Three years after the onset of the credit crisis, when British banks including RBS and Lloyds narrowly avoided bankruptcy thanks to Government intervention, it seems the prescribed regime of management clear-outs, capital rebuilding, global retrenchment, cost-cutting and a more considered approach to lending is beginning to bear fruit.
The half-year results for Britain’s banks were ahead of expectations and even prompted talk that part-nationalised institutions will soon be reprivatised through “Tell Sid”-style extravaganzas. The four major banks – HSBC, Lloyds Banking Group, Barclays and Royal Bank of Scotland – unveiled combined profits of £13.7 billion.
The Lazarus-like recovery of two “Scottish” banks – RBS and Lloyds, which swallowed up HBOS in September 2008 – is particularly remarkable.
At Lloyds, chief executive Eric Daniels piled on the superlatives as he unveiled first-half profits of £1.6bn, a significant turnaround given the bank made a £3.96bn loss in the same period last year. The difference from February 2010, when Daniels was so ashamed of the bank’s 2009 performance he dodged BBC business reporter Joe Lynam in the street, was marked.
RBS managed a respectable pre-tax profit of £1.14bn, up from £15 million a year earlier. “We are making good progress with disposals and overall business restructuring,” said a cool, calm and collected chief executive Stephen Hester. But he conceded that rebuilding RBS is “a marathon not a sprint. There is, of course, plenty left to do”.
However, it’s only by analysing the fine detail and the macroeconomic backdrop against which the turnarounds have been achieved that the sustainability of the UK banks’ recoveries can properly be gauged.
Colin McLean, chief executive of SVM Asset Management, points out that Lloyds has benefited from the recent watering down of the Basel III proposals relating to the size and scope of future capital buffers. The emasculation of the Basel III regime, which followed powerful lobbying from the banking sector, has “relieved Lloyds of the necessity to sell its insurance arm, which includes Scottish Widows”, says McLean.
Also, there is a danger that the macroeconomic foundations on which the banks’ return to profit are based may be ephemeral. They include an unprecedentedly benign interest rate regime, £300bn of “soft loans” from the UK Government, and the effects of a less competitive marketplace. None of these crutches is going to last for ever.
Lack of competition, which intensified following the merger of Lloyds and HBOS and the melting away of foreign competition during the credit crisis, has enhanced what the bankers euphemistically call their “pricing power”. In other words, it enables them to charge higher interest on loans and impose more onerous terms on their retail and corporate borrowers.
The net interest margin at Lloyds – the difference between average interest on deposits and average interest charged on loans – rose from 1.83% in December 2009 to 2.08% today. At RBS, the net interest margin at its retail division rose to 3.77% from 3.57% one year earlier.
The return to profitability at RBS and Lloyds was also fuelled by massive cost savings, largely accomplished by headcount reductions. Lloyds has slashed annual running costs by £1.1bn, with the loss of about 17,000 job losses since the HBOS merger, and is well on the way to achieving its target of £2bn in cost savings by the end of 2011. RBS has dispensed with the services of some 28,000 people since its near collapse in 2008.
RBS and Lloyds have also been helped by the current, more benign economic backdrop, itself a consequence of the Bank of England’s now suspended quantitative easing programme. This has helped stabilise the commercial property market, a major factor in the reduction in provisions for bad debts (ie loans they believe will turn sour).
Provisions at Lloyds halved from £13.4bn a year ago to £6.6bn today, while those at RBS fallen from £7.5bn to £5.2bn now. (Exposure to massive losses on loans to the Irish commercial property market, where both Scotland-based players were active in the boom, continues to overhang the bad debt provisions.)
So what are we to conclude from this picture? Edinburgh-based Stewart Hamilton, emeritus professor at Lausanne Business School IMD, warns that the banks have not turned the corner. He points out that much of their current success is dependent on ultra-low interest rates, held at 0.5% by the Bank of England’s monetary policy committee last Thursday. He says any rise in base rates would present the banks with a major headache.
“The rate has never been this low in my lifetime. If base rates were to rise, loan impairments would increase dramatically,” he says.
Refinancing short-term wholesale funding is the most obvious challenge faced over the next 12 to 24 months. In the noughties, the banks circumvented need to match loans and deposits through borrowing from the global wholesale markets, but the rates of borrowing are going to look far uglier as they refinance post-economic crisis. Lloyds is seen by analysts as having the biggest mountain to climb, with £160bn of financing falling due for renewal in the next 12 months.
RBS and Lloyds will struggle when special liquidity is withdrawn
Hamilton warns that when circa £300bn of “soft loans” currently being provided by the UK Government through the Special Liquidity Scheme to RBS and Lloyds is withdrawn, as Bank of England governor Mervyn King says will happen in 2012, the banks will struggle to replace the funding at reasonable rates and their ability to generate profits might desert them.
“That can’t help but have a significant impact on their profitability, because in the open market they will never be able to raise finance on the same terms,” says Hamilton.
Bruce Packard, analyst at stockbroker Seymour Pierce, highlights the fact Lloyds has seen an outflow of customer deposits in recent months, which he says is concerning given the wholesale funding problem. Packard says: “If the last few years have taught us anything, it’s that banks can report healthy profits in any one reporting period but at the same time be storing up trouble for the future.”
