Rising interest rates are typically good news for banks and recent results have been encouraging but UK banking stocks have singularly failed to deliver so far in 2022.

This reflects their close ties to the UK economy amid concerns of a possible recession – something which is neatly illustrated by the relative outperformance of HSBC (HSBC), which has a much bigger presence in Asia than it does domestically.

In a recent AJ Bell Money & Markets podcast interview Laura Foll, fund manager at Janus Henderson, explained: ‘There is a fear of us going into a recession and historically banks have not wanted to be the sector you own in a recession because you start to get fears about bad debts.

‘Or in other words, have banks lent to people at the end of the cycle that they shouldn’t have lent to.’

Yet first quarter results from the UK banks demonstrated better than expected profitability and increased confidence in delivering strong returns.

Foll added: ‘At the moment there are a huge amount of deposits in the banking system, almost too many. This means that the banks can pass on interest rates to you and me as the deposit holders relatively slowly. And yet if you are out there looking for a mortgage, it is apparent that that mortgage rates have gone up pretty steeply over the last couple of months’.

‘So that margin the banks make between what they pay you and me as the deposit holder and somebody getting a mortgage is getting bigger. This means that banks’ margins in theory should be going up and that should be good for banks’ earnings.’

This underpins the high dividend yields the sector offers. Lloyds (LLOY) and Barclays (BARC) are currently trading on 2023 prospective dividend yields of 7.1% and 7.9% respectively.

Broker Numis suggests that Barclays and NatWest (NWG) have the potential to offer significantly higher total effective yields (these include special dividends and share buybacks).

However, the prospect of earnings upgrades and generous income is manifestly not being rewarded by the market.

Given the fragility of the UK economy, investors who believe the US economy will prove to be more resilient could consider the alternative option of investing in US banks.

The US banks sector has significantly more capital, greater liquidity, and generates strong returns, even if its quarterly results season is off to a shaky start.

The sector recently cleared their annual stress test exercise. This success has potentially paved the way for higher dividends. 

WHO GAINS THE MOST FROM RISING RATES?

Research by Jefferies outlined in the table shows the impact a 25 basis point interest rate increase has on the net interest income of each UK bank.

NatWest is the standout winner. For every quarter point rise in interest rates it experiences a 5.5% uplift to its net interest income – a key measure of a bank’s profitability.

This is one of the key reasons why it is one of the largest active positions in the Edinburgh Investment Trust (EDIN).

Fund manager James de Uphaugh explains: ‘The period since the Great Financial Crisis in 2008, has not been a normal period for banks. Many have been in cash deleveraging mode working through bad loans and rebuilding their capital levels under the hawkish eye of regulators. UK base rates have been on the floor over the period so NatWest, which has a 16% share of the deposit market has struggled to make a normal margin’.

‘The risk reward for UK banks is favourable as valuations stand out at historically large discounts to tangible book with very robust capital levels and strong balance sheets’.

‘We favour NatWest given the de-risking of its loan book over the last few years. It currently stands at over a 25% discount to tangible book value and should generate a return of on tangible equity above 12% over the next few years as interest rates begin to normalise.’

In a recent research note Credit Suisse analyst Omar Kennam highlighted how Lloyds also benefits from a steepening yield curve.

‘Pricing in a Bank of England rate of 2.25% leads us to upgrade our net income estimates for Lloyds by 2%-7% for 2022-2024’

First quarter results for Lloyds beat expectations. Pre-tax profit of £1.62 billion was ahead of consensus by 12% with outperformance on income, costs and impairments.

The net interest margin guidance was upgraded to more than 270 basis points in 2022 versus a previous expectation of 260 basis points.

Expectations for return on tangible equity in 2022 has also risen from 10% to above 11%, which is among the highest for the large mainstream UK banks.

HOW THIS IS UNDERPINNING DIVIDENDS

The UK bank sector is a great source of potential dividend income. In a research note published at the beginning of this year broker Numis highlighted that UK banks are now generating respectable earnings profits, 85% of which should convert to capital over the next three years.

