If there is one thing UK banks agree on at the moment it is this: impairment charges have peaked. Barclays, Lloyds Banking Group, HSBC and RBS all said as much in their respective results statements.
But how quickly will bad charges fall?
Some analysts think they’ll decline very rapidly. But Credit Suisse banking analyst Jonathan Pierce, who has just published another sobering report on the sector, has a rather different view:
Certainly, it appears that impairment charges peaked in H1 2009 at 3 per cent of loans, and this downward trend should continue into 2010. But we remain cautious about the speed of recovery and note that today 7 per cent of loans are non-performing despite rates at 0.5 per cent. This much strain in the system suggests that as rates rise, charges will remain under pressure. As such, we see no return to “normalised” impairment until 2013 at the earliest.
And that’s not good news particularly if you believe, like Pierce, that revenue growth is going to be sluggish over the next couple of years due to the impact of new liquidity rules, amongst other things.
Pierce calculates that UK banks will have to issue £430-£750bn of wholesale funding over the next three years if they want to preserve the size of their balance sheets, whilst meeting the new rules.
In reality of course, that won’t be possible, so banks will have no option but to shrink their balance sheets, says Pierce:
This suggests to us that assets (weighted towards loans) will have to fall by a net £200-530bn to compensate, equivalent to 6-18 per cent of the existing funded balance sheet. Applying a 2 per cent margin to this would imply a drop in net interest income of around £4-10bn or 10- 25 per cent of the 2009 number, on our estimates. Of course, this ignores the impact on noninterest income which could also be substantial.
Although he doubts shrinkage of that size is practical:
It is also debatable whether this sort of balance sheet contraction is even possible. In 2009, the funded balance sheet fell by 9 per cent but this was assisted by QE, a sharp decline in financial loans, and write-downs. These are all effects we would expect to reduce in 2010. In fact, in H2 2009, funded assets were flat. The problem is one we’ve highlighted before – the UK banking system is dominated by long-term assets including mortgages and commercial property (over two-thirds of loans) which are difficult to run-down quickly.
So the banks might have no choice but to shrink and issue more term-funding at higher rates:
And herein lays the conundrum. We don’t think the banks can raise this much money over three years (equivalent to £45-80bn per bank per year) unless they are prepared to pay very considerable spreads. Of course, the BOE might extend its funding schemes, but this seems unlikely to us with the newly introduced (and very expensive) discount window facility intended to provide the backstop for the sector.
It is also possible that regulators will give banks longer to build NSFR ratios – and indeed the FSA recently said it would not tighten liquidity requirements until Q4 2010 at the earliest. But unless the timetable is extended very substantially (e.g. 2015 or beyond) we believe the issue remains the same.
And this, says Pierce, derails the ‘buy’ case for UK banks — something which rests on the assumption that declining impairment charges and rising revenues will drive return on tangible equity above the cost of equity in the next couple of years.
Full report in the usual place.
Related link:
BarCap’s `credit surprise’ snapback – FT Alphaville
Banks’ coverage ratio capers, cont. – FT Alphaville
Barclays needs more capital – FT Alphaville