Simon Maughan, analyst at MF Global, warns the price Lloyds would have to pay to replace the wholesale funding remains a “huge question mark” over its entire business. He says the bank’s management is “keeping its fingers crossed that the wholesale markets return to normal”. This is the hang-on-and-hope-something-will-turn-up school of management.
Another cloud on the horizon for RBS and Lloyds is a more hostile government. The Labour government could have made the £1.6 trillion support package of October 2008 conditional on structural changes such as breaking up large banks, to make them less risky, less oligopolistic and no longer “too big to fail”; or on behavioural changes including barring them from the payment of bonuses that reward reckless short-term thinking.
With Nick Clegg and David Cameron in Downing Street, the mood has changed. The Coalition Government has launched a Banking Commission, chaired by Sir John Vickers, which has been given a year to deliver a framework for making the sector more sustainable and responsible.
The body may recommend a forced split of “utility” functions – retail and commercial banking – from “casino” activities such as investment banking. Such a split, along the lines of the Volcker Rule in the US, would be particularly painful for RBS, which has so far been allowed to retain its investment banking arm, and Barclays, which has threatened to move abroad if such a change is introduced.
The Government is also replacing the regulatory system introduced by Gordon Brown in 1997 with a more unified regime under Bank of England governor Mervyn King. It is also forcing the banks to pay a banking levy equivalent to 0.04% of qualifying liabilities from January 2011, rising to 0.07%. Albeit that this is not quite as onerous as some analysts had feared, this levy still tightens the regulatory screws and is expected to raise £8bn over four years.
There are meanwhile numerous class actions and regulatory investigations overhanging the banks. These mainly relate to alleged wrongdoing in the final years of the credit bubble, including that bank boards duped investors into supporting rights issues by presenting a misleading picture of their institutions’ financial health.
And there are still bigger potential problems coming the banks’ way. There is the economic fall-out from Government austerity measures. These will lead to 750,000 public sector job losses, of which 60,000 will be in Scotland. This surge in unemployment will jeopardise the UK’s economic recovery and reverse the downward trend in provisions for bad debts.
Meanwhile, one of the most vexed political questions, and one on which King and Business Secretary Vince Cable have been particularly vociferous, is whether the banks are doing enough to lend to SMEs.
There have been persuasive cries of pain from the small business sector with horror stories about banks behaving abominably, seizing assets, arbitrarily imposing more onerous conditions, removing overdraft facilities from longstanding creditworthy clients on a whim, and demanding much more robust guarantees and stronger collateral.
The banks are adamant they have done nothing wrong. They insist they are still lending to viable businesses and that, if there is a drop in supply, it is a reflection of reduced demand. Lloyds’s Daniels last Wednesday said: “It’s not a question of being mean and turning customers away. We are seeing very little demand out there.”
One senior global banker says many British SMEs came to regard easy credit as their birthright during the credit boom. “We now know that all the RBS and Lloyds and other UK banks were dramatically mispricing such risk in 2000-08,” he says. “All that’s happening now is that it is being realistically priced.”
The banks will have to hope they win that argument with the authorities, however. The nightmare scenario for the banks part-owned by the Government is that it loses patience over lending and uses its shareholdings to force them to change tack.
In short, RBS and Lloyds’ two steps forward in the past few days seem merely that. There are still any number of factors that could derail their progress in the coming months. And this is about far more than whether the likes of Eric Daniels will keep their seats in bank boardrooms in future.
As Edinburgh-based banking consultant and author Robert McDowell says, the risk is that once the soft loans are repaid and the wholesale funding becomes unaffordable, the banks are driven back to their old position of having to match loans and deposits. Without the credit that we have all become used to, there would be dire economic consequences.
He says: “In a private, highly leveraged, debt-based economy, there can be little or no private sector growth with bank lending contracting at 5-8% of private sector GDP.”
That’s the dragon around the corner we had better hope we don’t meet.
This business focus article was published in the Sunday Herald on 8 August 2010.
Why do the people of Britain have to continue suffering at the hands of bankers whose attitude to the general public is becoming more contemptous by the minute? As Eric Daniels sprains his arm through patting himself on his back so vigorously for finding yet more questionable ways to get the bank back into profit, he is forgetting that his mindless DENIAL is the enemy of real RECOVERY. The ultimate short-term, small-time thinker, Daniels, needs a few short, sharp shocks to awaken him out of his reverie that “profits at any price” are even remotely acceptable, either politically, socially, economically, morally, or spiritually.
Life is not so profitable for the majority of people whom these banks profess to ‘serve’. Even cash-strapped businesses don’t get a look in now, because let’s face it, the banks don’t need to “lend” to make money — they already have our loot, and are making more and more money off the same seed capital because of their contemptible leveraging game.
As long as the government continues to support a debt-based (fraudulent) monetary system, the problems will continue. We need to completely overhaul our financial system, ban bonuses for banks, and take control of printing our own money through central government, pulling it away from the House of Rothschild and the Central Banking Cartel. There is no other way that to unlock the spell.