The surge in interest rate rises from central banks has generally been good news for banking stocks. But with a cost-of-living crisis threatening defaults on loans, what could be next for banks and do they look attractive?
Here are our key investor takeaways on the biggest UK banks’ most recent full year results.
This article isn't personal advice. If you’re not sure if an investment is right for you, seek advice. Investments and any income they give you can fall as well as rise in value, so you could get back less than you invest.
Higher interest rates provide a tailwind
Net interest margin (NIM) is a key metric when looking at banking stocks. It measures the profitability of a bank’s lending and borrowing operations. It’s essentially the difference between the interest banks earn on loans and the interest they pay on deposits, as a percentage of income-generating assets.
Net interest margin
Source: Refinitiv Eikon DataStream 27/02/23.
As central banks raised interest rates over 2022, that’s been a tailwind for NIM across the banks we provide research on.
In the UK, we’re expecting interest rate rises to continue over 2023. This should provide a tailwind for UK banks’ net interest income over the year.
Cost-of-living crisis increases the chance of loan defaults
One of the key risks facing banks is customers defaulting on loans, whether that’s individuals or businesses. Based on a range of economic factors, banks will estimate the value of defaults they expect to occur. They’ll typically set up provisions for expected defaults by taking a hit to profit now, in the form of an impairment.
As the broader economic outlook worsened over 2022, major banks took billions’ worth of impairments as they expected increased defaults. For now, default levels are edging higher, but are by no means in troubling territory given broader conditions. We’d expect defaults to creep higher over 2023, as the cost-of-living crisis takes its toll. However, we’re cautiously optimistic that it won’t be as bad as feared.
If that plays out, impairments can be reversed and that’s something we saw as we emerged from the pandemic, providing an unexpected tailwind to profits.
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Are banks at attractive valuations?
Broadly speaking, the major UK banks trade on forward valuations below longer-term averages. On the face of it, that’s not too surprising. We’ve had a pandemic, war, global energy crisis and now a cost-of-living crisis to contend with. That’s put pressure on banks’ key customers – the consumer, and small to medium-sized businesses.
Forward price-to-book ratio
Source: Refinitiv Eikon DataStream 27.02.23
More positive economic news toward the back end of 2022 and the start of 2023 has been a tailwind for valuations.
It’s looking more likely that we might avoid a hard recession in major global economies. That’d be good news for UK banks who have exposure at home, but also abroad. If we can avoid the worst, the sector at current valuations looks well placed to benefit. Of course, there are no guarantees.
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Unless otherwise stated, estimates are a consensus of analyst forecasts provided by Refinitiv. These estimates aren’t a reliable indicator of future performance. Investments rise and fall in value so investors could make a loss.
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