UK bank shares in demand after breezing BoE’s severe stress test

Gains for the banking sector on hopes of rate rise, after passing the Bank of England’s latest modelling. Our City analyst reports.

Stress test results and the outside chance that interest rates might still rise on Thursday have encouraged Lloyds Banking Group (LSE:LLOY) shares to rally off last night's two-month low.

The UK's biggest mortgage lender rose 2% or 0.7p to 45.1p alongside gains of a similar scale for NatWest (LSE:NWG) and Barclays (LSE:BARC), as figures from the Office for National Statistics pointed to resilience in the UK jobs market despite the end of the furlough scheme.

The unemployment rate was close to pre-pandemic levels at 4.2% and employers added 257,000 staff to their payrolls for an overall figure of 29.4 million.

The robust figures kept alive hopes that interest rates might soon rise from their pandemic low of 0.1%, a move that would ease the long-running squeeze on bank sector margins.

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The two-day meeting of the Bank of England's Monetary Policy Committee begins tomorrow, the same day as inflation figures are due to be published showing a jump in the rate to around 5%.

A bigger-than-expected inflation number will add to pressure on the Bank to act on rates, although most economists think continued uncertainty over the Omicron variant will persuade members to hold fire. They may also want another month of labour market data, to see if high job vacancy rates are feeding into faster wage growth.

Paul Dales, UK economist at Capital Economics, said: “In November, the Bank of England wanted to wait for more news on the labour market before raising interest rates. It’s got it. But now we think it will want to wait for more news on Omicron before raising rates.”

The Bank of England's latest stress test for the banking system modelled a severe scenario with an unemployment rate of 12% and GDP falling by 9%. This double-dip scenario following the Covid-19 2020 downturn would add another £70 billion in impairments on top of £20 billion already taken.

All eight banks in the test remained above minimum requirements, with none required to take action in the real world in response to the findings. The test involved Virgin Money (LSE:VMUK) for the first time, as well as Lloyds, Barclays, HSBC (LSE:HSBA), NatWest, Santander UK, Standard Chartered (LSE:STAN) and building society Nationwide (LSE:NBS).

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Their combined capital ratio fell from 16.2% at the end of 2020 to average lows of 9.6%, before management action got this back up to 10.5%. The stress test will provide the basis for boardroom decision-making on dividends and capital returns ahead of February's annual results.

UK banks held about 15% of their market value above their internal capital ratio targets in the third quarter, but UBS said the severity of the test and plans by the Bank of England to rebuild the sector's “rainy day” capital buffer may offer potential reasons for bosses to slow returns.

The counter-cyclical capital buffer was frozen in response to Covid-19, but the Bank thinks lenders are strong enough for this to rise to 1% by the end of next year and 2% by 2023.

UBS noted that Lloyds had the lowest gap to the reference rate in the stress test, providing some incentive to retain capital that might prove strategically valuable later.

The Swiss bank continues to regard Barclays and HSBC as its top picks in the banking sector, but also has “buy” recommendations on Lloyds, Paragon Banking Group (LSE:PAG) and Virgin Money due to their “attractive valuations and strong balance sheets”.