I had to laugh, though no offence intended, when KPMG press released announced breathlessly, "
Economy will drive banking performance in 2010, finds KPMG's UK Banks Performance Benchmarking Survey..." OMG, how can that be? How could banks let themselves play second fiddle to the economy. the economy is only the benchmark surely and big banks have for years outperformed that poxy benchmark. But, look where that got to?
Credit Suisse (CS) undoubtedly have one of the very best teams analysing banks and some of my observations (duly marked) below come from them. The problem I see it is that for some time yet banks are short term 'plays' from an investor perspective.
Banks' share price projections are interesting for the next 2 years, but in that time, in the UK especially, much may change as a result of competition enquiry, possible big bank break-ups, new entrants, risk becoming nationally defined as a result of the sovereign debt crisis, possible Euro Area recession imminent, banks reptariating their lending, banking and trading books shrinking, problems governments want to overcome to force banks to grow lending to boost recovery when lending is still in retreat, and the impact of Basel III regulations requiring larger capital, liquidity and economic capital buffer reserves.
Economic recovery and getting a better external sovereign balance depends on manufacturing, which has half the world share today compared to 1980 (2.6%/5.2%). Yet, UK manufacturing on which most of our exports depend has been weak for years and has a long way to climb back to support the coalition government's OBR rosy forecasts. It is 17% of UK GDO but gets bank credit equivalent to 5%/GDP (compared to 30%/GDP in Germany). UK bank lending directly supports 28% of UK exportable tradable good production compared to 42% in Germany! This is a january 2010 graph:
If UK banks are to positively help recovery they have to lend more to business and less to property, unless we are merely to try and return to a credit-boom economy and risk higher external trade and payments deficits, which means returning to securitisations to finance those deficits? UK business has headroom to carry a much bigger debt servicing cost. UK banks lend 1.5% of non-finance customer loans to small firms and self-employed (who provide half of all private scetor jobs). In Germany the figure is ten times higher! If UK banks did more to lend proportionate to all economic sectors their performance would both help economic recovery significantly and be assured of gaining from that recovery fully. Instead, the usual risk and shareholder valuations are based on "book values" (net assets) irrespective of their economic composition.
CS believe banks should be valued on book - of course, even if many have market values still below 'book'. My view is they should be valued by a basis point calculation of both sides of the balance sheet to determine the cyclical strength of net interest income. We are still in a period when one-offs including sales of operational units, asset disposals, asset swaps, bad banks, fee income, tax adjustments, state-aid, bonuses (deferred or not), other restructuring, systems investment, redundancies, and so on, dominate net profit before tax, when stability would mean that net interest income has returned to a dependable amrgin and inter-bank lending is economically priced. The recent bank of England Stability Review stated that funding markets (for banks to refinance their funding gaps) have been effectively 'closed' (uneconomically priced) for the past two months of Europe's sovereign debt crisis. There will be more such crises hitting banks' funding.
The Bank of England also notes that UK banks' funding gaps have almost halved. APS played its part in this alongside banks shrinking their loanbooks, which the economy experiences like a hole in the head.
I'm presenting a paper in Germany next weekend to economists, MEPs and journalists.
This is about banking and the euro crisis that I've playfully entitled DAS euro BOOT (find version of this on www.asymptotix.eu). I've identified bias in different member states' banking lending that creates and underpins whether states are export-led, credit-boom, or a mix. Regulation needs to have the power to task banks with restructuring their lending portfolios in credit-boom (typically 70% of non-financial customer lending exposed to property and mortgages) and export-led economies (typically 60% of bank lending exposed to industry and trade).
The €720bn fund that European Commission President van Rompuy has cobbled together is intended to reassure the markets. It like the Federal reserve's TARP in size and intent. Congress had to vote it and took a large slice to determine the precise allocation and ensure everything was duly reported. I would like to see the European Parliament getting similarly involved because I am doubtful of the European Commission having sole charge of a fund worth five years of Commission budget! It is not the same as US Federal Reserve and Treasury or the Bank of England and HM Treasury, or the ECB, IMF, or the newly envisioned European Banking Authority. The EU and Euro Area simply do not have financial institutions with the power and flexibility of the USA and UK. This European Stabilisation 'Bank' fund is being set up entirely within Commission control for which experience and skill-set, and much else, are not in place, and would normally take a couple of years at the very least of detailed preparation to get right. But, in the crisis there is understandable panic to be seen to be taking action. "Stitch in Time" failed as it is bound to when so many stakeholders have to be appeased politically. The fund is five times the Commission's annual budget, which already tests the Commission's accounting beyond its sometimes tawdry limits! I think the whole matter needs European Parliament's scrutiny starting now.
