Banks were hit hard yesterday in the wake of the UK’s vote to leave the EU, with trading in RBS and Barclays temporarily suspended yesterday morning. Today, the market has opened firmer with financials amongst the leading gainers emphasising the increasingly volatile world we are now inhabiting. Standing back from the short-term noise, what are our initial thoughts on the impact Brexit will have on the UK banking sector?
We wrote in February about the revenue problem that has led to negative earnings revisions for UK and European banks year after year. Brexit makes that problem worse. In the UK, gentle loan growth hasn’t been enough to meet analysts’ revenue estimates – and that growth will now likely fade, with corporate investment slowing and some tightening of underwriting standards, for example in mortgage lending. Potential changes to funding costs and interest rates may compound this pressure. Costs have historically been sticky, so the operating leverage impact of lower revenues is meaningful to earnings per share, even before we ask other questions about the implications of Brexit.
In Europe, the revenue problem for the banks is similar, with interest rates materially more important, given loan growth of less than 1% last year. The gap between current interest rates and the average on banks’ books means that we need a huge positive economic surprise in order for earnings headwinds not to come through for FY 2017 or 2018. That outcome is now very remote.
In these early days, the question is quickly turning to whether slower corporate investment will lead to a UK recession and what that would look like. Not only in terms of the outlook for interest rates and the revenue question above but in terms of bad debt provisions. The UK banks also carry high operating leverage here to even a mild recession, certainly if it leads to a material rise in unemployment. Markets do not know what a recession driven by declining corporate investment will look like. The circumstances are unusual – and therefore unemployment projections are quite uncertain.
We’ve looked at operating leverage to UK revenues and provisions to analyse which of the UK banks are most affected. Lloyds comes off better than Barclays or RBS or the challenger banks – but of course it’s not a good picture for any of them. A 3% reduction in loan growth and a 50% increase in impairments from the currently low levels would reduce UK domestic sector-wide PBT by 20%. The Bank of England would point out that its 2015 stress test shows that the UK banks’ capital is adequate to withstand a much tougher environment than is likely. Indeed, both capital and liquidity are very much stronger than they were in 2008 and clearly resilient from a systemic perspective. But the output of those stress tests – and the Treasury’s Brexit scenarios – will likely still make it hard for equity investors to look across the valley in this sector until they have a reasonable sense of how deep the valley actually is. And we are a distance from knowing that today.
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