Scottish Investment Trust fund manager Alasdair McKinnon on why part of the financial sector is starting to look interesting again

Ten years ago, many of the world’s banks were essentially bust. The global financial crisis was in full swing, and banks were facing their comeuppance for employing huge amounts of leverage to boost returns. This practice worked for a while but such precarious methods never end well.

The crisis exposed banks’ capital buffers as dangerously thin. It effectively wiped out their equity when unfeasibly optimistic asset prices were forced to match reality.

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Such was the anxiety over the banks’ solvency that UK politicians seriously contemplated putting troops on the street, if banks were unable to dispense cash, to quell an understandably angry population. Consequently, the banks were entirely uninvestable.

We have since come a long way. European and US banks have been heavily punished, with regulators collecting hundreds of billions of dollars in fines. The Dodd-Frank Act in the US brought far-reaching reforms, with tighter rules governing the amount and quality of capital to ward off
a future crisis.

LET LOOSE FROM THE NOOSE

The period of punishment is now ending. The regulatory environment is more settled, with much stricter oversight. After considerable delay, one of the final planks of global bank governance was agreed in December – the so-called Basel 4 rules.

The new environment necessarily constrains banks’ activities but with the rules of the game largely agreed, the banks can plan accordingly.

Banks are now in much better shape. Over the past decade, they have recapitalised to insulate against further crises.

With bad debts largely written down or disposed of, their balance sheets are also much cleaner.

Admittedly, returns on equity are lower today than they were before the crisis. But that’s because banks must carry more equity and forego the returns of the more speculative parts of their business. Overall, the outlook for cash returns from bank stocks has improved.

INTEREST RATE BOOST

The macroeconomic environment is also more favourable. Following the crisis, interest rates were cut to historic lows to prop up the economy and asset prices. Now they are rising again – allowing banks to widen margins on lending.

After six rate rises, the US is well on its way – and where the US goes, the world often follows.

Europe could be next, and even the Bank of Japan may look at moving away from negative interest rates. Rates are still very low in a historical context but banks are not sitting on their hands. Instead, most are focusing on cost-cutting to improve profitability.

The political backdrop is helping too. Populist governments are willing to spend money, which should be good for banks’ profits. In the US, president Trump has cut taxes heavily. This should not only fatten bank profits but also put more money into consumers’ pockets, which in turn helps the banks.

ROOM FOR RECOVERY

In the US, much of this has been acknowledged in share prices. After rallying in anticipation of the spoils of a Trump presidency, US bank shares
are close to their pre-crisis highs. But not all banks have recovered as much.

The MSCI Europe Banks Index is still more than 60% below its 2007 pinnacle, potentially a sizeable opportunity. Banks are traditionally the largest part of the stock market but have been playing second fiddle to tech stocks in recent years, leaving plenty of room to catch up.

FOUR BANKS IN FOCUS

• Royal Bank of Scotland 

• Sumitomo Mitsui Financial Group 

• Intesa Sanpaolo

• Citizens Financial

So where do we see opportunities in the banking sector? Well, one is perhaps the most infamous name of the financial crisis. After expanding aggressively at the peak of the market, Royal Bank of Scotland (RBS) became the poster child for banking failure. But the company is now on its way to putting the crisis behind it.

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RBS has succeeded in deleveraging its balance sheet and refocusing on its core UK market and is close to settling one of its last major fines. That clears the way for the company to restart dividends.

Its latest results showed a tripling of profits, suggesting real progress. We categorise the company as an ‘ugly duckling’ – a stock whose transformation could take the market by surprise.

Another ‘ugly duckling’ is Sumitomo Mitsui Financial Group. Japan’s banks went through their own crisis in the 1990s, but are in much better shape today. They remain out of favour with investors because of Japan’s negative interest rates. But with change afoot in Japan, any improvement in the economy is likely to benefit its cheaply valued banks.

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Some of Scottish Investment Trust’s (SCIN) other banking holdings have more immediate attractions. Intesa Sanpaolo suffered during Italy’s bad-debt crisis but its well-capitalised balance sheet allowed it to navigate the crisis safely. Intesa has successfully offloaded many of its non-performing loans and has improved its cost efficiency to protect profits and its attractive dividend.

Finally, Citizens Financial is a US bank that regained independence when former parent company RBS retreated to the UK. Given RBS’s numerous preoccupations closer to home, its US operation was not efficiently run. The spin-off created an opportunity to run the business more effectively; and Citizens is performing well as it steadily improves its profitability.

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