Banks are so intertwined, unlike competing firms in most other 'industries' that all of the above and more are uncertainties unnerving banks' performances. CS say recent events highlight that “normalised” earnings performance is illusory distraction because of structurally challenged balance sheets. When that is the case, banks can get into self-harming spirals of not extending new lending waiting for others to do so first before they will and so all hang back. When valuations of UK banks can fall 25% in a month, there is considerable nervousness, uncertainty and also short term profit-taking and shorting still dominating the market.
Clear risks remain: Market dislocation is unhelpful for a sector (UK) with an NSFR of 85% (including SLS and APS) and £300bn of wholesale redemptions in 2010-12. The banks (particularly LBG) need funding gap refinancing markets to reopen soon (also called 'term markets', with Bank of England calling on banks to both speed up their medium and longer term note borrowing and shift borrowing to longer term, which is very hard, if not impossible, when margin spreads appear uneconomically high!). The Bank of England said term markets (for banks refinancing their funding gaps) have been closed for 2 months and UK banks need to refinance about £700bn in next 18 months or so! banks are undertstandably reluctant to fully disclose their liquidity financing for fear of being blackmailed by lenders.
CS says "wider LIBOR OIS spreads (are) unhelpful", an under-statement since as all should know this issue is The Credit Crunch i.e. that beast is far from vanquished. This catastrophe is the effect of the sovereign debt crisis's pisspoor political and instutional handling so that what was a way of shorting profits from bank stocks is now a way of shorting them again via shorting governments.
CS believes LBG has more liabilities than assets priced off LIBOR and that this exposure is increasing. maybe, but I can't believe that is a serious problem. CS think Barclays and RBS have a net asset exposure but this is likely to be marginal.
Weaker sterling will lead to what CS call "RWA inflation" whereby Tier 1 capital reserves have to increase. But, in my view the ease with which banks have grown their liquidity reserves suggests they can without too much difficulty increase their Tier 2 capital and by taking loan loss provisions against Tier 2 help to secure their Tier 1 ratios.
CS says this mainly affects Barclays where CS think the 6% drop in £ versus US$ since March 2010 will boost its RWA by around £10bn (£0.8bn higher Tier 1), but I can't see that as a problem, and CS anyway say that euro weakness should partly offset this. They all got Market Risk RWA wrong and many had severe bugs in their Credit Risk accounting engines (the reason for Fortis's collapse). RBS has plans to spend £6bn on new accounting systems. All major banks have a few $£billion of similar requirements medium term, not least new general ledger systems with more headings and risk accounts.
My view is that RWA is a dog's dinner in the banks' calculations and as they improve their systems at regulators' urgent behest there will sizeable RWA increases anyway that eclipse currency moves, even early years of recovery in collateral values. Such effects will be lost like odd socks in the wash when risk data is more accurate, more complete, and above all makes a 'success', any kind of success, of Pillar II of CRD (Basel II), Solvency II, and IFRS accounting standard. Pillar II is really what so-called Basel III is. All of Basel III is already built in or available as discretionary power to regulators within Pillar II. What is that? essentially it is where the banks have to collate holistically all their risks (not just credit, market and operational risks) and relate these to the bank's performance in the context of the underlying economie sin which they do business. Insightful readers will immediately think this is beyond the intelligence of bankers and even of their systems. Yes, that's so and why the banks are resisting like pack-mules on the beaches at Gallipoli. This is the massive heart and core of basel II that aims to transform the management culture of banking, and as all know cultural change is the hardest challenge.
BASIS POINTS IMPACT ESTIMATESCS estimated the impact of the Basel III proposals as if implemented at end 2009, including an uplift for Counterparty Credit Risk (CS's special feature that it exclusively spotted), would be c280bps for HSBC and c150bps for Standard Chartered.
These are sizeable hurdle-rates that should percolate through all of the banks' business units. But, if the cost of borrowing and underlying net interest income can meet this half way or better, then the impact is mitigated. But, that is a big if? CS says their cost impacts compare favourably to an average impact of 470bps for UK's more domestic concentrated banks. In aggregate, UK major banks have only about half of their customer lending domestically.
