In last week’s Net Interest, we discussed the UK’s NatWest Group, formerly known as Royal Bank of Scotland. This week we stay in the UK, broadening the focus to look at the investment case for the entire UK banks sector. To guide us, we have a guest author: Tom Rayner. Tom has been immersed in equity research for 25 years, working at a number of investment banking firms to bring institutional investors the latest insights on UK banks. Most recently, he was UK banks analyst for Numis Securities and before that he occupied similar roles at Exane, Barclays and Citigroup. 

As well as Tom’s contribution, paid subscribers have access to three additional pieces – on independent equity research, where I look at the financial performance of research boutique Redburn; banker bonuses, where I examine the implications of the bonus cap in Europe; and Coronavirus fraud after the UK government released lender-specific data on its small business loan scheme.

But first, UK banks. Over to Tom.

Two arguments in favour of UK banks

There are two main arguments in favour of UK banks right now. The first, which ties in nicely with the name of this newsletter, is that net interest income is about to go up – a lot. With banks sitting on record levels of liquidity, pumped into the system by central banks attempting to ward off the economic damage of the Covid pandemic, and with global interest rates expected to rise sharply, banks should enjoy a significant boost to revenue. If market implied rates prove to be correct, this boost should be large enough to drive up earnings and returns to levels that force investors to take notice.

While structural hedges smooth out the impact of interest rate movements, a sustained low interest rate environment gradually destroys bank profitability. Such an environment has effectively been in place since the global financial crisis and, while fundamental change may at last be underway, many investors could be forgiven for thinking that sub-cost of capital returns and large discounts to book value are simply the sectoral norm. The days when Lloyds Bank traded at over six times book value will likely never be repeated, with capital and liquidity requirements now many times higher than they were under former regulatory guidelines. But that does not necessarily make current valuations – in some cases implying sustainable returns of only 5-6% – any more reliable than when the market was pricing in sustainable returns of 30% and annual growth of 6%.

The second argument in favour of UK banks is that, with no repeat of disastrous litigation and conduct costs – which alongside restructuring charges absorbed 100% of domestic UK bank earnings in the decade 2010-20 – the recovery in earnings power should translate into a significant increase in shareholder distributions.

In 2005, banks accounted for approximately 26% of the UK equity market’s dividends. By 2015, this had halved to 13% and by 2020, on the back of regulatory restrictions, it had fallen to 0%. Banks’ share of overall dividends now stands at 6% as at 2021 (or 8% excluding special dividends made in sectors such as mining) which represents a reasonable bounce-back but remains a long way from the type of contribution the sector made before the financial crisis. While it is true that the authorities’ stress-testing methodology assumes that bank dividends are switched off in periods of stress, meaning a repeat of the 2020 dividend suspension cannot be ruled out, the global pandemic was an extreme event and not one that can be credibly built into a base-case analysis.

Underlying distribution trends may be obscured by banks choosing to return capital to shareholders via buybacks, which are easier to get regulatory approval for and make economic sense if your stock is trading below intrinsic value, but as share prices recover this should become less of an issue. There is every chance that banks once again become a core dividend contributor for the UK equity market.

Valuation multiples remain depressed

The combination of higher returns and an enhanced conversion of earnings into distributions should have a positive impact on bank valuations, especially if combined with a decline in the sector’s risk premium. Changes to a sector’s cost of equity tend to take place over economic cycles rather than on a day-to-day basis but it should not be forgotten that, post the financial crisis, UK banks are better capitalised, have stronger liquidity ratios and have de-risked their balance sheets. Academic research by the Bank of England, and others, supports the notion that such developments will eventually lead to a fall in a bank’s equity beta and, all else equal, its cost of equity.

The availability of long-run data series for certain UK banks, such as Barclays, provides further support to this argument. In more than five decades prior to 1970, when the average equity:asset ratio was c.7%, the loan:deposit ratio 40% and liquid assets accounted for c.36% of total assets, Barclays generated an average return on capital of 8-9% and traded at 1.1x book value, implying a cost of equity of 8-9%.

In the decades that followed, leading up to the financial crisis in 2008, a period characterised by a massive increase in the size of the UK banking sector’s balance sheet, Barclays saw its equity:asset ratio fall to c.1%, its loan:deposit ratio rise to 140% and liquid assets fall to c.2% of total assets. Increased leverage led to a significant increase in profitability, with the average return on capital rising to c.15%, but with the average price to book multiple only rising to 1.4x, this implied an increase in the cost of equity to 12-13%.

The subsequent financial crisis, and the “lost decade” that followed, confirmed the market was right to start discounting increased risk for the bank sector, although with hindsight this did not go nearly far enough.