Numis estimate that UK banks sector distributions will total £32 billion between the January 2022 and the end of 2024. This represents 34% of the sector’s market value, with cash dividends half of that.

It is important to acknowledge that this estimate is 20% above consensus.

However, using Numis estimates Lloyds is trading on a 2023 cash dividend yield of 6.1% but the total effective yield is nearly double this figure (cash dividend plus buybacks and special dividends) of 12.1%, given the anticipated £1.75 billion buyback.

Numis suggests that Barclays and NatWest offer even more appealing total effective yields.

The former is expected to deliver a 2023 total effective yield of 15.2%, rising to 15.7% in 2024 courtesy of a £1.5 billion buy-back forecast in both 2023 and 2024.

For the latter, an eye watering 2023 total effective yield of 17.1% is predicted based on a substantial £2.35 billion share buyback. This falls to 13.8% in 2024 as the size of the share buyback is anticipated to decline to £1.46 billion. Investors need to consider the risk that buybacks could be delayed or cancelled if banks become more concerned about bad debts.

WHAT ABOUT LEVERAGE?

In a 2020 Institute of Economic Affairs paper Kevin Dodd, professor of Finance at Durham University and Delan Buckner, an ex-regulator, argued that although the Bank of England maintained that UK banks are strongly capitalised, the evidence from banks’ share prices and market values contradicts this claim.

They claim that in 2020 the UK banks were more fragile than they were going into the last financial crisis.

The authors highlight that the UK banks sector had a market capitalisation of £360.9 billion at the end of 2006, but at May 2020 this had slipped to £138.8 billion, a fall of 62%.

During this period they suggest banks’ average capital ratios have fallen from 11.2 % to 2.3%, worked out by dividing their total assets by market cap.

Critically, the paper also maintains that the banks average leverage on this measure has increased almost four-fold from 8.9 in 2006 to a level of 44 in 2020.

The authors do acknowledge that some people argue they should use book value rather than market value to assess leverage and on these measures, the banks are in (modestly) better financial shape than they were in 2006.

While the analysis in the IEA paper ends in 2020, recent first quarter results from Lloyds (27 April) validate some of the concerns it raises.

‘Lloyds tier one capital ratio’, a measure of the buffer the bank has to guard against crisis conditions, fell by 3.1 percentage points to 14.2%, which was below a consensus estimate of 14.6%.

Management also indicated that impairments for bad loans are likely to increase this year.

Chief executive Charlie Nunn stressed that: ‘Whilst we are seeing continued recovery from the coronavirus pandemic, the outlook for the UK economy remains uncertain, particularly with regards to the persistency and impact of higher inflation’

Similarly first quarter results from NatWest (29 April) also revealed a tier one ratio of 15.2%, which was below a consensus forecast of 15.6%.

THE US ALTERNATIVE

Nick Brind, fund manager at Polar Capital Global Financials Trust (PCPT), outlines why he has an overweight position in large US banks instead of the large UK domestic banks:

‘If it was not for understandable concerns around recession risk it would be a case of a rising tide raises all boats with the tailwind of rising interest rates. However, we believe the US economy should be more resilient than the UK’

‘Furthermore, US banks have stronger balance sheets, are more profitable and are benefiting from faster loan growth, so all things being equal they should perform better’.

‘US regulators have also shown to be more pragmatic as evidenced by the decisions by the UK regulator to ban all dividends and buybacks and dividends in 2020 unlike in the US’.

Investors looking for diversified exposure to US banks could consider using exchange-traded funds. iShares S&P US Banks (BNKS) tracks a basket of large and mid-sized US banks for an ongoing charge of 0.35%. An alternative option is Xtrackers MSCI USA Banks (XUFB), which is cheaper with an ongoing charge of 0.12%. However, its performance is marginally worse than the iShares product on a one-year and three-year view.

DISCLAIMER: AJ Bell owns Shares magazine. The editor of this story (Tom Sieber) owns shares in AJ Bell.

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