British Banks' Profits Surprise

European banks are following their American counterparts in reporting better-than-expected earnings, as fees from investment banking and securities trading help offset retail banking losses. On Aug. 3 the two British-based banks that refused to accept government bailouts during the worst of the financial crisis, HSBC (HBC) and Barclays (BCS), reported strong profits, sparking hopes that an economic recovery might finally be under way. Both banks announced first-half pretax profits of $5 billion—an 8% rise for Barclays but a 57% decline for HSBC, Europe's largest bank—compared with a year earlier.

Considering that many analysts had expected HSBC to slip into the red, the results were a positive surprise. The two British lenders follow the likes of Goldman Sachs (GS), Credit Suisse (CS), JPMorgan Chase (JPM), and Deutsche Bank (DB) in posting higher earnings on the back of a strong performance by investment banking. At Barclays Capital, the group's investment arm, profits more than doubled, to $1.7 billion. And pretax profits at HSBC's global banking and markets business more than doubled, to $6.3 billion, on an increase in currency trading and underwriting bond sales.

The strong numbers renewed optimism that the worst of the downturn may be over. It's likely that "we have passed, or are about to pass" the bottom of the cycle in financial markets, HSBC Chairman Stephen Green said in a statement. Careful to temper his upbeat remarks, though, Green cautioned that "the timing, shape, and scale of any recovery in the wider economy remain highly uncertain."

That's because any true turnaround depends on reviving banks' ailing retail operations—and so far, that hasn't happened. "The foundation for recovery is there," says Ralph Silva, research director at financial consulting firm Tower Group (TWGP) in London. "But if retail banking does not recover, there will be no recovery."

more damage from bad mortgage loansBoth Barclays and HSBC have suffered from the souring of a sizable chunk of their retail loans. Barclays' writedowns soared by 86%, to $7.8 billion, while bad debt charges at HSBC rose 39%, to just under $14 billion. Many of HSBC's problems are due to the poor performance of loans made by Household International, the U.S. subprime lender it acquired in 2003. HSBC's U.S. business posted a $2.9 billion loss for the period, though the bank says bad debts are rising at a slower rate after efforts in previous years to cut down on higher-risk loans. HSBC is in the process of winding down its U.S. operations after deciding in March that Household will not issue new loans.

The bad news is that many in the industry still expect the number of defaults to rise. On July 31, Deutsche Bank CEO Josef Ackermann predicted that even banks that have so far avoided losses are not immune to rising delinquencies by both corporate and consumer borrowers. "Bad loans are the next wave" of the financial crisis, Ackermann said. As long as the global economy remains depressed, agrees Tower Group's Silva, "default rates across the spectrum will increase significantly."

In June the European Central Bank's financial stability report estimated that European banks alone could write down a further $405 billion by the end of 2010—mostly from defaulting corporate and consumer loans—on top of the estimated $393 billion in losses since 2007.

banks' cash hoarding delays recoveryA surge in bad loans is likely to take a toll on the earnings of Britain's Lloyds Banking Group (LYG) and Royal Bank of Scotland (RBS) when they report first-half results on Aug. 3 and Aug. 7, respectively. Analysts expect first-half bad debts at RBS, which is 70% owned by the British government, to jump from $2.5 billion to more than $10 billion as credit losses and impairments on loans to businesses and households mount. However, after a record $40.6 billion loss at RBS in 2008, analysts expect the bank to report a modest pretax profit of around $2 billion as a result of higher investment-banking fees and one-time gains on disposals.

But Lloyds, Britain's largest retail lender, is likely to face pretax losses for the six months ending on June 30 of $8.6 billion, compared with a $4.7 billion profit for the same period last year. Lloyds, which bought leading mortgage lender HBOS in January and is now 43% owned by the British government, could see its impairment charge rise to $18.5 billion, according to analysts at Keefe, Bruyette & Woods (KBW).

For retail-focused banks such as Lloyds, rising levels of bad debt have created a sort of Catch-22. Facing big losses on loans, banks are hoarding cash to repair badly damaged balance sheets instead of lending. Yet the longer banks remain unwilling to lend, the longer the economy will take to recover. The result: higher unemployment, less spending—and ultimately more loan defaults.

At the end of July, British Chancellor of the Exchequer Alistair Darling met with the heads of the country's biggest lenders to ascertain why the cost of loans to small companies has risen even as the Bank of England base rate has stayed at a record low of 0.5%. Darling says he wants the banks to rebuild their balance sheets, but he told the BBC: "Because of the fact we've got this recession, we also need them to lend money."

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