The bull and bear cases for buying bank shares

A decade after Lehmans collapse and the start of the financial crisis, there are signs that the banks are bouncing back, but should you buy?

It has been a decade since US investment bank Lehman Brothers collapsed and UK banks plunged into freefall as the financial system was pushed to breaking point. The intervening years have seen banks sell off assets, write off debts and offload entire parts of their business. Huge fines and compensation bills have been paid and there has been a steady stream of scandals and blunders.

Finally, though, it seems the sector is putting its past behind it. Bulls say the industry is going from strength to strength: Lloyds has posted profits ahead of market expectations, while RBS has paid its first dividend in a decade. But have the banks bounced back far enough to win over investors?

Steve Davies, manager of the Jupiter UK Growth fund, thinks so: he has around 18 per cent of the fund’s £1.3 billion of assets invested in the sector.

A proxy for economic growth

Jamie Clark, co-manager of the Liontrust Macro Equity Income fund, elaborates further. ‘Why would you own a bank? Because it’s a proxy for economic growth and demand for credit. The UK has a number of problems, many Brexit-related – but its economy is performing a lot better than many had expected.’

Brexit may be a major cloud on the horizon for the sector, but focusing on this alone means ignoring the several silver linings, chief among them the fact that interest rates are finally rising. This should materially help profit margins for banks, which have come under pressure as retail lenders have been involved in a race to the bottom on mortgage rates in recent years.

This is an industry where interest rates and profits tend to move upward in tandem – higher rates mean banks can charge borrowers more for loans and mortgages, while they are not obliged to fully pass on rate hikes to their savings customers.

Another positive is that the last of the conduct issues are almost behind the sector. Barclays and RBS settled fines with the US Department of Justice of £1.55 billion and £3.6 billion respectively, and the deadline for payment protection insurance (PPI) compensation is approaching in August 2019. Total compensation payouts are likely to reach an eye-watering £35 billion by then.

Shaking off these heavy compensation bills means banks finally have some spare cash to start giving back to shareholders. HSBC and Lloyds shares are expected to yield 5.5 per cent this year, Barclays 3.5 per cent, RBS 3.2 per cent and Standard Chartered 2.6 per cent, according to analysis by AJ Bell.

What is particularly reassuring is their level of dividend cover – this is the number of times a company’s earnings will cover its payout to shareholders, expressed as a ratio, and typically experts like it to be at least two times. Lloyds’s dividend cover is a respectable 2.1 times earnings while RBS, Standard Chartered and Barclays all have dividend cover ratios above three times. Only HSBC is missing the mark at 1.4 times earnings.

A table of pros and cons for investing in the big four banks: Lloyds, RBS, Barclays and HSBC

 

Digital revolution

Meanwhile, the big five FTSE banks – Lloyds, RBS, HSBC, Barclays and Standard Chartered – racked up profits of £9.3 billion between them in the second quarter of this year. This is their strongest three-month period since the start of 2013. Higher profits mean banks can invest in their businesses. Among their top priorities are digitisation as customers move away from bricks-and-mortar branches to mobile apps and websites.

The migration of customers to online and mobile banking is plain to see. Cheque use is down 16 per cent year-on-year, while the number of account logins from mobile devices is up 20 per cent. Banks that don’t invest in their digital offering will quickly find themselves left behind.

There were fears that the big banks would struggle to keep up with newer challengers in their digital offering. While they were bogged down in shoring up their balance sheets, new entrants could start fresh with a low cost base and blank sheet of paper.

But Davies is not concerned about these upstarts. He says: ‘If you take Barclays, for example, and look at what its app can do, it’s actually very functional compared to the start-ups. There was a fear that challengers would have a significant technological advantage, but it’s not obvious to me that this is the case. Banking is different from any other product and there is a huge amount of trust involved; a lot of people won’t be comfortable putting their life savings with a start-up.’

Instead, he thinks the key to banks’ success is in keeping customers’ current accounts – something it was feared would become more difficult to do when the Current Account Switching Service was launched in 2013. Actually, surprisingly few people have bothered to change their bank – research has shown that people are more likely to change their life partner than their current account.

Davies says: ‘Current accounts are very sticky, and when you’re not paying for a product the incentive to move is really quite low. So, although we have had challengers appear, their market share is still very small.

Next page: where are the experts investing?

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