9th September 2011 by The Value Perspective
By Kevin Murphy.
In Open season, we considered why the share prices of Barclays, Lloyds and Royal Bank of Scotland (RBS) have fallen so dramatically over August yet, whatever the precise reasons may have been, a more important consideration now is whether the UK banks remain attractive investments.
At this stage, and for reasons we shall come to shortly, we believe they do – and indeed are much more attractive today than they were only a couple of years ago – and yet it is interesting to hear many investors saying that economic and market conditions now ‘feel a lot like 2008’.
Apart from anything else, this highlights why feelings and emotions need to be treated with extreme caution in investment because, when people say it feels like 2008, they are really saying they are fearful. For, with the possible exception of share price volatility, nothing about UK banks today is remotely comparable with 2008 – and certainly not the fundamentals, which are significantly better.
Nowadays, the extent to which a bank is protected in the event of unanticipated losses is measured by its ‘Core Tier 1 ratio’ (put simply- a banks capital requirement) and Barclays, Lloyds and RBS have seen their ratios double in size since 2008. So, rather than being in the region of 5%, the Core Tier 1 ratio of each bank is now between 10% and 12%, which is not only significantly ahead of regulatory requirements as they stand, it is also ahead of what they will be when the so-called ‘Basle III’ global regulatory framework starts coming into force from 2013.
Furthermore, all three banks have made a lot of progress in the funding market, which can be seen from the improvements in their loan/deposit ratios – the amount banks have loaned out versus the amount of deposits they actually have.
In recent years, Barclays has reduced this ratio from 138% to 118% while Lloyds has come down from 178% to 144% – or 114% in its core bank. Meanwhile RBS has done the best job so far, reducing its ratio from 150% to 114% – or 96% in the core. Bearing in mind effecting change in banks of this size is like turning round a super-tanker, these are notable improvements indeed.
But not only are the banks’ capital and funding positions both significantly better than they were in 2008, there are also regulatory mechanisms in place that did not exist three years ago. Back then, if a bank could not borrow cheaply in the market, there was little in the way of a Plan B. Now, thanks to mechanisms put in place by the Bank of England and other global central banks, the UK banks have other options to help them get by in the event of a temporary tightening in the lending markets.
Another consideration, as discussed in Open season, is the forthcoming report from the Independent Commission on Banking (ICB), which is due to be published on 12 September. After all, the commission’s interim report raised the prospect of an element of ‘ring-fencing’ – the separation of retail and investment banking – and the degree to which that happens will undoubtedly have an impact on the UK banks.
However, the final report will only be a recommendation rather than law. It will be reviewed by a body of MPs, who will then decide what and what not to implement. It should be remembered the UK government – or, if you prefer, the taxpayer – owns some four-fifths of RBS and two-fifths of Lloyds, which leaves the politicians on the hook in various ways.
If the banks are unable to lend profitably, they will not lend and if they do not lend, the UK economy is in trouble. Equally, if the banks cannot lend profitably, then they will not make money and obviously that would be bad news for the government and for the taxpayer. Ultimately the banks need to be in a position to make money, which means they need to be able to lend profitably while, to be able to move forward, they need certainty about their regulatory responsibilities.
No matter how you look at it, the UK banking sector today is nothing like it was in 2008. Banks are in much better shape than they were on both a capital and a funding basis while policy is now in place to help them out if the need arises. As ever, investors should treat feelings with caution because it is the numbers that count. Forget 2008 – in 2011, UK banks now trade at a price to tangible book value ratio of 0.5, which is a valuation not seen for a generation.
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