Five years after the run on Northern Rock, four years after the epoch-making crash of Lehman Brothers, the clouds over Britain’s banking sector remain as dark as ever. We may have been the first country to recapitalise our banks when the crisis struck, but as the years have unfurled the sheer scale of the legacy of the ‘nice decade’ (1997-2007, ‘nice’ being the Bank of England governor Sir Mervyn King’s acronym for non-inflationary consistent expansion) has been revealed, and regulators have begun to wonder out loud whether further injections of capital may be needed before the repair job is completed.
It is often forgotten just how big a role the wider financial sector plays in Britain’s economy. When the International Monetary Fund made its annual inspection earlier this year, its economists noted that one reason for the UK’s lagging recovery was that the liabilities of the financial sector represented a whopping 500 per cent of GDP, against 80 per cent in the US. The IMF’s point, reiterated recently by Sir Mervyn, is that robust banks are needed for a robust recovery.
The events of recent months have not been helpful. Scarcely a day passes without some new regulatory intervention, and even the strongest non-high-street banks such as Standard Chartered have seen their shares battered. In StanChart’s case it was a relatively unknown US agency, the New York Department of Financial Services, that obtained a £217 million settlement with the bank over money-laundering allegations.
Most of the regulatory focus has been on Barclays, Royal Bank of Scotland, Lloyds Banking Group and to a lesser extent HSBC. Barclays has found itself under pressure because of the foolish decision it took to settle first with the US and British authorities over the attempt to rig Libor interest rates. This led to the exit of a trio of top executives: the chairman Marcus Agius, the chief executive Bob Diamond and the chief operating officer Jerry del Missier.
RBS also has acknowledged Libor misdemeanours but has yet to settle with the authorities. The government is more concerned with the state of RBS and Lloyds because it is the dominant investor in each group. For RBS the troubles are piling up, and each regulatory problem uncovered makes it more difficult for the bank to trade its way out of trouble — and harder for the taxpayers’ stake eventually to return to the market. Among the issues still to be provided for are the final bill for Libor, the mounting cost of payment protection insurance, and real estate losses at Ulster Bank. Added to this list are the cost of its involvement in US sub-prime mortgage lending that resulted in a $42 million fine from the Nevada authorities in October, and the expectation of more to come.
It is the fear that one-off charges against profits will prevent RBS from building the necessary capital and liquidity cushion that is causing anxiety among bank supervisors. Andrew Bailey, a Bank of England policy-maker currently assigned to the FSA, has written to RBS suggesting that it makes further disposals, such as its American branch operation Citizens, so as to boost its capital. RBS demonstrated that there is still an appetite for initial public offerings in financial stocks when it disposed of a one-third interest in the insurer Direct Line last month, raising £787 million.
It has become clear, however, that British regulators have not finished in their effort to purge the banks of past mistakes. Even the strongest banking brands are having to deal with legacy issues. Santander UK has disclosed it is setting aside a further £232 million to cover the potential cost of items such as the mis-selling of interest-only mortgages and packaged premium bank accounts. HSBC is seeking to extricate itself from some of the acquisitions it made in the last decade in the US and beyond, and to focus expansion on growth markets in Asia-Pacific. It is still vulnerable to regulatory action from its involvement in US sub-prime and claims of money laundering through its Mexican subsidiaries as well as lingering problems with British consumers. But HSBC remains a profit machine that is far more able to absorb losses from the past and must still be regarded as the safest investment opportunity in the UK banking sector. It also measures up well against foreign rivals such as JPMorgan Chase, because of its exposure to the fastest-expanding -markets.
Barclays, after its boardroom upheavals, remains a bank in transition. Its new chief executive, Antony Jenkins, clearly wants to build up the retail side of the bank: he has demonstrated a determination to expand by purchasing ING’s portfolio of British mortgages. On the other hand, it is still not clear how committed Jenkins and his new chairman Sir David Walker are to the investment bank, which in recent years has been the driver of growth. Barclays still carries regulatory baggage including a Serious Fraud Office inquiry into its Middle East capital-raising in October 2008. Nevertheless, it remains firmly established in the private sector, having eschewed a bailout, and is sensibly expanding in growth markets in Africa, where it has a long history. But it cannot escape toughening regulatory requirements and may need to seek new capital that could dilute existing shareholders.
It would be nice to recommend buying shares in RBS in the hopes that one day it may be restored to its former glory. But that looks unlikely: the risks are far too great. A better investment in a state-dominated bank might well be Lloyds (which I hold), because of its strong position in the UK’s retail market, once it has discarded its legacy liabilities. After all, it was the lust for market share that attracted dull old Lloyds to acquire dodgy HBOS in the first instance.
StanChart also looks a relatively good investment, given its heavy exposure to Asia-Pacific and despite its skirmish with the US regulators. The Direct Line IPO demonstrated that well focused general insurers, of which Admiral is another, can be attractive. Demand should be strong when esure — created, like Direct Line, by the insurance genius Peter Wood — comes to the public markets this year or early next.
But if anything, bank shares have become toxic again in recent weeks. If the UK economy is really on the mend then the balance sheets and shares of the banks could recover. But not in the short run.