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Banks’ balance sheet repairs begin to pay off

With UK banks now sufficiently attractive for the government to finally shed a first tranche of its holding in bailed-out Lloyds Bank, the sector looks at its healthiest in years. Capital ratios, net interest margins and asset quality are all up, while funding costs have fallen. But some analysts see the unexpectedly aggressive environment under the new Prudential Regulatory Authority (PRA) raising the risk of lenders being forced to recognise remaining losses before their recapitalisation is complete, reports Julian Lewis.

Britain’s modest economic recovery has supported the banks’ rehabilitation after the crisis of 2008-09. “There are not too many danger signs in the UK economy. In many ways, the backdrop is more benign for the banks than many people thought it would be two years ago,” says Simon Adamson, CEO and senior analyst, European banks, at CreditSights in London.

Against this improving background, the country’s banks are performing more strongly on many measures. “We’ve seen for a while that the banks have been gradually improving their balance sheets, capital ratios and non-performing loan coverage,” notes Roger Doig, credit analyst at Schroder Investment Management in London. 

He cites in particular the government-owned Lloyds Bank and RBS’s reduction of non-core assets, their writing down of their Irish exposures and some progress on their commercial real estate lending. 

Importantly, banks have also bolstered their depleted capital. “The capital situation at most banks has improved tremendously,” says Claudia Nelson, senior analyst, financial institutions, at Fitch Ratings.  

“A number of the banks are remarkably well into the process of recapitalisation,” agrees Doig, who compares UK lenders’ progress favourably with that of the major French banks — though they started from a position of higher asset quality. 

Improved fundamentals have won better support from investors. “From a credit perception and spread perspective European banks and especially the UK names have come a long way in the last 12 months. UK financials are now viewed as some of the most defensive names in Europe,” reports David Carmalt, head of financial institutions, DCM, Lloyds Bank. 

No longer negative…

The sector’s progress was evident recently when Moody’s upgraded its outlook on UK banks to neutral from negative. The agency acknowledges the supportive operating environment, including stable interest rates (though the very low level of rates has been challenging for some lenders’ net interest margins, it appears to have served to keep borrowers current who would have struggled otherwise). 

Consensus is for UK rates to start rising in 2015, though Bank of England governor Mark Carney has indicated this may not occur until 2016. 

Moody’s hails improvements in a number of key areas, such as funding and liquidity. “There has been a really material improvement in the UK banks’ funding position,” believes Laurie Mayers, associate managing director, financial institutions group at Moody’s. 

Some observers attribute this to the Bank of England and UK Treasury’s Funding for Lending scheme, which seeks to incentivise banks to lend to small and medium sized enterprises by giving them access to central bank refinancing. The Bank and HMT extended FLS this April. Others point to a terming out of the sector’s previously heavy reliance on money market funding.  

Earnings are improving for another reason besides fundamentals, according to analysts. Hefty conduct charges imposed on banks for mis-selling both consumer and corporate products, such as payment protection insurance (PPI), interest rate swaps and Libor, are now starting to fall away — though individual institutions continue to attract fines, as in the case of Barclays (recently forced to compensate borrowers for administrative mistakes on personal loans and threatened with a substantial penalty over its crisis-era sale of a stake to the Qatar Investment Authority, though the bank is appealing this). 

…but risks remain

Even so, Moody’s views these positives as offset by negatives like remaining risk on the banks’ commercial real estate loans. “Pressures on the ratings are balanced. We don’t see any bias to either upgrade or downgrade,” Mayers notes.  

Moreover, not all UK banks are recovering equally well. While most of the sector is improving, “some banks are buffeted more than the others by continuing negative factors,” says Nelson at Fitch. These are headed by some banks’ continuing exposures to commercial real estate, Ireland and continental Europe. 

The sector’s credit ratings are much lower now than some years ago, CreditSights’ Adamson notes. Apart from HSBC, they are also quite low relative to European peers. Besides the banks’ continuing problems, this reflects the coalition government’s determination to avoid future bail-outs of struggling banks. 

Stringent regulation

This determination is reflected in a new regulatory approach that has transferred supervision of banks to a new department twithin the Bank of England, the Prudential Regulatory Authority. “The prompt for this change of approach has been the severity of the financial crisis, a crisis that has been through a searing phase of prudential problems — failing banks,” acknowledged Andrew Bailey, the authority’s CEO, in a recent speech.  

“The PRA has taken on its new role in a very strong and very serious way,” says Fitch’s Nelson. She cites the authority’s requests for additional information from the banks it supervises, its “quite strong” statements on the sector and its use of rigorous stress analyses.