But with the post-crisis period characterised by a significant tightening of regulatory rules, the state of UK bank balance sheets today bears little resemblance to the position in 2008. Purely in terms of the quantum of capital and liquidity held, it can be argued that the pre-1970s period is a better comparator than almost any time during the last fifty years or so. And while there are material economic risks to be considered, not least the sharp rise in global inflation that is causing legitimate concerns about a hard economic landing, the large UK banks generally appear to be well placed. With a typically more affluent retail customer base, which since the onset of the pandemic has increased savings balances and reduced unsecured debt, and with corporates having deleveraged and increased liquidity, there is little reason to fear a disastrous credit cycle.

This is reflected in consensus forecasts, which only show a steady normalisation of impairment charges taking place over the next few years. While IFRS 9, a relatively new accounting standard governing how banks recognise impairments, has arguably made the credit cycle more volatile and dependent on economic judgements, with interest rates expected to rise strongly many UK banks are now forecast to deliver returns on capital of 11-12% in the next few years.

If this increase in profitability was assumed to be sustained, and combined with a drop in the cost of equity towards a pre-1970s style 8-9%, price to book multiples could move from an average of 0.65x today (based on consensus 2022 estimates) to more than double that in the next few years. Added to an improved outlook for near-term distributions, with an average dividend yield in excess of 6% being supplemented in many cases by share buybacks, this starts to represent a significant investment opportunity.

UK banks are not “dinosaurs”

And that might not be the end of the story.

It is easy to write-off incumbent banks as “dinosaurs”, desperately trying to defend market share but with no real answer to new entrants, with stock markets quick to penalise industries perceived to be in decline. But in reality traditional UK banks are not “dinosaurs”. While recognising the threats posed to parts of their business from challenger banks and fintech companies, they also see opportunities from technological developments to reduce costs and boost revenue, as well as enjoying capital and funding advantages over many of these competitors.

Comparing technology investment between banks and fintech companies is complicated by differences in approach. For example, capitalisation rates and the length of assumed amortisation periods can vary significantly from one company to another. HSBC provides perhaps the clearest disclosure with $6 billion spent on technology in 2021, representing 19% of adjusted operating expenses, a figure that is expected to rise to c.$7 billion by 2025, equivalent to c.21% of adjusted operating expenses.

Other UK banks have also committed themselves to material investment programmes, without necessarily setting out how much expense will drop into income statements in each year, with benefits expected to be seen in the form of reduced processing costs and enhanced revenues. Insider Intelligence, an independent research provider, forecasts that UK banks’ total annual IT / technology expenditure will rise from £9.4 billion in 2021 to £13.9 billion by 2026, reflecting a five year growth rate of 8%.

But regardless of the precise scale of the spending, an arguably more important question is how much is merely defensive – running to stand still if you like – and how much might prove to be transformational, either through lowering processing costs, or by opening up new markets or geographies that otherwise would not have been cost effective to explore. Properly answering this question would require a separate post of its own but a quick skim of recent UK bank presentations shows that managements believe the opportunities to be material, with the Covid pandemic arguably leading to an acceleration in an already established trend towards mobile banking and digitisation.

For instance, Barclays reports that from 2018-21 mobile banking customers have risen by 33%, to 9.7 million from 7.3 million, whereas branch visits have fallen by 66%, to 29.0 million from 84.9 million. Likewise, Lloyds Banking Group has seen the number of customers that are digitally active rise by more than 45% in the last five years to 18.3 million. NatWest Group reports similar trends while Standard Chartered, having successfully built out virtual banks in Hong Kong and Singapore, is increasingly using virtual banking as an entry route into African countries where the economics of establishing a physical presence would not be viable.

I have been a bank analyst for too long to become starry eyed and start believing that UK banks will be at the forefront of future technological change. Inertia is strong and dealing with past errors has absorbed significant amounts of management time and capital. It has arguably taken too long for banks to effectively tackle legacy IT systems and embrace the new technologies we are seeing across a range of challenger banks and fintech companies. For management teams with long-term incentive plans often heavily weighted to short-term return on capital targets, the temptation to underinvest, or to give up market share simply to preserve margins, is often too strong to overcome.

But things do appear to be changing with a much greater focus on the productivity benefits that technology can bring. The Lloyds Bank Financial Institutions Sentiment Survey 2021 shows that ‘technology, automation and digital investment’ is the top priority for 77% of respondents, with 80% of respondents expecting to grow investment in their tech systems and core platforms. The survey also flagged that larger UK banks are seeking to use multi-cloud technologies as a way of reducing cybercrime. These are welcome developments, which are occurring at a time when the external environment is becoming more supportive of earnings growth and capital drags are rapidly retreating. Banking is an economically sensitive industry and UK banks could yet experience stiffer headwinds from a sharp slowdown in economic growth. But simply writing them off as “dinosaurs”, from an investment perspective at least, might prove to be a big mistake.

Paid subscribers can read on for insights on independent equity research, banker bonuses and Coronavirus fraud. And if any paid subscriber wants my presentation on How To Value a Bank, please ask. ...