Interactive Investor

UK banks: A review and what's in store for 2018

28th December 2017 10:21

Emil Ahmad from interactive investor

As the full ramifications of the 2008 financial crisis became apparent, only one sector could be exclusively cast in the role of the lead villain; the banking sector. The public was baying for blood and the media was happy to oblige. The process of repairing this breach of trust has been a  long and arduous journey and, 10 years later, an element of distrust still prevails.

A key factor in the financial crisis was the minimum amount of capital banks retained as the myopic pursuit of profit and bonuses drove leverage to unsustainable levels. As part of the rebuilding process, the Bank of England introduced a 'stress test' in 2014 to ensure that our banks would never have to be bailed out by the taxpayer again.

In November,  the seven major UK players (including Nationwide) were able to breathe a collective sigh of relief when all successfully negotiated this rigorous assessment of their financial mettle. Ultimately, all the banks are sufficiently capitalised to cope with a recession, a collapse in the housing market and rising unemployment. This will provide a welcome boost to the government as they revisit plans to re-privatise Royal Bank of Scotland.

Although the banks will be heartened by this success, there is still much work to be done. Both Barclays and RBS exhibited vulnerabilities in the extreme stress test scenarios and reflect the fact that some problems persist in the sector. As we head into 2018, it is worth reflecting on how each bank currently stands.


As one of the two stress test laggards, it is perhaps unsurprising that Barclays has delivered a less than stellar performance in 2017. The stock has delivered a loss of over 7% this year, despite rallying by 13% in the last five weeks. Currently trading just above its 200p support level, Barclays is paying dividends to shareholders, despite a cut in 2015.

Barclays' restructuring plan has finally reached completion, potentially allowing it to steal a march on competitors as it seeks to refocus on core competencies and increase market share. The risk profile of the bank has benefited from an £85 billion reduction in exposure to non-core risk-weighted assets.

However, headwinds to future earnings remain in the form of mis-sold PPI (£8.4 billion compensation pot set aside) and the ongoing US investigation into residential mortgage-backed securities.

In the UK credit card space, the company maintains its leadership position with Barclaycard. Nevertheless, Lloyds Banking Group's acquisition of MBNA Europe ensures an overall market share of 26%, providing Barclays with some stiff competition.

Although the bank remains well-diversified, it is centred around a few business lines with too much reliance on Barclays International for revenue generation. From a geographical perspective, the lion's share of income is generated in its domestic market (52%), with 34% coming from the company's US interests and the balance from Europe.

Primarily driven by reduced litigation costs and impairment charges, Q3 2017 profit before tax for Barclays UK hit £661 million, a year-on-year improvement of £586 million. Barclays International could not duplicate this performance, with Q3 profit of £652 million representing a year-on-year drop of almost 40%. The Consumer, Cards and Payments division is the main culprit .

Considering the Q3 results, group CEO Jes Staley noted, "The completion of our restructuring, and the strength of our capital base today…means we can now turn our full attention towards what matters most to our shareholders: improving group returns."


Generally trading in the 62-73p range for the majority of 2017, Lloyds has delivered investors a return of more than 6% over the course of the year. Recovery from the financial fallout and subsequent bailout was slow, with dividends only reintroduced in 2015 after annual profits quadrupled.

This bank is very much UK-centric, with 95% of its asset base in its domestic market. A complete overhaul of the bank's structure began six years ago and a leaner, meaner Lloyds has subsequently emerged; in essence, a relatively low-risk domestic retail and commercial bank.

The acquisition of MBNA Europe and Bank of America's UK credit card book will provide major impetus to Lloyds' aim of increasing its consumer finance presence. With a low interest rate environment continuing to hurt the banking sector's bottom line, these acquisitions will help Lloyds diversify its revenue base into higher-yielding areas.

The bank's enhancement of its digital offering began in 2014, a couple of years earlier than most of its competitors. This has allowed Lloyds to aggressively capture market share; the company enjoys a 21% share of the digital banking space and meets around 60% of its customers' requirements via the digital service.

There has also been a focus on core competencies and enhancing its operational risk profile, as Lloyds has sold non-core assets and exited a number of markets. As a UK-focused bank with a minimal international portfolio, any delays in the Brexit process creates a greater degree of risk for Lloyds than many of its immediate competitors.

Q3 results were solid, with net interest income up 12% after the credit card book delivered an exceptional performance. Total income rose by 8.1% over the period and statutory profits made a year-on-year gain of over 100% (£1.95 billion).

CEO António Horta-Osório was upbeat about prospects, stating, "These results highlight the strength of our customer focused, simple and low risk business model and the benefits of our competitive advantage in the UK."

Royal Bank of Scotland Group

RBS has been on a tear of late, advancing by 12% since early September. Over 2017 as a whole, the share price has strengthened by around 22%. However, RBS still needs to resolve its outstanding US litigation and conduct issues which could weigh heavily on FY 2018's bottom line.

