a sector fraught with unknowns.

At HSBC, for example, the bank had previously set aside $700m to pay fines for violating US federal anti-money laundering laws. In its third-quarter update the bank announced a further $800m provision, making $1.5bn in total, but added a worrying comment that “the final amount of the financial penalties could be higher, possibly significantly higher, than the amount accrued.”

This echoed a similar situation at Standard Chartered where, after an initial $340m fine relating to financial transactions with Iran, the bank continues to negotiate with the Manhattan District Attorney, the US Treasury Department, the Justice Department and the New York Federal Reserve.

This lack of visibility comes at a time which is already difficult for the banks. They are being encouraged to increase their lending, at a time when lending could be precarious owing to the fragility of many of the economies in which they operate. At the same time, there is the seemingly contradictory requirement for banks to increase their capital cushions in an effort to avert any future bailouts being necessary.

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The government's stake in Lloyds and RBS continues to prove a concern, and the absence of a dividend diminishes the shares' attractiveness for many investors. These issues are undoubtedly holding their share prices back, and in all probability will continue to do so until there is greater clarity as to how and when the government intends to dispose of its stake.

With global regulators clamouring to bear down on the banks, the sector remains under pressure. There seems little doubt that the days of the banks as medium-risk investments has passed, and the volatility of their share prices is testament to the fact that the banks have moved sharply up the risk scale.

In the meantime, those investors who are prepared to enter the sector are generally looking for strong, stable earnings, geographical and product diversity, and a decent dividend yield. Only one of the UK banks currently ticks all of these boxes and, in the eyes of analysts at least, HSBC is the pick of the bunch.

Further details on each bank's update can be found on the research pages of Barclays, Lloyds Banking Group, Royal Bank of Scotland, Standard Chartered and HSBC. If you would like to receive future updates directly to your inbox, simply register for our free share research updates.

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