Why banks are still too big to ignore

Banks continue to make the headlines and not necessarily for the right reasons. Lloyds may have pleased investors by reinitiating dividends after a gap stretching all the way back to 2008's interim payment but earnings figures were generally disappointing and the sector has lagged the FTSE All-Share over the past year, as if to suggest the market has yet to be fully convinced the banks are back on a sustainable growth track.

At around 15% of the FTSE 100's market capitalisation, the banks cannot be ignored, especially as they are also expected to generate between 15% and 20% of the index's forecast aggregate profits and dividends for 2015.

The problem for investors is banks are fiendishly complex companies. A very thorough piece of research from Exane BNP Paribas lists ten key swing factors that drive the sector's profit and loss account. Only a real zealot with a lot of time on their hands will have the inclination to keep their eye on everything from net interest margins to compliance costs to loan growth to asset quality.

There may be some merit to treating them as proxies for the broader economy, or indeed the capital markets in the case of those with substantial investment banking operations. The rise of crowd funding sites, Peer-to-Peer lenders and newly established challenger banks muddies the waters here, as does the ever-growing compliance cost burden faced by the industry (even if it can be argued all of these are self-inflicted wounds), so banks may not be the straightforward economic proxy they once were.

Profit advances are largely coming from cost-cutting and shrinking balance sheets, factors which cannot help forever, while loan growth remains muted. At a time when organic growth is highly prized banks are not really delivering here, even while some life insurers are, especially those with big fund management arms as they ride the demographic wave and help the globe's rising population save for their retirements.

Sceptics will also argue banks are still a potential fault-line in the equity market, given the global debt mountain's inexorable growth and concerns over whether energy-related junk bonds, Greece or consumers' personal liabilities could still come to haunt us all.

If investors do want exposure to the sector, encouraged perhaps by Lloyds' dividend move or the prospect of improved global economic momentum, a fund which covers the full range of financial stocks would be an option to consider. A good selection of 'clean', actively run funds, one investment trust and a handful of exchange-traded funds (ETFs) all specialise in global financial stocks, including insurers, service providers and asset managers as well as banks.

Top five performing funds which specialist in just financial stocks over the the past three years

Source: Morningstar, for the Sector Equity Financial Services category. Clean funds only.
Where more than one class of fund features only the best performer is listed.

One investment company targets financials...

Source: Morningstar, The Association of Investment Companies, for the Sector Specialist: Financials category

...as do a handful of exchange-traded funds

Source: AJ Bell Research Centre, Morningstar, for the Sector Equity Financial Services category.
Where more than one class of fund features only the best performer is listed.

Twin dilemma

While their plight may attract little public sympathy, banks do face something of a strategic dilemma. On the one hand, they are being encouraged to lend by governments and central banks who wish to try and foster a robust economic upturn. On the other, they are being leant on by regulators to buffer their balance sheets by accumulating more capital, a requirement which encourages them to hoard cash and lend less.

For the moment, the regulator looks to be winning out, if the 2014 full-year results from the UK's Big Five of Barclays, HSBC, Lloyds, RBS and Standard Chartered are any guide. As a group, they continued to cut costs, sell assets and sweat their balance sheets as they prepared for the regulatory requirements placed upon them when it comes to their financial strength. Common Equity Tier 1, or CET, ratios continued to improve at Lloyds, Barclays, HSBC and RBS. Only Standard Chartered failed to deliver here and in response the lender targeted an improvement from 10.7% to the 11% to 12% range in 2015 and beyond. The chart here shows the CET ratio as bars on the left and the change in percentage points as the line on the right.

Banks continue to focus on improving their capital strength

Source: Company Accounts

Barclays and RBS continued to slim down their investment banks where earnings are very cyclical and unpredictable. This looks a sensible move as lower exposure here should lower risk and improve the overall quality of their earnings.

The one bank which was perhaps a little more upbeat was Lloyds, which announced a 0.75p-per-share final dividend, the first cash return to shareholders since 2008. That sum represents a total payout of some £535 million, a not insignificant sum when the FTSE 100 is forecast to pay out around £70 billion in dividends in 2015.

In crude terms, every 1p per share on the Lloyds payout adds around 1% to the aggregate FTSE 100 dividend figure, to again stress just how important the banks are to the broader market. Exane BNP Paribas' research suggests Lloyds could return 7p a share to clients by 2017, via dividends or share buybacks.

The chart below shows the forecast dividend yields for 2015, though it in this context it is important investors check earnings and free cashflow cover are sufficient to mean those payments are safe, or at least entrust this work to a good fund manager.

Forecast dividend yields for the UK's Big Five banks in 2015

Source: Digital Look, Consensus analyst forecasts

Show me the money

Banks earnings (and potentially their dividends) remain unpredictable owing to the standard variables outlined by Exane BNP Paribas but also issues such as Greece and also litigation. Barclays set aside £750 million for the investigation into malpractice in the foreign currency markets and another £200 million for payment protection insurance and interest-rate hedge mis-selling in the fourth quarter alone. HSBC has already had a brush with the US authorities with regard to money laundering in Mexico and is now attracting scrutiny for how its Swiss private bank handled its clients' tax affairs.

Further provisions could weigh on earnings forecasts while it would be far from helpful were the economic recovery to stall, especially as the full-year 2014 figures already have a slightly disappointing tinge to them.

The Big Five racked up pre-tax earnings of £29.3 billion, way up from the £12 billion seen in 2013 analysts had been expecting some £36 billion back in December.

Aggregate pre-tax profit forecasts for the Big Five banks sagged throughout 2014

Source: Digital Look, Consensus analyst forecasts

As a result forecasts for this year have been cut by around 7% to around £35 billion, a figure which means the quintet is still expected to earn less than it did in 2007.

Banks are still expected to earn less in 2015 than they did in 2007

Source: Company accounts, Digital Look, Analyst consensus forecasts

More to be done

It's been a long road back to the heady profits of 2007 and analysts had expected the banks to get there in 2013 and 2014, only to be disappointed on each occasion. Forecasts for 2015 are now a little more cautious, but the ongoing slippage in earnings estimates may explain why the banks overall are still doing relatively poorly.

The chart below shows how the Banks sector has markedly underperformed the FTSE All-Share over the past 12 months. This is not a phenomenon restricted to the UK. Banks have lagged broader national indices in the US, Europe and Japan too, although they are at least making decent headway in absolute terms over the Channel and on Tokyo's exchanges.

Banks are underforming in the UK...

Source: Thomson Reuters Datastream

...and the USA...

Source: Thomson Reuters Datastream

...although they are showing better momentum in Europe...

Source: Thomson Reuters Datastream

Perhaps the regulatory burden in the US and UK weighs more heavily, especially as the European stress tests of last autumn did not feel particularly stressful at all at the time and came to a remarkably sanguine conclusion.

Equally, the US and UK banking sectors began to underperform in 2005, some two years before the crisis hit, so let us hope their laggard showings are not a gentle warning of trickier times to come.

Russ Mould, AJ Bell Investment Director