RBS Outperforms In A Stressed Year For UK banks

While we have seen a continued recovery in the UK economy in 2014 this economic recovery has not translated into a positive performance in the UK banking sector, despite some broadly better than expected profit numbers, heading into the back end of this year.

When we looked ahead into 2014 there were some broad concerns about how European Banking Union would look if politicians in Europe came to an agreement, while increased regulatory burdens as well as the European Central Bank’s Asset Quality Review were all factors that served to influence bank share prices throughout the year.

Though all UK banks passed the stress tests the continued forensic dissemination of banks misconduct over the past ten years has continued to come back and haunt the sector throughout 2014, with fines being dished out by regulators like confetti at a wedding in the last twelve months, with virtually no bank being spared, as new probes into FX price rigging, interest rate manipulation and dark pools dominating the news flow throughout the year.

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What was more concerning was that some of the misconduct appeared to have been taking place well after the peak of the financial crisis and in some cases as recently as this year!

There still remain significant doubts about the credibility of the recent EBA stress tests after the revelation that Royal Bank of Scotland over-stated its financial strength in these European stress tests. While the correction of the error didn’t mean that the banks’ tier 1 capital ratio fell below the 5.5% minimum it did bring it very close, bringing it down from 6.7% to 5.7%.

This episode does raise wider questions with respect to the tests as a whole though, and that is if all the banks conduct their own stress tests how do we know they are being totally honest about their findings. Given recent experience, can we really take their word for it, despite the fact that the banks are being benchmarked against their financial positions at the end of 2013?

This morning’s Bank of England stress tests appear to be a much more rigorous set of benchmarks as shown by the fact that both Royal Bank of Scotland and Lloyds Banking Group barely managed to pass them, and we can see that the test benchmarks were clearly much more rigorous and credible.

Along with the Co-operative Bank, which failed the test, the banks were found to be very susceptible to a house price crash of 35%, along with a rise in unemployment to 12% and a spike in interest rates above 4%.

There were other factors that have served to drag on the banking sector this year with Standard Chartered Bank once again the worst performer following on from a poor 2013, it is also the worst performer in 2014, down over 30%, being particularly hit hard by the slowdown in Asia, which it is heavily exposed to, especially in South Korea, as well as renewed regulatory probes by US regulators into its dealings with Iran.

Of the two tax payer owned banks while Royal Bank of Scotland has performed the best this year it’s been a fairly choppy ride, while Lloyds Banking Group has continued to dilute the government’s stake in the business down to 25%, thus removing further the dead-hand of political interference.

The performance of RBS has been helped by a new CEO Ross McEwan imposing his own corporate vision, as well as the disposal of its US unit Citizens Bank earlier this year. While the bank has had to set aside further provisions for PPI as well as other regulatory and IT issues, it has this year reported three successive quarters of profits in a row after the kitchen sinking we saw at the end of last year. After an £8.2bn loss in 2013 a potential profit in 2014 of over £4bn is certainly progress, but a lot will depend on the UK’s economic performance over the next 12 months.

Lloyds Banking Group’s share price continues to be capped by the prospect of further sales of the government’s stake in the business, while the recent spin off of TSB in September at a discount while helping increase competition in the overall sector has undoubtedly impacted on the banks overall profitability.

Confidence in the resilience of the UK banking sector has certainly improved on where we were a year ago, as well as back in 2008, and while the continued improvement in the UK economy is undoubtedly a factor in that, it is also a fact that the government initiative of “help to buy” has also helped in boosting property prices in the UK, a sector that both banks are heavily exposed to.

In the process this has helped in reducing the amount of non-performing loans on the respective banks books, thus helping boost profits as bad loan valuations decline.

This does raise the troubling prospect that the recent improvement in both banks performance and profitability is no more than a valuation illusion, hence the stress tests and as such remains very much dependant on the performance of the UK economy in the weeks and months ahead, as pressure continues to build for the banks to continue to reduce their size and global reach.

Given that UK banks are likely to continue to retrench in the coming months in the face of higher regulatory and compliance oversight, with Barclays a particular example in light of its problems with “dark pools” in the US and the slow decrease in size of its investment banking division, it is becoming more and more apparent that UK banks are going to be much more susceptible to the eddy’s and currents of the UK economy.

This, in addition to as any chill political winds that blow their way as was aptly demonstrated by the recent actions by the Chancellor of the Exchequer in this month’s Autumn Statement that curbed banks’ ability to claim tax relief on past losses, and is likely to hurt RBS and Lloyds the most, given that they have both incurred some of the biggest losses in recent years. It could well also mean that any hopes of a resumption in an annual dividend have been put back once again.

Given that we have a general election in May next year, this ongoing political uncertainty is likely to keep investors cautious ahead of the prospect of a potential Labour administration that continues to view the banking sector through hostile eyes with talk of breaking the banks up to increase competition, while increasing taxes on their pay structures.

The UK banking sector certainly has its problems but if the experience in Europe has taught us anything, more banks doesn’t necessarily mean a safer and more competitive banking sector.

We still have a fairly broad cross section of banks in addition to the big four banks including the Co-operative Bank, Santander, Nationwide, Tesco Bank, Tsb Bnk Grp (LONDON:TSB) and Metro Bank, with Virgin Money Holdings UK PLC (LONDON:VM) set to introduce a current account, maybe we should be asking why consumers remain reluctant to cross over to a significant number of smaller rivals?

Both Germany and Spain have more banks than the UK and no-one could conceivably argue that their banking system is any better shape than our own.

Over the last three months the performance had been somewhat improved but banking shares have started to come under pressure again, as fears over a falling Oil price has raised concerns that banks with large loan exposures to oil production companies could see large scale losses as a result of defaults, if the oil price remains near multi year lows around or below $50 a barrel for any length of time.

It is estimated that all three of the big UK banks have around $10bn-$15bn each worth of oil exposure so they will be hoping that the oil price doesn’t do what it did in 2008 and drop below $40 for an extended period of time.

The Asia focussed banks in particular have performed much worse, due to concerns about the slowdown in China and the rest of Asia, with only Royal Bank of Scotland in positive territory while HSBC Holdings Plc (LONDON:HSBA) is down over 10% and Standard Chartered down over 30%, year to date.

In conclusion, the performance of the banking sector is likely to be a very tricky one to call in the coming months, and for the reasons outlined above is likely to be an investment for the brave, while the recent slump in the oil price has given bank CEO’s one more thing to worry about, as well as trying to pass the next set of stress tests, which are now likely to become an annual event.

In order to deal with these issues the banks are likely to find their capacity to lend money to the real economy somewhat limited in the coming months, which could well invite further criticism from politicians looking to score political points in the lead up to next year’s election.

The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

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Written By: CMC Markets