The profitability of banks has been under attack from several angles – yet a few of the biggest still offer potential for investors.
The financial crisis may have receded from the forefront of our minds, but its effects remain very much with us.
Nowhere is this truer than in the banking sector. Major banks were bailed out by their home governments following the crisis and a number of them still have significant levels of state ownership, among them Lloyds, in which the UK government has a 9.2% stake, and RBS, in which it retains a 73% stake.
But legacy issues run far deeper than that. Post-crisis rules on capital ratios have limited the ability of banks to borrow; rules on ‘ring-fencing’ have been imposed in order to protect banks’ retail operations from the risks associated with their investment banking operations; and rules have been made even tighter for banks deemed to be “systemically important”. For UK banks, there are plenty of headwinds.
“Bank profitability is under attack in several ways, as ultra-low interest rates and competitive loan markets result in falling net interest margins,” says Nick Purves of RWC Partners. “In the past they’ve been able to offset this through the use of greater leverage although this is now not possible as a result of tighter regulation. The result of this is that industry return on equity has fallen quite sharply.”
KPMG calculated that the pre-tax profits of Barclays, HSBC, Lloyds, RBS and Standard Chartered dropped to a combined total of £12.4 billion last year – commensurate with 2013 levels. It therefore came as no surprise when the corporate earnings season delivered a sour set of results in the UK’s banking sector. Barclays saw its annualised profits dip 25% in the first quarter (Q1), and at Standard Chartered profits fell by more than 50%.
“Despite the general gloom on banks at the moment, underlying profits at Barclays in Q1 are 7% ahead of consensus and investment bank trends are stronger than for their peers,” said Chris Field of Majedie Asset Management. “The new management team has a good plan, which is to focus on the core areas and to accelerate the disposal of non-core assets and less profitable parts of the business, such as in South Africa.”
Profits at HSBC, the UK’s largest bank, fell 14%, but it occupies an unusual position in British banking, one that cushions it from at least some of the current growth slide.
“The Fund we run has a position in HSBC which reflects the fact that its capital ratios are strongest in the sector and it’s got a greater degree of geographical diversification,” says Purves. The company is valued at around one times tangible book and while its dividend is at risk, in our view this largely already reflected in the share price. The bank is also one of the biggest potential beneficiaries of any future rise in interest rates.”
When it comes to profitability, banks in continental Europe appear to have made greater headway since the crisis. A recent analysis published in the Financial Times in advance of earnings season found that profits at the UK’s five largest banks were at 63% below their 2007 figure, whereas profits at their continental competitors were short by just 34%.
Yet one reason for the difference was that UK banks had been obliged to put aside far more capital to cover regulatory costs and potential fines. In fact, many UK banks are finally approaching balance sheet health once more, aided in part by the fact that the UK’s financial crisis did not spark a property crash. Some investors are concerned that a number of leading European banks have made only stuttering progress in dealing with bad loans on their books.
“The loss recognition process at European banks has barely begun and those banks remain way behind the curve in the process of crystallising non-performing loans,” says Neil Woodford of Woodford Investment Management. “Money supply isn’t going to grow for the moment as the banks are not lending.”
Continental banks certainly share one experience in common with their British counterparts, namely an unhappy first quarter. BNP Paribas was a rare exception; its profits rose 10%. But UBS announced a profits fall of 64% in the first quarter; Commerzbank a dip of 72%; and Deutsche Bank saw profits slide 58%. Italian banks, still struggling with the weight of non-performing loans on their books, are a particular worry.1
Beyond the headwinds of increased regulations and fines, banks are also seeing their margins squeezed by low interest rates. While the Bank of England has kept interest rates low, the European Central Bank has pushed them into negative territory. That makes it difficult for continental banks to lend at rates sufficient that support their business model.
One concern shared by many investors relates to the oil price. Banks across Europe have a range of exposures to oil majors through their lending. Inevitably, the low oil price undermined profitability at most of the majors, which in turn affected banks’ loan books.
“The market has been using the banks as the chief conduit to express worry about the outlook for global growth, and there is concern over levels of lending to the energy sector,” says Chris Field. “But this is not a repeat of 2008 – bank balance sheets are significantly stronger.”
Another issue that has raised anxiety in recent months is the exposure of bank to the oil sector, which has struggled to maintain profitability since prices fell last year. Yet while fears tend to be indiscriminate, the reality is that oil exposures are far more serious in the US banking sector, due to problems in the shale oil industry. Moreover, European banks stocks often have their exposures already priced in – and the oil price has been rising in recent weeks.
“Energy exposure is actually not a big deal for the European banks we invest in – it is a much more serious problem in the US,” says Stuart Mitchell, who manages the St. James’s Place Continental European fund. “We have an overweighting in European banks, which has been a success over the past five years. BNP Paribas used to have an oil exposure of around €8–10 billion, but I met with the finance director recently and it’s now down to around €1 billion.”
1 At time of writing, UniCredit and Intesa Sanpaolo, Italy’s two largest banks, were yet to announce results for the first quarter.
The value of an investment with St. James's Place may fall as well as rise. You may get back less than the amount invested.
Majedie Asset Management, RWC Partners, S. W. Mitchell Capital and Woodford Investment Management are fund managers for St. James’s Place.
This material is not a recommendation, or intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.