The outlook for banks – life after lockdown

The last economic crisis was born and bred in the banking sector. This time round the banks will hopefully prove part of the solution rather than the problem.

This article is not personal advice. If you’re unsure whether an investment is right for you, please seek advice. All investments fall as well as rise in value, so you could get back less than you invest.

The story so far – providing the plumbing

Banks have been called upon to provide the plumbing for much of the government’s relief efforts in the early stages of the current crisis.

As well as mortgage and loan repayment holidays for hundreds of thousands of retail customers, the banking system has approved billions of pounds of loans to businesses as companies look to reinforce their balance sheets.

That’s led to a dramatic increase in total lending at the UK’s largest banks. In the three months to the end of March Lloyds, for example, saw its total loans rise £2.7bn while RBS – which has more exposure to Small and Medium sized Enterprises (SMEs) – saw lending rise £13.1bn. The growth in loans has been driven almost entirely by corporate customers, whereas the general public have actually been net savers – adding some £52bn to savings in May alone.

We expect total lending will have continued to increase rapidly in more recent months. Government support schemes like the Coronavirus Business Interruption Loan Scheme (CBILS) and Bounce Back Loan Scheme (BBLS) are largely implemented by banks, and total lending across the government’s various coronavirus lending schemes had reached £41bn by 23 June.

Alongside a dramatic increase in corporate lending banks have also had to amend their assumptions for defaults on loans. Barclays set aside £2.1bn at the end of March to cover expected loan losses, and RBS now expects a little less than one in 110 loans to go bad compared to around one in 900 at the same point last year. It’s worth noting though that changed bad debt assumptions don’t include corporate loans made under the two largest government lending schemes (CBILS and BBLS) which are largely or entirely guaranteed by government.

The challenges to come

Alongside the massive government backed lending schemes the crisis has also seen central banks cut interest rates. The Bank of England only cut the base rate to 0.1% in mid-March, so we’ve yet to hear much detail from the banks on what it means for them. However, low interest rates are usually bad news for the sector – and we’re currently at a record low.

The problem banks have is that while rate cuts are quickly passed on to borrowers – where interest rates are often priced as base rate plus a set percentage – it’s harder to pass the cuts on to savers. Since banks use deposits from savers to make loans to borrowers that’s a problem. The interest paid by borrowers is lower but the cost to banks of financing the loan is much the same. So the gap between the two interest rates (known as a net interest margin) is smaller, and it’s the gap that makes a bank its money.

Interest rates look set to stay low for a very long time. The market is pricing in a 45.3% chance of another rate cut by the end of 2021, which is a concern for bank profits.

The looming possibility, we might even go so far as to say probability, of an economic downturn following the pandemic makes matters worse. When times are tough defaults rise, and while some of that has now been accounted for banks have warned there could be more impairments to come.

Even if government guarantees for newer lending mean losses don’t reach the balance sheet and income statement, a rise in bad loans is not without its risks. Banks are under obligation to try and collect on loans before turning to government guarantees. As the recent support programmes come with reduced due diligence requirements to make the lending process faster the proportion of bad loans could be high.

After the reputational damage of the financial crisis the last things banks need is to be seen pushing SMEs into bankruptcy over coronavirus loans that probably wouldn’t have been made in normal times.

What does the future hold?

All this paints a pretty bleak picture of the future for banks, and the industry’s valuations reflect that. The market value of all five of the FTSE 100 banks is well below the book value of their assets (indicated in the below table as by a price to book value of less than one).

Bank	Current price-to-book ratio	10 year average price-to-book ratio
Barclays	0.32	0.56
HSBC	0.47	0.9
Lloyds	0.45	0.92
RBS	0.34	0.60
Standard Chartered	0.24	0.89

Source: Refinitiv, 13/07/20

However, there are some areas of relative strength.

Firstly we suspect that consumer finance will perform relatively well, with relatively fewer bad loans. The furlough scheme means employment held up pretty well in the early stages of the crisis, especially when compared to past crises, with major job losses only really starting in late May and June. That gave the general public the opportunity to reduce debt and build up savings – in May alone credit card debt fell by £1.8bn across the country. If consumer lending does prove less vulnerable that would bode well for banks like Lloyds where retail lending accounts for a relatively large portion of total loans.

Banks with a high degree of fee based non-interest income might also find themselves in a relatively good place. Barclays and HSBC for instance have large investment banking businesses. With lots of companies looking to raise extra funding through share placings and some dramatic market movements providing a tailwind for the trading business this should be a bumper period for investment bankers.

Unfortunately a large investment bank is usually paired with a sizeable corporate lending business. While large corporates might prove less vulnerable than SMEs, having the balance sheet to weather a downturn, it’s still potentially painful.

Looking for stability and efficiency

Given the clear challenges for income growth in the banking sector at the moment we’re more focused on the, perhaps superficially boring, traits of stability and efficiency.

Banks with a larger capital base will be better able to navigate turbulence in the economy. The need to preserve and increase capital bases led regulators to ban the UK’s banks from paying dividends earlier this year. The sector was already in a pretty good place by historical standards, but keeping dividends in the business should help that grow.

We’re not immediately concerned by any names in the sector. However, we do worry about what bad loans could do to asset values in the future. If a downturn in the economy results in a big increase in bad loans that will eat into capital reserves. The more thinly capitalised names will be less well able to wear that without turning to shareholders for support.

Bank	Last reported CET1 ratio	Last reported Cost : income ratio
Barclays	13.1%	60%
HSBC	14.6%	57.6%
Lloyds	14.2%	49.7%
RBS	16.6%	57.7%
Standard Chartered	13.4%	54.5%

Source: Company Reports, 13/07/20

RBS is clearly the standout name on capitalisation with a CET1 ratio (a key measure of banking capital) of 16.6%. However, it performs less well when we look at efficiency.

A bank’s cost to income ratio measures how much of every pound in revenue is spent in operating costs. Increased digitisation has been a driving force increasing banking efficiency in recent years and in the current low growth environment we think it’s more important than ever.

Lower operating costs mean more can be invested in growth, used to bolster the balance sheet or (in normal times) paid to shareholders. It also increases the margin for error when times are tough, and they’re certainly tough now.

The author of this article holds shares in Lloyds Banking Group plc.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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