The Bigger Threats to U.K. Banks

Recession would threaten consumer lending as well as mortgages

Want a frightening Brexit-related statistic?

British banks have more than 65 billion pounds ($84 billion) of exposure to commercial real estate -- precisely the sector markets fear is vulnerable to a big correction as investors rush to pull their money.

The good news is that the financial impact of a dive in commercial property looks manageable for U.K. banks such as Lloyds and RBS, not least because they've spent the past decade retrenching from this area and strengthening their balance sheets.

Real Estate Retrenchment

U.K. loans to real estate has been negative in recent years as banks retreat from commercial property

Source: Bank of England

A 2008-style price plunge would lead to 965 million pounds in total impairments for Lloyds and RBS, according to Bernstein analysts -- about five percent of the amount the two lenders had to set aside for the payment protection insurance scandal.

But history suggests a sharp fall in commercial real estate is accompanied by as fall in home prices and a wider recession. The latter two would be a much bigger cause of pain to the banks: while they'd been cutting exposure to developers, they'd been ramping up their exposure to consumers and homeowners.

This chart, based on Goldman Sachs research, shows how commercial real estate would account for only a fraction of banks' impairments in the event of an economic shock.

Not Strictly Commercial

Economic shock would see more impairments in consumer and business loans than commercial property

Source: Goldman Sachs

Five-year cumulative loan impairments in commercial property would run to 3.9 billion pounds across seven banks, according to Goldman. That's still only about half Lloyds's underlying profit for 2015.

More concerning are the six billion pounds in cumulative impairments seen in mortgages, the 17 billion pounds seen in non-mortgage consumer lending and the 11 billion pounds seen in loans to businesses.

Unlike commercial real estate, these areas have been a key plank of U.K. banks' growth strategies in recent years. Mortgage lending to aspiring landlords has recently grown at double-digit rates, boosted by a housing boom and government subsidies; consumer credit growth hit an 11-year high in February; lending to businesses turned positive in early 2015. These are all under threat from a slowing economy -- whatever happens to the commercial property market.

The drop in British financial stocks, which has seen about 10 percent bitten off the FTSE 350 banks index since the Brexit vote, may have further to go.

And even if an economic shock doesn't come to pass, it wouldn't take much of a reversal in fortunes to start eating into lenders' profits.

S&P already expects industry credit losses to rise from a recent low of 0.14 percent of loans in 2015 (about 3.3 billion pounds) to 0.45 percent in 2017. That may not sound like much, but it's likely to be accompanied by a squeeze on margins as banks are encouraged to keep lending in the face of falling interest rates.

It's not clear that both these scenarios are fully reflected in bank valuations. Lloyds, the country's biggest mortgage lender, faces the steepest bill of the seven banks in the Goldman's stress test model -- yet trades at only a 20 percent discount to book value.

Nordic Valuation

Lloyds retains a relatively high price-to-book valuation ratio despite Brexit risks

Source: Bloomberg

Broker recommendations are skewed to `Buy' and analysts still expect Lloyds shares to rise 22 percent over the coming 12 months. True, the lender has a robust 13 percent core Tier 1 capital ratio, pays a dividend and a track record in defending profit margins.

But its strengths will be tested by the fortunes of the domestic retail market to which it is inextricably tied. If Brexit bites, that becomes even harder.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lionel Laurent in London at

    To contact the editor responsible for this story:
    Edward Evans at

    Before it's here, it's on the Bloomberg Terminal.