If the banks were the main cause of the crash and the financial crisis, they were also one of the biggest losers.
On 7 August 2007, French bank BNP Paribas suspended redemptions from three of its investment funds, citing difficulties in getting valuations on some of their underlying holdings. Although there had been earlier indicators that something was going wrong in the world of sub-prime mortgage lending in the US, this is widely seen as the date when the global financial crisis, or credit crunch, began.
Run on the bank
In September 2007, Northern Rock, the UK’s fifth biggest mortgage lender, sought state support and was subsequently nationalised after the UK’s first run on a bank in almost 150 years. But the casualties did not stop there. US investment bank Bear Sterns had to be rescued by rival JP Morgan, while Lehman Brothers, the fourth-largest investment bank in the US, became the world’s biggest bankruptcy when it filed for administration in September 2008.
In the UK, Halifax Bank of Scotland had to be bailed out by Lloyds Banking Group, while Royal Bank of Scotland resorted to two rounds of emergency fundraising from shareholders before being bailed out by the government; meanwhile, shareholders in Bradford & Bingley lost their money when the former building society was nationalised to avoid its collapse.
Between 12 October 2007 and 6 March 2009 the FTSE 100 index fell 46 per cent, but investors in banks would have fared much worse. During this period shares in RBS fell 96 per cent, while investors in HSBC, Lloyds and Barclays saw losses of 62 per cent, 89 per cent and 90 per cent respectively. Shareholders in Northern Rock and Bradford & Bingley lost their money when the lenders were nationalised.
While the FTSE 100 was back to its pre-crisis level (excluding dividends) by May 2013, investors in the banks are still sitting on big paper losses.
According to figures from investment manager Schroders, £1,000 invested in UK bank stocks on 31 December 2006 would have been worth just £543 on 31 December 2016, with dividends reinvested. But if the scars inflicted by the losses have not fully healed, are the banks finally starting to turn things around sufficiently to make the sector a worthy investment today?
In the aftermath of the financial crisis, governments and regulators around the world moved to reform banking rules, to prevent any recurrence of the crisis. In the UK, banks were forced to hold much higher levels of capital, and of much higher quality.
They also ended some of their lending practices, such as self-certified mortgage lending. Flooding the financial markets with liquidity in the form of quantitative easing has also helped the banks become more financially resilient by allowing them to rebuild their capital base.
The bulk of the work to repair balance sheets and cut costs has been carried out, and profitability is beginning to return. HSBC, the UK’s largest bank, has said revenues for the first six months of this year are up 5 per cent, boosted by strong growth in Asia. Lloyds Banking Group reported an 8 per cent increase in pre-tax profits for the same period, helped by a further 1 per cent reduction in its operating costs. It also increased its interim dividend by 18 per cent after reinstating its dividend last year. Even RBS is back in profit for the first six months of 2017, although with further big fines still to come in the US it is unlikely to see a profit for its full financial year.
The results of the turnaround can be seen in professional investors’ interest. In April, fund manager Neil Woodford invested in Lloyds, having largely avoided banks for the past 15 years. Woodford was previously a big critic of the banks, but he says: ‘The banks are now broadly repaired in the UK. They will continue to rebuild capital. But now they are lending to the economy, particularly to the SME business sector, which is the first time really since the financial crisis that credit has flowed to the economy at an acceptable price – and that’s an important new and positive dynamic for the UK economy.’ Lloyds is now one of the biggest positions in the Woodford Income Focus and Woodford Equity Income funds.
The case for dividends
In 2008, the top three dividend-paying companies in the UK – HSBC, Barclays and Lloyds – were banks, but these payments were one of the casualties in the scramble to repair balance sheets. However, some banks have recovered their strength as income payers.
Following the sale of the government’s stake, Lloyds has rejoined HSBC in the top five FTSE 100 dividend-payers table for the second quarter of 2017, and further growth in its dividend is likely. Tom Buckingham, fund manager of the JP Morgan UK Higher Income fund, says Lloyds is once again an attractive option.
‘Companies such as Lloyds have completed their clean-up – non-core businesses such as TSB having been spunoff, the balance sheet having been bolstered, and the government having exited its stake. With a core equity tier 1 ratio [a bank’s core equity capital as a proportion of its total riskweighted assets – a measurement of its financial strength] in excess of 13 per cent, we view the 6 per cent – plus forecast dividend yield as being well underpinned and sustainable, and view the company as an attractive investment.’
Not all the big banks are back to their pre-crisis levels, however. RBS remains some way off being able to pay a dividend, and last year Barclays announced it was halving its dividend for 2017 and 2018 to boost its capital reserves. In August, Standard Chartered said it was suspending its dividend over ‘regulatory uncertainties’, which include a lack of clarity over how much capital it will be required to hold in future.