The PRA’s most critical impact has been to force banks to up their capital. While the authority has not gone as far as suggested by Sir John Vickers, who chaired the government-mandated Independent Commission on Banking in 2010, analysts regard its intervention as significantly more demanding of banks than previously. (Sir John recently called for lenders to double their current capital buffers against future losses.) 

“Our impression is that UK bank regulators have been more forceful than others,” comments Johannes Wassenberg, managing director, EMEA banking, at Moody’s in London. He regards it as “in general positive” that UK banks have been obliged to strengthen their capital ratios and resolve their problem assets. 

“We were surprised at how aggressive the Bank of England was,” agrees Schroders’ Doig. For years regulators in the UK allowed banks to take a gradual approach to recovery. But more recently the central bank indicated that after four years of very accommodating monetary policy it would be better for the UK economy if banks were to recognise losses and start lending again. 

Soon afterwards the PRA reviewed the capital adequacy of banks and building societies. Not only was the sector collectively lacking some £27bn of capital at the end of last year, though this deficit had improved to £13.4bn by June, but it also found that some institutions fell short of a new 3% leverage ratio target (calculated under Basel III and CRD IV). 

The clearest victim of this rapid change of stance was the smaller lender Co-operative Bank. Even after abandoning a plan to buy some 600 branches from Lloyds Bank, it had to launch a £1.5bn effort to rebuild capital — including an end to its mutual ownership through a partial equity market listing. Next month Co-operative will conclude a liability management exercise that should generate most of the capital it needs by bailing in junior bondholders. 

But the much larger Barclays and Nationwide were also caught by the speed of the shift. After initially insisting that it would reach another PRA target — adjusted 7% fully-loaded common equity — by the end of the year “without recourse to equity capital issuance” and would reduce leverage “over time”, Barclays subsequently had to launch an underwritten £5.8bn rights issue (one new for four existing, at a discount of some 40%). 

Together with deleveraging measures and the issue of new quasi-equity, this should allow it to meet the 3% leverage target. The bank calculated its result on this measure as 2.2% at the end of June (though PRA put it at 2.5%), a £12.8bn shortfall. 

Rapid recognition?

For bondholders, the biggest risk over the sector is the possibility that regulators force further banks to rapidly recognise any hidden losses and put additional capital against them, judges Schroders’ Doig. “If that is the case, there is a risk to junior bondholders of some kind of burden-sharing, given the environment.”

He contrasts this approach with “normal crisis recovery” in which lenders gradually rebuild loss-depleted capital by retaining the earnings from their higher quality, newer loan portfolios. 

“There has been a sea-change in UK regulators’ view of subordinated and hybrid capital,” agrees CreditSights’ Adamson. “If not equivalent to equity, they see it as close to equity. That is always a threat to bondholders if there is a capital gap.” 

The question of how long the banks get is ultimately a political one, Doig concludes. “It is out of the banks’ hands.” Nelson at Fitch connects this to the PRA’s task of providing “very tight overview to ensure the stability of the sector without any future need for government support.” 

“The direction of travel is very clear. It is a question of the timeline and how far regulators and government will go with bank legislation and requirements for structural and operational changes,” adds Wassenberg. He notes “significant impediments still” to the resolution of large, complex banks and great uncertainty — even with bail-in and ring-fencing of investment and retail operations in place — over whether this could be achieved without triggering consequences for the entire banking system. 

While the regulatory environment has become more stringent, analysts are concerned at a lack of transparency over some important aspects of supervision. “The thresholds are not clear at which regulators deem banks to be viable. We can’t see the leeway,” Wassenberg notes. This can lead to negative surprises such as unexpected disclosure of capital deficits and over-leverage, he says. 

“’Regulatory risk’ is something that many issuers cite,” adds Carmalt at Lloyds Bank. “Regardless of your current capital position or progress made with regards to reaching new targets, regulators can always decide to consider a new metric.”

However, Mayers sees scope for greater clarity on banks’ overall capital requirements when standardised Basel III buffers are adopted. “Today the buffers are not disclosed.” Banks are even discouraged from discussing them, according to some in the sector. Clarity would increase further if Pillar 2A becomes part of the regulatory minimum, Mayers adds. 

The PRA’s recent actions to ensure large UK banks are adequately capitalised are not a dramatic shift in approach given their existing practises of using Pillar 2 add-ons and setting stressed capital buffers, she judges. “It is not a 360 degree change. This is taking things one step further,” she argues, citing the interim capital and liquidity regime that the UK authorities put in place as far back as 2008/09. 

