In racing journalist Marten Julian’s book ‘Strictly Classified’, he recounts the strange behaviour of a horse owned by the former jockey Willie Carson. While this animal was normally relaxed and confident, a natural herd leader, whenever it passed a particular rubbish bin on the way to its morning gallop it would shy away as if terrified of what was held within. Nobody could recall what could have triggered such a response, but the horse was clearly spooked.
Many investors have a similar Pavlovian response to the banking sector, with the crucial difference that they are perfectly capable of rationalising the trauma behind the fear factor. The global financial crisis was the first experience of a market downturn of any note for many investors and analysts. While the reasons behind the crisis and their effect on the banking sector are, by now, well understood, the longer-term effects on investor psychology are still being learned. Many still avoid the UK banking sector, viewing it as a ‘rubbish bin’ best avoided entirely. This is unwarranted.
That is not to say it isn’t understandable. Banks clearly face significant challenges and returns on capital will be markedly lower than they have been historically, but some perspective is called for. In recent years the UK banking sector has had to face an unholy trinity of ongoing regulation, misconduct and muted growth. However, the latest pronunciations from European regulators suggest that the risk of significant asset inflation has reduced for the vast majority of banks, UK stress tests were passed with flying colours and the UK has finally announced a long stop date for PPI claims.
The advent of negative interest rates presents another sizable hurdle but even these are unlikely to be the death knell for the sector. In Sweden and Denmark where rates have been negative since 2014, net interest margins have proven more resilient than the European average. In the UK, many domestic banks still have levers that can be pulled to protect net interest margins, including the reduction of their cost of funding through deposit repricing. Lloyds’ guidance for 2016 actually pointed towards a slight increase in its net interest margins, a robust outlook at a time of bearish sentiment.
It should also not be forgotten that the banking sector is much better capitalised than it was prior to the financial crisis. Between the end of 2011 and July 2015, UK banks’ aggregate Basel III core equity tier 1 ratios increased by 4.1 percentage points to more than 11 per cent. This improved capital strength, combined with the easing regulatory environment, means that there is likely to be a greater dispersion of returns within the banking sector. Sector-wide concerns should take a backseat to company-specific issues.
With a relatively positive ‘home’ economy likely to be supportive of loan growth, domestic-oriented banks such as Lloyds should continue to generate sufficient capital each year to allow increased returns to shareholders. Banks with greater exposure to underperforming economies or those with outsized investment bank divisions, such as HSBC, may struggle in the near-term, but this is arguably already more than reflected in current share prices.
The challenges facing the UK banking sector are plentiful. Recent stock moves, however, suggest that either their business models were broken entirely or that a global recession is imminent. Neither appears likely. Investors scarred by recent history have overreacted as new challenges reignite old concerns. Horses are herd animals, whose reactions are still primal in nature. Investors don’t need to act in a similar way and shouldn’t be afraid to plough their own furrow.
Neil Veitch is manager of the SVM UK Opportunities fund.