RBS has not paid a dividend in over a decade, a situation unlikely to change until the bank returns to a more robust level of financial health and the US residential mortgage-backed securities case is concluded.

Despite the US headwinds, profitability is improving and restructuring is progressing in line with managerial expectations. Net income in this financial year has received a boost from lower litigation and conduct costs in addition to a reduced restructuring outlay. It's estimated that operating costs may consume about 75% of revenue in the medium term, with earnings volatility likely to continue over the next few years. This will primarily be driven by restructuring costs and the financial burden of ongoing US litigation and conduct cases.

The retail banking business remains a key component of RBS's portfolio, with the UK-based business line generating around 45% of group revenue. Personal and Business Banking (PBB) remains central to revenue growth.

It's not all bad news for the UK's most heavily nationalised bank, with net income of £392 million in Q3 signifying the third successive quarter of profit. Net interest income also grew 4% year-on-year, with improved net interest margin development a positive driver.

However, these gains were offset by a 5% reduction in net fee and commissions income as compared to Q3 2016. CEO Ross McEwan said the results confirm that the strategy to simplify the bank "is working".

Standard Chartered

Although Standard Chartered has lost ground in the second half of the year, the stock has delivered a 12-month return of almost 15%. The bank has been pressing ahead with its restructuring plans, with most of the work expected to be completed by the end of 2018.

In addition to restructuring $100 billion of risk-weighted assets to improve returns, it has also invested $3 billion in a systems upgrade project to enhance compliance handling and digital efficiency. More robust internal compliance functions will prove to be essential in financing the working-capital requirement of Chinese companies and banks exposed to increasing levels of non-performing loans. Higher loan losses in this region remain a risk over the next few years.

Standard Chartered has secured a strong position in Asian trade finance, a region which accounts for approximately 40-50% of the global market. China is the most important country in the region for trade finance, but its transition to a services-led economy could translate to reduced demand.

The company arguably has a riskier business model than many of its competitors, as it has a significant exposure to many volatile emerging markets. It's estimated that only 40-50% of commercial client loans are investment grade and headwinds for the bank are a slowdown in Chinese economic growth, commodities exposure and fraud-related risks. From a UK perspective, the bank is less vulnerable to Brexit risks due to its Asian and emerging market focus.

Q3 2017 results indicated operating profit of $10.8 billion for the first three quarters of 2017, a 5% year-on-year increase. Underlying profit before tax over the same period posted an 88% increase as compared to 2016, primarily driven by a decline in loan-loss charges and a one-off gain from asset sales.

Boss Bill Winters feels that progress is being made, stating, "We are transitioning our businesses to deliver higher quality income to improve sustainable returns. This process and the continued investments to support it are reflected in the results and will deliver greater long-term value to our shareholders."


Continuing its pattern from last year, HSBC has continued to make gains throughout 2017. The stock has returned over 22% in 2017, as the bank appears to be in pretty solid shape. Restructuring has been navigated successfully in recent years, as HSBC exited unprofitable markets and offloaded underperforming portfolios.

The most profitable parts of HSBC's portfolio are the Hong Kong and UK retail mortgage books, which account for 30% of overall exposure in this area. Retail banking in these two markets is another highly profitable area, as the bank's low-cost funding advantages come into play. HSBC has maintained its dominant position within the Hong Kong banking system, where it's estimated it has a 22% deposit share and 32% of its assets are based. These two figures increase significantly if you include its majority ownership of Hang Seng Bank.

Within the UK, HSBC is one of the four main banks which control about 80% of retail banking. The UK portfolio also includes First Direct and the multi-brand strategy appears to be working successfully within this market. As is the case with Standard Chartered, the bank maintains a strong position in Asian trade finance. The bank is truly global in nature and diversification allows it to absorb economic shocks more effectively than competitors.

Compared with 2016, net income for the bank in the first nine months of this year was $11.5 billion, a 55% year-on-year increase. Profit before tax ($14.9 billion) grew by 41% over the same period, but was fundamentally driven by a 60% reduction in loan impairment charges.

CEO Stuart Gulliver, who leaves the bank in 2018, is happy with performance, stating, "We maintained good momentum in the third quarter, with higher revenue in our three main global businesses. We also continued to make good progress with the strategic actions we set out in 2015.

"Our international network continued to deliver strong growth in the third quarter, and our pivot to Asia is driving higher returns and lending growth, particularly in Hong Kong."

As we head into the New Year, there are encouraging signs for the banking sector. From a global perspective, interest rates rises, led by the US Federal Reserve, can only be good news for the bottom line in 2018.

It was thought that Donald Trump's tax reforms would also provide a boost to banks with US exposure. That may now not be the case as overseas lenders face higher US funding costs than American peers. Still, in terms of their UK presence, official confirmation of their ability to withstand recessionary and misconduct headwinds must provide some degree of satisfaction.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.