Moreover, the PRA is only one element of the new regulatory environment. The Bank of England’s Financial Policy Committee provides a macro-prudential direction for the PRA’s supervision of the sector. Its ability to direct the authority to investigate sector-wide issues and to use macro-prudential tools such as adjusting risk weightings on commercial real estate is “a very important development,” she comments. 

The FPC’s role and the debate it inspires also stand out because few other countries operate similar bodies, Adamson at CreditSights says — though he notes a tension between the committee’s prudential, risk-dampening mission and its mandate to encourage lending in support of economic growth. 

A key test of this will be when banks start upping the risk of their domestic lending — particularly mortgages — for the sake of higher revenues, he believes. “It will be interesting to see when the next asset bubble arises how effective the FPC will be in pricking it,” agrees Wassenberg. 

Capital cladding

While UK banks are starving the senior debt market of supply, thanks to their improved funding positions, they are likely to issue new subordinated and hybrid capital, bankers report. Some could do so this year. 

For one thing, the PRA is pushing them hard to hold additional capital. For another, regulators have now finally given a definitive view on new forms of bank capital under Basel III. As investors now assess their credit strength on the basis of the new regime’s fully-loaded version, this enables banks to respond with instruments that will receive full credit. 

“Banks are now, after further clarification of which structures are expected to be compliant, in a much better position to plan their capital stacks as we head into Basel III, with both transition of legacy instruments and the structure of new-style capital far clearer,” says Lloyds Bank’ Carmalt. 

Higher-trigger 7% AT1 debt should enable lenders like Barclays and Nationwide, the country’s largest mutually-owned building society, to meet the PRA’s 3% target leverage ratio. But now banks are bracing for the PRA to raise its new benchmark beyond 3%. 

“A number of investors have questioned whether leverage ratio targets may be increased. While there is always that chance, most issuers we speak to think that this is unlikely,” Carmalt reports. “It is inevitable as banks start to comply that the target will be pushed higher. It is easy to see it going up to 4% and it may go higher,” believes Adamson at CreditSights, who notes that UK banks’ leverage is currently quite high on this measure relative to banks elsewhere. 


Progressing privatisation 

The UK government’s reprivatisation of Lloyds Bank and RBS is now under way. In September UK Financial Investments, the holding vehicle for the state’s stakes, sold 6% of Lloyds Bank in a £3.2bn placing. The shares were discounted to a level of 75p, just above the price at which the Treasury bought into the bank during its 2008 rescue — and comfortably above its indicated 61p break-even. 

The further 33% of Lloyds Bank that remains in public hands could be shed in time for the 2015 general election, analysts judge. This might be achieved in part through a retail-targeted public offering, the coalition government has suggested. 

The bank’s saleability reflects what Denzil DeBie, director, financial institutions at Fitch Ratings, terms “certainly a turnaround from several years of loss-making”. He applauds the bank’s “de-risked balance sheet, smaller tail risks and provisioning levels that mitigate large losses in Ireland.” 

“Lloyds Bank is now a straightforward story — basically a UK retail and commercial bank,” concludes Simon Adamson, CEO and senior analyst, European banks, at CreditSights.

RBS — where the government’s holding is a far larger 81% — is a significantly more substantial challenge, observers agree. Most expect the Treasury’s current strategic review to affirm that the costs of a good bank/bad bank split would outweigh the benefits. But consensus is that the institution’s commercial real estate exposures and its ownership of the troubled Ulster Bank, a major lender in both the Republic and Northern Ireland, will require further action. 

One option is for RBS to reduce its size further, says Adamson. For example, it could proceed to a full sale of Citizens Bank in the US (rather than the partial sale RBS announced in February), shrink its investment bank further and/or cut Ulster Bank back. The ‘dividend access share’ that prevents it making payouts to shareholders could also be altered. 

The bank has returned to profitability, earning £1.4bn in H1 13 compared to a £1.7bn loss in the same period last year. But despite this performance the UK Business Secretary, Vince Cable, recently indicated that RBS is unlikely to be reprivatised before the current Parliament ends or “probably” inside five years. 

While RBS’s operational performance is close to that of Lloyds Bank, Adamson accepts that the institution’s greater institutional and political complexity will make an eventual sale more challenging. He warns that the valuation of the bank’s assets that BlackRock is undertaking as part of the Treasury’s review could trigger a further need for capital if RBS is found to have overstated their value.   


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