Tuesday, 9 April 2013

The banking sector – fit for investment?

Is there a place for UK-focused banks within portfolios?
Last year was all about the bank shares re-rating following Draghi’s ‘whatever it takes’ statement and the announcements of Outright Monetary Transactions (OMT) and Long Term Refinancing Operation (LTRO), at a time when there was negative sentiment towards the shares. The bank shares reacted positively through the summer, as investors saw light at the end of the tunnel. The European Central Bank’s OMT programme impacted wholesale funding costs and reduced Credit Default Swap spreads, which invariably improved the positions of the banks themselves; both the UK’s Funding for Lending (FLS) scheme and Extended Collateral Repo programme had similar effects.

This year, we believe that it is all about book value growth and a need to see an improvement in overall profitability. The focus on capital operational cost efficiencies was shown in the 2012 results, as milestones were achieved earlier than expected and guidance erred towards an improving impairment cycle. The recent Financial Policy Committee announcement focuses on improving Basel III Core Tier One ratios; we believe the targets will be met early (Basel legislation introduction was extended to 2019 but the UK banks are aiming for December 2013, in our opinion). We believe that all banks are capable of achieving approximately 10% but it is harder for some than others.

Within our UK listed coverage, there are two types of bank – those predominantly UK focused and those exposed to Asia. Our preference remains for conservatively capitalised companies with global exposure but we believe that, due to the valuation differentials, there is a place for UK-focused banks within portfolios.

Our framework for bank analysis is based around:
  1. Core Tier One ratios (Basel III)
  2. Loan to Deposit ratios
  3. Net Interest Margins
  4. Cost/income ratios
  5. Impairment charges as a percentage of average advances
  6. Return on Tangible Equity
  7. Price to Tangible Book Value
All of the UK banks have been pulling back on lending to try and fix balance sheets however, loan to deposit ratios are now improving and banks are starting to look at lending again. Interest margins have insured the system, driven by the government’s FLS and, because there is plentiful access to alternative sources, other funding costs have eased. Savings rates have been dropping every month over the past five months; this will take 12 months to feed through into companies’ profit and loss accounts, therefore we would expect revenue to improve beyond this. According to various metrics, mortgage affordability is the best it has ever been and the recently announced ‘Help-to-Buy’ scheme should further assist. However, this is mostly the case for those already on the ladder – the situation is very different for first time buyers.

One of our key concerns regarding the sector is the amount of non-performing loans (NPLs) held by each of the banks and future conduct redress. Regarding the FPC’s statement which ‘identified future conduct costs arising over a three year period could exceed provisions by around £10 billion’, we view the main risks as the ongoing Payment Protection Insurance (PPI) claims, LIBOR, interest rate hedging products and potential further anti-money laundering charges. The FPC estimate was in-line with expectations and previous comments regarding provisions and has no further incremental impact on our coverage, in our opinion.

PPI: The regulator has indicated that the maximum cost of PPI could be £15.6bn. The total provisions taken by the UK exposed companies now amounts to £12.9bn and only 60% of that has been used so far. In March 2010, the FSA reported that 16.1m PPI policies had been sold since 2005 (excluding regular PPI on first charge mortgages), equivalent to approximately £17bn of gross written premiums.

LIBOR: We expect LIBOR to become more of an issue in 2013; however, the recent announcement from the US with respect to tail risk loss calculations, should be seen as a positive. The ruling dismisses any Racketeer Influenced and Corrupt Organizations Act (RICO) claims and the NY court rejected claims against banks for the manipulation of LIBOR. European banks' potential losses from private lawsuits related to interest rate rigging, could be materially lower after a US judge dismissed a large portion of such claims.

Valuation
The relationship between ROE and Price to Book Value is usually stronger for financial services firms relative to other sector. A low Price to Tangible Net Asset Value is often justified by low ROEs (and losses). As we look towards 2014, by which time the sector should be in much better shape, the restructuring environment should have concluded and the prospect of dividends should be supporting investor demand, we prefer those companies where the consensus Return on Tangible Equity is above the important 10% level (the level we estimate for the cost of equity for banks).

Edmund Salvesen
Equity Analyst - Deputy Head of Equity Research

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