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A new blueprint

27 July 2015

How traditional banks are looking to change and thrive in the post-2008 regulatory climate.

Banks used to be seen as solid, mature businesses providing steady growth and generous annual dividends.

But the financial crisis exposed the banks as over-leveraged institutions that had failed to manage their risks appropriately.

Northern Rock was the first to fall, followed by the other converted building societies, Alliance & Leicester and Bradford & Bingley. These supposedly ultra-conservative institutions had strayed from their core areas of expertise and had to be rescued by the government and/or stronger peers. Their demise proved to be the precursor to a far wider and deeper malaise that attacked almost every bank in the developed world and brought the UK banking sector to its knees.

The impact has been felt by taxpayers, thanks to the huge rescue packages required to bail out the banks. The global recession that followed can be partly attributed to the banking turmoil. Equity investors in the clearing banks – Barclays, HSBC, Lloyds and RBS – were also hit as share prices plummeted.

Since then, recovery has been slow. Banks have become the scapegoat for the fast-spending, highly indebted culture that pervaded the West before the crisis. It is an image they have found hard to shrug off, not least because of the waves of scandal that have hit the sector in the intervening years.

From mis-selling PPI to fixing LIBOR rates and manipulating foreign exchange markets, the succession of scandals has been breathtaking. It has underpinned regulators’ resolve to change the way banks operate and behave. As well as paying billions of pounds in fines, they have been forced to strengthen their Tier 1 capital ratios, a key measure of their financial viability. This means their balance sheets are stronger and it has become more expensive for them to invest in assets deemed to be risky, encouraging the sector to return to a business model focused on retail banking.

‘Before the crisis most UK banks had a Tier 1 capital ratio of around 6%. Now they are up to 11% or 12%. At the same time their valuations are much lower,’ says James de Uphaugh, chief investment officer at fund manager Majedie Asset Management.

‘The shares were often trading at two to four times banks’ book value before 2007. Now, Barclays and RBS are trading at 0.9 times, while HSBC is on 1.1 and Lloyds is about 1.3. In essence, they are far cheaper than they were but they have more capital, more liquidity and are less vulnerable to systemic shock,’ he adds.

This suggests that UK clearing banks have long-term potential, a view backed up by a recent report for the Competition and Markets Authority which reveals that, even after being shown up as cavalier towards both customers and investors, the big four banks still dominate the current account market.

Its survey of almost 4,500 bank customers shows that more than half have been with their bank for more than ten years. People are thinking about switching but the rate at which they are actually switching is declining – from 21% over the past three years to 16% in the 12 months to April. And very few people actually take the plunge – 8% in the past three years and 3% in the year to April.

‘Because banks look broadly similar and banking is perceived to be free, people tend to move only when their existing bank really upsets them,’ says Steve Davies, head of UK retail banking at consultants PwC. 

The banks are trying hard to regain customers’ trust. They’re investing in service at their branches and developing their technology, so they can appear more customer-friendly while cutting costs.

‘Banks are on a far sounder footing than they were,’ says de Uphaugh. ‘The UK economy is doing okay, Europe is recovering and interest rates are likely to rise, which is good news for them. Behaviourally, too, we’ve seen a big change. Of course, banks are leveraged institutions so they are never going to be bulletproof, but in terms of risk and reward the pendulum has swung too far.

‘In due course the legacy fines will drop away, and in the end the banks will be able to pay good dividends again.’

Nonetheless, the industry faces considerable hurdles.

‘Regulation is the main challenge. An important secondary challenge is increasing shareholder returns without increasing risk,’ says Robin Savage, banking analyst at broker Cannacord Genuity.

Both regulation and legislation are affecting banks’ activities. Regulation is discouraging them from participating in risky but sometimes rewarding markets, while legislation has given birth to the bank levy, an expensive tax which is so disliked by the banks that it has prompted HSBC to threaten to move its HQ away from London altogether. It will announce its decision later this year.

‘The new environment makes it harder for high street clearing banks to deliver growth. The problem is balance sheet growth. Underlying profits are improving but that is down to cost-cutting and a benign bad debt environment,’ says Ian Gordon, banking analyst at investment bank Investec.

‘Before the crisis, banks were generating a return on equity of more than 20%. Now returns are in single digits and I don’t believe any of them will reach double-digit returns until 2018.’

To some extent, stricter regulation and low growth are two sides of the same coin, both suggesting that the returns of yesteryear are unlikely to be repeated. Yet banks still need to find the money to cope with another very real challenge – outdated IT systems.

‘A lot of banks’ systems are old and complex, and are out of sync with the way young people, who have grown up with technology, live their lives,’ says Davies.

This technology gap has created an opening for so-called challenger banks, including Shawbrook and Aldermore, which floated on the stock market earlier this year.

Much has been made of the threat they pose to the established banks. Shares in both have risen since they floated1. ‘Both enjoy much lower costs than their larger rivals; they have no legacy fines or outdated IT and their returns are substantially higher,’ says Gordon.

‘The challenger banks are focused on various niches where they can provide superior service and product, while delivering impressive returns to shareholders and growing their market shares,’ adds Savage.

TSB was perceived to be so attractive that it was only listed on the stock market for nine months before being snapped up by Spanish bank Sabadell. 

‘Challenger banks are interesting. Yes, they are niche players but their cost/income ratios are better than the established players and their returns on equity are better,’ says David Sayer, global head of banking at KPMG.

Some, such as Virgin Money and Metro Bank, focus on providing consumers with better service. Swedish Handelsbanken, one of the fastest-growing banks in Europe, focuses on providing SMEs with the kind of service that old-fashioned bank managers used to give 30 or 40 years ago, with local branches and staff entrenched in the community. Shawbrook and Aldermore, by contrast, have no branches at all.

‘Challenger banks have attractive business models with simple cost structures, no legacy issues and an ability to cherry-pick the markets they want to be in,’ says Gordon.

However, established banks have one key advantage – their large customer base.

‘Most people distrust banks but they are reasonably happy with their own branch. If banks can use that loyalty and build on it by investing in IT, offering simpler products and improving efficiency, they can improve customer service and reduce costs. Then they should be able to flourish,’ says Sayer.

There is a long way to go but the high street banks have already started to make progress. If they continue on the right path they may yet deliver long-term gains for shareholders. In the meantime, the challenger banks snapping at their heels should encourage competition, benefiting both customers and investors.

Where the opinions of third parties are offered, these may not necessarily reflect those of St. James's  Place and are subject to market or economic changes. This martial is not a recommendation, or intended to be relied pon as a forecast, research or advice.

1 http://investors.shawbrook.co.uk www.investors.aldermore.co.uk

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