British banks are back. With that has come talk of raising their taxes.
Shares in the four big UK lenders — HSBC, NatWest, Lloyds and Barclays — have hit their highest levels since the financial crisis in recent weeks. Valuations are at their fullest in five years. NatWest just turned in its best quarterly profits since 2008.
“The valuations for UK banks are now higher than any time in recent history,” said Benjamin Toms, an analyst at Royal Bank of Canada.
That made banks’ profits potentially an easy target for the Treasury. Ministers have spent the summer flirting with a raid on the sector as part of an effort to find politically acceptable ways to bolster public finances.
Raising the surcharge on bank profits from 3 per cent to 5 per cent, as former deputy prime minister Angela Rayner proposed in May, would add about £600mn to government coffers.
The threat has receded — with lenders now expected to be spared in next week’s Budget — after an intense lobbying campaign that emphasised the sector’s role in powering growth. Barclays’ chief executive CS Venkatakrishnan last month told the Financial Times he hoped adding to banks’ tax burden was “an extremely low probability”.
“London is a great global financial centre and the path to growth does not lie to taxing the sector even more,” he added.
But it is hard for banks to argue that they have not benefited from a period of higher interest rates — and more recently, the Bank of England’s slow pace of cuts.
After the squeeze from the zero interest rate era of the 2010s, higher interest rates have helped plump banks’ net interest margins — the difference between the interest lenders receive on loans and the rate they pay for deposits. Lloyds reported a margin of 3.11 per cent in 2023, compared with 2.12 per cent a decade earlier.
Aman Rakkar, an analyst at Barclays who covers UK banks, said the increase in interest rates in the UK was the most dramatic among the main currencies of dollars, euros, sterling and yen.
“The movement in the UK [of interest rates] is among the most pronounced, which means if you’re in the business of generating spread, you have seen a truly transformational tailwind.”
During the zero interest rate period, bank business models had been confined to making money on lending because deposits were no longer profitable, he added. The return of deposit margins “makes the business model more viable and balanced”.
But interest rates are only half of the story. “There are other things that have helped push share prices higher,” Toms said.
Most striking has been UK banks’ use of structural hedging techniques to manage the rate cycle and their profits.
Structural hedges are interest rate swaps that allow banks to smooth the impact of rate changes on profits. Hedges put on when rates were low stopped the banks enjoying the full bump from rising interest rates at the time. But now interest rates have started falling, hedges that were put on when rates were high help to damp the blow to profits.
Earlier this month, TSB Bank recorded a 38 per cent increase in statutory pre-tax profits largely because of structural hedging techniques.
“Interest rates have been a big driver,” said Ambrose Faulks of Artemis Investment Management. “Because of the structural hedge, there is much more visibility for the Barclays and the Lloyds of the world. That hedge will drive net interest income for the next three or four years.”
Immediately after the crisis, banks were under pressure to build up their regulatory capital buffers. NatWest has built up a core equity tier one capital ratio of 14.2 per cent, compared with 4 per cent in 2007.
One senior executive at a large UK bank said: “The earnings we were making and the capital that we were generating post-financial crisis were going to build up the capital ratios and also paying off conduct charges and litigation charges.”
Conduct and litigation charges have eased, with banks generally taking less of a hit than they feared, according to independent banks analyst John Cronin.
But British lenders have yet to see off the threat from the car finance mis-selling probes, which echo the payment protection insurance scandal that depressed bank profits for years.
Fears over car finance liabilities have hit Lloyds’ results, with the bank’s pre-tax profits falling 36 per cent in the latest quarter. It has earmarked £2bn to cover costs; Barclays has provisioned £325mn.
While some investors toast a return to profitability, not all lenders are so cheerful.
One board member at a large UK bank said: “We have only just started washing our faces recently . . . in many cases these [banks] are near £1tn balance sheets and should be generating much higher returns for shareholders and the economy. We have been destroying shareholder value ever since the financial crisis.”
Others note UK banks lag behind their counterparts in the US and Europe. The country’s domestic groups trade at a price-to-earnings discount of about 13 per cent compared with the rest of the sector, according to analysts at UBS.
Although that could signal there is further room for shares to rally, uncertainty over taxes for the sector could add to lenders’ cost of equity, UBS said, with implications for their ability to fund growth.
“A growth economy needs a lower hurdle rate, in our view,” UBS analysts said.
Some investors worry this may be as good as it gets for bank profitability, as rates come down and the boost from structural hedges wanes.
Edward Firth, an equity analyst from Keefe, Bruyette & Woods, said he was concerned the market was too relaxed about the potential impact from rate cuts. “There is huge political will to get rates down for obvious reasons and if they go down enough . . . that could see margins start to compress markedly.”
If interest income declines sharply, that could hurt profits if banks follow through with planned spending on technology and artificial intelligence, he said.
Banks have been venturing into new markets that are not as dependent on interest rates to help hedge their exposure further. HSBC has focused on its premier customers, while Lloyds has tried to chase fees from managing client pensions, investments and insurance.
But despite these efforts, they remain heavily reliant on income tied to interest rates. In the third quarter, NatWest generated 76 per cent of its total income through interest-related activities, slightly higher than Lloyds’ 70 per cent.
For the moment, that is very profitable. But lenders have been anxious that the chancellor may at some point choose to share in their spoils.
Venkatakrishnan told the FT last month: “No Budget keeps everyone happy, but the object of it is to foster growth in the country.”
Additional reporting by Ortenca Aliaj