End in sight for PPI
Another big plus for the banks is that the end of the seemingly interminable payment protection insurance (PPI) saga is now in sight. Last month, the Financial Conduct Authority (FCA) imposed a deadline for all new PPI claims of 29 August 2019, and has recently launched a campaign to encourage anyone who hasn’t yet claimed to do so.
So far UK banks have set aside more than £40 billion to cover the cost of PPI mis-selling, and these costs continue to rise, with all the UKfocused big banks putting more money aside for PPI in their latest financial reports. Barclays alone has allocated an extra £700 million.
Justin Bates, equity research analyst at Liberum, says the new deadline will bring more claims but the end is finally in sight. ‘The FCA’s campaign is likely to heighten awareness once again and will no doubt see renewed interest from retail clients in relation to making a claim,’ he says. ‘The FCA’s approach is very forceful, so the banks are by no means off the hook. That said, drawing a line in the sand will come as a welcome relief for investors.’
Are banks now good value?
Before the financial crisis bank stocks were expensive and, it turns out, very high-risk for investors. That situation appears to have been turned on its head: with a lot of the risk now removed from banks but with investors still sceptical of the sector, valuations have tumbled.
According to analysis from fund manager Schroders, before the financial crisis the big UK banks were trading on price-to-book values (the share price divided by the company’s net asset value per share) of almost 2. That has more than halved in the decade since; banks now have an average price-to-book ratio of 0.9, so effectively shares are worth less than the businesses’ assets.
But it’s not all plain sailing. PPI is not the only regulatory issue for the banks. RBS is still waiting to hear how much it will have to pay to the US Department of Justice over mis-selling of mortgage-backed securities, with a fine likely to reach billions of dollars. Barclays is also still under investigation in the US over this issue.
Another factor for investors to consider is where any future growth will come from. By refocusing on the UK, the banks’ fortunes are now dependent on the underlying economy. GDP growth is currently expected to be between 1.5 and 1.8 per cent for 2017, and Brexit looks to have delayed any increase to interest rates, causing a headwind for banks.
Garry White, chief markets commentator at Charles Stanley, says this means growth prospects in the UK are poor. ‘Interest rates are the biggest issue. Brexit has stalled prospects for interest rate increases in the UK – and without rising interest rates, the ability for banks to grow their profits is limited.’
Buckingham also says Brexit remains a concern for UK-facing banks, and that HSBC is therefore the best placed of the UK banks. ‘It is vital in our view to differentiate between those banks which are more exposed to the UK domestic economy, and those which are more diverse. HSBC, while listed in the UK, derives the majority of its business in Asia, and hence acts as a good, well-capitalised, high-yielding hedge against the more domestically focused UK banks.’
Moreover, adds Buckingham, HSBC’s exposure to the US makes it well-placed to benefit from the expected increase in interest rates by the US Federal Reserve.
However, this argument does not convince Charles Stanley’s White. ‘Should you invest in UK banks? Absolutely not. If you want to invest in banks, invest in US banks instead. If the dollar rises, this will be good from a currency perspective, and if interest rates over there continue to rise, this will be good for profitability.’
Battle of the five biggest banks
Barclays: Struggling compared with HSBC and Lloyds. Still waiting for its plan to concentrate on its UK and US businesses to pay off. Has cut its dividend to rebuild its balance sheet and is currently yielding around 1.5 per cent.
Star rating: 3 out of 5
HSBC: Consistently the best performer of the big UK-listed banks. Its Asian business and presence in the US offer potential for growth. Its tier one capital ratio is well above the level required. Shares are yielding 6 per cent and its buyback programme will help support share price in the short term.
Star rating: 4 out of 5
Lloyds Banking Group: The restructure is finally paying off and the government sold its last remaining stake in the firm in May. Despite further provision for PPI costs, the group posted a profit of almost £1 billion for the first six months of 2017. Expected to increase the full-year dividend to provide a yield of around 6 per cent next year. UK focus limits growth potential.
Star rating: 4 out of 5
RBS: Finally there is light at the end of the tunnel, but still a long way to go before RBS is anywhere near the end of its problems. Back in profit for the first half of 2017, but with a least one big fine from US regulators still to come, it looks likely to face its tenth annual loss. Remains 73 per cent owned by the government.
Star rating: 2 out of 5
Standard Chartered: The least affected by the financial crisis because of its Asian footprint, but its share price has fallen in recent years due to large write downs, falling revenues and fines for poor conduct. Now in the third year of a restructuring programme, and revenues and profits for the first half of 2016 are up, but its shares fell sharply in August following the cancellation of its interim dividend due to ‘regulatory uncertainties’.
Star rating: 3 out of 5
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