Comment: Forecasting banks’ health is no easy matter

WITH the Q1 numbers in from Barclays, Lloyds and RBS, what can we learn about the health of the UK banking sector?The banks were busily reassuring us that operating profits are up, despite the technical double-dip recession.

Last week, Barclays reported a pre-tax profit of £2.45 billion. On Tuesday Lloyds announced a pre-tax profit of £288m. Yesterday RBS claimed an operating profit of £1.2bn.

On the back of this, the two wards of state, Lloyds and RBS, made reassuring noises about paying off the last of their special loans from the Treasury. This will allow them to return to paying dividends – a necessary move before the government can start selling off its stake in the two banks.

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However, the real question to worry about is not how quickly the two banks escape the Treasury (which is on the cards). Rather, it is how they and other UK retail banks can find a way to generate long-term, sustainable value. That’s more problematic. Last year the big five – including Barclays, HSBC, and Standard Chartered – made combined pre-tax profits of £19.4bn. But this was down £2.9bn on 2010 despite aggressive cost cutting and restructuring. The banks that performed best were HSBC and Standard Chartered because they are focused on booming Asia rather than declining Europe.

Memo: Barclays, Lloyds and RBS have a strategic problem with Europe that goes beyond the euro crisis.

What business model are these three employing? Basically to shrink balance sheets that enables them to reduce dependence on risky and expensive wholesale funding. Lloyds cut its group customer lending by 5 per cent in Q1, letting it reduce wholesale funding by 8 per cent. RBS reduced its short-term wholesale funding by £23bn in the three months to March.

This inevitably shrinks bank lending and retail profits. Also, replacing wholesale funding by raising capital makes equity returns lower than for Asian-centred banks.

The only alternative is attracting more deposits, but how do you do that with interest rates at rock bottom? Quality of service becomes key. Expect bank competition for customers to centre on a new battlefront: paying using your mobile phone. But conservative UK banks lag in this area. The last one without a strategy for smart phones and iPads will lose business.

In the new constrained market, profit margins will depend more on non-interest income. Expect pressure on customers to switch to premium services such as RBS Black Account, plus fee increases. Yet UK banks are already under intense pressure from the authorities to simplify product lines following the disastrous mis-selling of payment protection insurance.

The big question for the banks vis-à-vis their shareholders is not bonuses or directors’ remuneration. It is how to generate a sustainable return on equity. In the good old days of the credit boom, banks out-performed other investments. That’s not going to be the case now. The obvious way out is for banks to continue driving down internal costs to match reduced revenues. Expect more cuts and redundancies.

Meanwhile, UK banks face a new regulatory framework, continuing public hostility, and the possibility of heavier taxes. Regardless of this week’s brighter Q1 news, the banking sector is not for the faint-hearted.

US unemployment now a structural factor

THE number of jobs in the US increased by 115,000 in April, a disappointing result. Analysts had expected a rise. Employment has grown in each of the past eight months, but not fast enough to reduce the jobless rate, which remains stuck monotonously above 8 per cent.

This has not stopped the Dow Jones reaching its highest level for more than four years, after official figures showed US manufacturing activity on the up.

How do we square increased production with only moderate growth in employment? Or, explain such exuberant investor confidence?

One explanation is that American unemployment is now structural, and not a cyclical problem arising from the 2008 recession. Unlike Europe, US firms have used the downturn to invest heavily in new technology. So fewer workers are needed to boost output while the unemployed lack skills.

If so, a third round of quantitative easing by the Federal Reserve won’t reduce the jobless numbers.