But there are positives. CS say recent dislocation has left the sector trading 15-20% below 2010 ETNAV, importantly leaving base rate expectations much lower – money markets price in 1.2% at December 2011. This reduces tail risk in problem loan portfolios (corporate lending) and reduces the risk of new NPL formation by UK banks.
Low rates help mortgage revenue, deposits already taken the hit. CS expect the spread on UK mortgage loans to increase 150bps over the next 2 years. Deposit revenue will struggle, but CS believe a drag of £19bn has already been experienced, with income now negative.
CS say UK bank balance sheets are also in better shape. In 2008, balance sheet structures were weak, opaque and poorly marked. Today, the equity tier 1 ratio is 10%, CS estimate that 12% of loans have been written down since 2007, and liquid assets cover 90% of 3-month funding (20% in 2008). This should help on the credit risk side.
More upbeat: In the long-term, CS's structural concerns remain strong. CS think the UK banks are investable and at current levels offer value. CS is conservative in its target price model. CS value Barclays at 365p offering 29% upside, RBS at 54p offering 26% upside, and LBG at 60p offering 20% upside potential. These are strong forecasts, but over 2 years, by which time there will have arrived the shock downward effect of Euro Area recession in my view.
On the major two banks with emerging market and least proportionate UK exposure, CS offer this: CS increased 2010E PBT for HSBC by c13% following the Q1 IMS - driver being lower impairment and stronger GBM performance, particularly in the US. Standard and HSBC delivered upbeat Q1 IMS statements of strong Q1 wholesale banking performance, and lower impairment trends. But, this may also reflect demand on HSBC for funding support for financial firms' restructuring where HSBC participation greenlights others? Funding and liquidity positions
"screen" better than UK domestics. CS estimate that HSBC has an Net Stable Funding Ratio (NSFR) around 98% and Standard around 105%, which compares favourably to the UK domestic banks average of c82%, on CS estimates.
Standard Chartered’s capital position looks good.
This is partly because its In CS's view, Standard
"screens better than HSBC on funding and liquidity and capital regulatory proposals". In part this is because much of their banking is outside hard-core Basel II territory of EU mainly - elsewhere the regulators are behind the curve. CS also sees Standard as a purer play on Asian market growth with greater revenue momentum, whereas the driver of HSBC’s earnings in the near term remains improving credit quality in the US (if, in my view, current high GDP growth continues and there is labour market good news).
In my view there is a big risk on being over-exposed to Asia, China especially, because bank lending there is heavily supported by state funds (all China's foreign reserves are loaned to the banks' liabilities) and there is I believe a crash coming. many investors in Asia may wish to squeeze the last of the upside before parachuting out, but if I was heavily invested there I would be anxious to be one of the first out the door.
CS's RBS note is interesting on 3 points looking at the bank's Q1 IMS statement:
1. A return to profitability - excl. exceptional items and stripping out debt charges, the group posted a £0.7bn PBT in Q1 2010 after average quarterly loss of around £1.3bn in H2 2009. To my thinking this is accomplished by window-dressing and not yet reliable. There were improvements in core and non-core. Non-core losses of £1.6bn compared to a quarterly loss of £2.6bn in H2 2009. Core – PBT of £2.4bn from a quarterly profit of £1.3bn in H2 2009. Both benefited from a sharp reduction in impairment charges and trading losses. In my view they suck if there is not a big improvement in net interest income. the debt charges are significant and long lasting when they include APS - and one needs to know if the 3285bn in APS assets are net performing or not, and who gets that money, RBS or BoE and what RBS's management fee is for managing the underlying?
2. Pre-provision profits in core - excl. debt charges, these total £3.4bn in Q1 2010 versus c. £2.5bn in H2 2009. The improvement was (like HSBC and others with investment banking) driven by GBM revenues - but £2.8bn, down 35% on exceptionally strong Q1 2009 (£4.4bn) but up versus a quarterly run-rate of £2bn in H2 2009 - and an abnormally large contribution from Central Items - which spiked £0.3bn from a loss of £0.2bn in Q4 2009 (all excl. fair value on own debt). CS says (old story) "This seems one-off, driven by non-IFRS economic hedges and a one-off VAT recovery of £0.2bn." CS notes that outside of GBM and central items, pre-provision profits were very lacklustre despite an improvement in the core margin to 2.11% versus 2.06% in Q4 2009; I worry that RBS is losing clients?
