Ian Lance

Ian Lance

Portfolio manager

UK banks – it’s not 2008

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When you have been working in the equity market for some time, there tend to be certain events that are etched in your memory such as the day that Chancellor of the Exchequer, Norman Lamont, moved interest rates to 15% in a vain attempt to defend the pound within the ERM and for a few minutes the interest payment on my mortgage was in excess of both my wife’s and my gross earnings. Inevitable events of 2008 and the Great Financial Crisis are difficult to forget and the nauseous feeling that I had as I watched UK banks’ share prices being marked down by two thirds in a day will stay with me forever. The following is from the Financial Times dated 19 January 2008.

‘Expectations that Royal Bank of Scotland will end under total state control sent it tumbling 66.6 per cent to 11.6p, a record drop. The lender warned it would post the biggest loss ever reported by a UK company, and revealed a cash call that will almost certainly see the government lift its stake from 58 per cent to 70 per cent. On its first day of trading post the HBOS takeover, Lloyds Banking Group sank 33.9 per cent to 65p.’

What may surprise you, therefore, is that the share prices of the UK banks are at the same level today (adjusted for issuance and consolidations) as they were on that fateful Monday morning when we thought that they were all insolvent.

Source: Bloomberg, 9 November 2020 (share price adjusted for issuance and consolidations). Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

So are investors correct to be as fearful today as they were at the worst point of the Great Financial Crisis?

Are the banks on the brink of insolvency once more?

As one would have hoped, regulators responded to the events of 2008-2009 by insisting that banks’ balance sheets were made significantly stronger. In the case of NatWest, the company has three times the amount of equity capital today as it did just prior to the financial crisis and the quality of its loan book is also much better. The company’s financial strength is borne out by the fact that its principal measure of capital strength, the Core Equity Tier 1 ratio (CET1), was higher at the end of September (18.2%) than it was at the beginning of the year (16.2%), despite the fact that the company had taken £3.1bn of loan losses in the nine month period. Investors sometimes forget that a bank typically generates around 1.5% of its loan book per annum in pre-provision profits and therefore the loan loss rate must exceed this for the bank to lose money and thereby eat into its capital reserves. Similarly, the end September CET1 ratio was higher at both Barclays (14.6% versus 13.8%) and Standard Chartered (14.4% versus 13.8%). Now if the UK government persist with its strategy of locking down the economy into perpetuity things could obviously change, but as things stand, there seems little justification from a solvency point of view for the current levels of valuation.

Are the banks in secular decline?

Quality growth fund managers (who seem to be most of the UK market today) seem to have written off almost the entirety of the UK equity market as being ‘uninvestable’ or ‘in secular decline’ (other than consumer goods and technology sectors, of course). Whilst there is undoubtedly secular change happening in banking (almost all industries are undergoing secular change of some sort), the overwhelming reason as to why bank returns are depressed today is the poor state of the economy.  Banks’ return on equity is unlikely to ever recover to the 15% to 20% levels seen before the Global Financial Crisis as this was in an environment of much higher interest rates and relied on the use of excessive leverage. As previously mentioned, since then regulators have raised bank capital requirements by a significant degree thereby permanently depressing industry return on equity.  But this does not mean that the industry cannot generate a lower but still healthy return on equity even on the assumption that interest rates remain depressed indefinitely.

The two dominant headwinds to banking profitability are ultra-low interest rates and a spike in loan losses that has resulted from the coronavirus. Low interest rates have been with us for a while now, although base rates have taken a further step down in recent months as economies have weakened.  Falling interest rates are of course damaging to bank profitability as they depress net interest margins, but it is important to remember that banks don’t automatically have to pass through the decline in base rates. Anyone trying to take out a mortgage recently will have noticed that the cost has been going up even as central banks have been cutting rates as the chart below shows.

Source: Bank of England, 31 October 2020.

Recognise also that banks have for many years been using improvements in technology to engineer cost out of their businesses and that these productivity improvements go some way in offsetting the fall in net interest margins, with coronavirus prompting a leap forward in this technological development. Remember also that for many banks, non-interest income (fee and trading income) accounts for a good portion of total income.  So even in a low interest environment banks can still make a reasonable return.

What would constitute a reasonable return? The banks announced their 2019 results in February this year, just before the full effects of coronavirus were understood. In their results, the three banks set out their medium-term return on equity targets. In the case of NatWest Group, the target was a 9% to 11% return on tangible equity (ROTE), for both Barclays and Standard Chartered it was a 10% ROTE. In each case, the bank assumed that interest rates remained depressed.  Separately, both NatWest and Standard Chartered also targeted annual income growth of 3% and 5% to 7% respectively, driven by higher volumes of lending.

Are banks going to be wiped out by loan losses?

In March and April, the full effects of the coronavirus became more apparent, prompting the banks to take provisions for estimated credit losses. Bank profitability is sensitive to the level of credit losses and the spike in losses in 2020 will severely impact this year’s return on equity. When estimating credit losses, the banks must make assumptions regarding the severity of the economic downturn.  By way of illustration, NatWest have conservatively assumed that UK GDP will contract by 14% this year and that unemployment will reach 10%. On this basis, NatWest expects to take around £4bn of credit losses this year (around 1.3% of their loan book) of which £3.1bn was booked in the first nine months of the year. These are obviously large numbers and may prompt some to ask whether the banks’ capital positions are strong enough or whether shareholders’ returns are likely to be diluted as the companies are forced to issue new equity in order to shore up their finances. Our strongly held view is that the capital positions are strong enough to weather the downturn. Whilst it may be that the economy deteriorates even further than currently expected, forcing banks to take another series of loan loss provisions in 2021, the events so far give us confidence that the banks are sufficiently capitalised to not only survive the crisis without raising additional equity, but more than that can be part of the solution, by continuing to provide loans to responsible borrowers. This is borne out by the fact that new mortgage volumes are currently at a record level in the UK as house buyers try to take advantage of the temporary cut in stamp duty.

Conclusion

We don’t believe that the reality confronted by the banks is anything like as desperate as that faced in 2009 and therefore it makes no sense to us that their share prices are lower than during that turbulent time. If that is the case, then they are almost certainly undervalued. To give you a sense of how undervalued, a bank that can generate a return equivalent to its cost of equity should trade at approximately 1x tangible book and most of the UK banks’ share prices would have to more than double to get to that level. If NatWest made an 8% return on equity that would equate to about 20p of earnings per share which means that at the current share price of 120p it is trading on only 6x earnings although this figure is significantly reduced if you take into account the excess capital that the bank is currently holding. If 2020 is not a repeat of 2008, it seems likely that these shares may be very undervalued.

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. This article does not constitute investment advice and the information shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.

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