3. TNAV across the group - CS note this came in at 51p at March 2010 versus 51p at December 2009 with the small profit . The equity tier 1 ratio was 10.6% from 11.0% at December 2009 with RWA up 5% due to Basel I ABN Amro capital relief trade roll off (£16bn) and currency. CS had £15bn ABN Amro impact in the numbers at the full year stage anyway. Overall, the main focus is likely to be the return to profitability in Q1 2010 and hence the potential for the TNAV of 51p to represent a floor to the share price.
But CS has two lingering concerns that to readers who are not professional investors may seem opaque or arcane:
1. Around 12p of the 51p TNAV is non-core, on CS estimates, and likely to deplete further moving forwards. CS think investors are really paying for the 39p in core and any residual left in several years time in non-core. The book multiple is not, therefore, as attractive as it superficially appears;
2. The core business generated around 5.8p in Q1 2009 annualised, but normalised CS think this was nearer 4p. CS assume impairment at 80bps (which boosts the EPS) but assume a more normal revenue run-rate of £9bn per annum in GBM and no contribution from Central items. CS also take out the contribution from the businesses that RBS is being forced to sell by the EC.
To buy RBS therefore, CS say "investors must believe that the pre-provision profitability of the core businesses will improve markedly in the next few years". Otherwise the shares are trading on 12 times forward, normalised earnings which CS doesn’t think is cheap. This is feasible given the continued improvement in margins and cost program, but there are also likely to be headwinds in the other direction like additional taxes and deposit protection levies. In summary, while CS think this is a fairly decent set of numbers from RBS, CS believe the market pre-empted this and don’t think the valuation is cheap.
Finally, no one is guessing openly just now when the Coalition government will sell its RBS and LBG shares maybe when they hit £60bn. But, the government is committed to a year long competition review (no longer than 1 year) that will consider breaking up the banks to split investment banking off, and possibly splitting Natwest from RBS and HBoS from LBG (my guess) and perhaps share sales can then only happen after such mighty decisions are made?
Note that CS is not being very sensitive about the impact on reported earnings of Basel II - this is because Basel III has more of a restructuring internal redistributive effect than a net performance effect, at least not directly on distributed profit, which has other additional hurdles.
On 26th May CS upgraded Lloyds to Outperform and flagged that sustained low interest rates would allow for a £4bn increase in mortgage revenues over the next three years. Yes, but meanwhile bank stocks fell, in part Euro sovereign debt crisis and otherwise "Basel III" new requirements, though mainly because interbank funding had again dried up, and because central banks are closing (not shutting) their overnight windows.
The spread between the three-month US dollar Libor and the overnight indexed swap rate, commonly used as an indicator of banks’ trust in each other’s credit worthiness, almost trebled since May 1. Overall, Europe’s banks are facing a hit equal to about 10% of 2009 earnings to pay for increased funding costs in 2010, according to Citigroup research issued last week. Higher costs of unsecured funding for 24 European big banks would be c.€15bn ($18bn) this year, or 10% of net earnings last year, because of fears (absurdly exaggerated in my view) about sovereign debt exposure. I assume from this that the 24 banks on average currently need to refinance about €40bn, for which they had been relying on ECB over the past year for something up to half. 
Banks using central bank facilities at the ECB include UK lenders with branch operations on the continent facing a shortfall up to £100bn when the facility is removed. Spanish lenders are especially upset because they especially have been frozen out (or let's call it blackmailed by uneconomically high funding rates to refinance their funding gaps) of wholesale lending markets in recent weeks. They correctly warn of dangers in withdrawing the support given that the debt crisis is obviously still gripping the €uro Area (EA). Perhaps the ECB is trying to signal its confidence in EU President van Rompuy's hastily cobbled together €720bn stabilisation fund. But all must know that so far this is more back of fag packet agreed blueprint than a financially operational fact. 
Three-month euribor rates - a base measure of the rate banks are willing (plus a sovereign risk and bank risk margin) to lend each other are at 76bp, which should rise depending on how much banks borrow from the ECB in three - month loan programme.
As central banks seek to shrink their balance sheets back down again, alongside governments shrinking their budget deficits, balance sheet shrinkage by commercial banks is likely to have to continue! This could be a deflationary catastrophe. It is only relatively the case 9against a negative trend) that this 'deleveraging; by commericial banks may be less severe with looser liquidity regulation. Mortgage lenders are worried however about their ability to refloat the mortgage market. 
