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Nervous Investors Are Watching U.K. Banks This Week

  • Banks face more revenue headwinds as BOE poised to slash rates
  • Commercial real estate in spotlight after fund withdrawals

As U.K. banks post second-quarter results, investors will be watching for yet another deepening of cost cuts -- courtesy of Brexit.

Lloyds Banking Group Plc was already mulling deeper job cuts on top of the 9,000 previously announced to combat record-low interest rates, people familiar with the plans said earlier this year. The five major U.K. banks are all in the midst of cost-cutting programs, collectively trying to trim about $15 billion from their expenses. Earnings figures themselves will be a sideshow, even with some positive news from bond trading and oil’s rebound.

While most European banks have been cutting assets and staff to boost profitability and meet capital requirements, British lenders had been able to rely on one of the strongest domestic markets in the region before the nation voted to leave the European Union on June 23. Post-Brexit, the Bank of England is expected to cut interest rates to shore up the economy, and that’s set to crimp lending margins at firms like Lloyds, Barclays Plc and Royal Bank of Scotland Group Plc just as demand for loans wobbles.

"I don’t think any bank’s current cost-cutting plans are sufficient to generate normalized returns in the time periods they’re targeting,” said Ian Gordon, an analyst at Investec Plc in London. “Will branch closures continue? Yes. Might they accelerate? Yes. For capital markets and investment banks, will we see cost takeout? Yes. Will we see further streamlining? Yes."

A report Friday showed U.K. business activity shrinking at the fastest pace since the last recession seven years ago, driven by a plunge in services, the biggest part of the economy. The Bank of England has signaled it’s readying stimulus for August, which could include more quantitative easing or a cut to its key rate from the already record-low 0.5 percent.

The banks have had near-unanimous downgrades to their earnings outlooks since the Brexit vote, and RBS Chief Executive Officer Ross McEwan has blamed the 23 percent drop in his bank’s stock since then on the interest-rate outlook. A rate cut would hurt net interest margin, the difference between a bank’s income from lending and cost of funding, because loans are often priced in relation to the BOE base rate.

That’s before the banks consider other Brexit issues, like their exposure to London real estate and the potential loss of passporting rights that let bankers at firms like Barclays service customers elsewhere in the EU.

“Given the uncertainty around the outlook, investors are likely to look beyond second-quarter numbers to the potential impact of weaker economic trends, lower rates, EU passporting issues and what U.K. bank managements can do to mitigate with incremental cost savings,” said Raul Sinha, an analyst at JPMorgan Chase & Co. in London.

Jefferies Group LLC analyst Joseph Dickerson cut his forecasts for 2017 profit by 68 percent at Barclays, 50 percent at RBS and 24 percent at Lloyds after the vote. The two largest credit-rating firms also downgraded their outlooks for the sector, with Moody’s Investors Service citing weaker demand for credit and pressure on interest margins as the central bank keeps borrowing costs low.

In commercial real estate, seven funds suspended trading earlier this month to avoid a fire sale of properties to meet redemptions. Lending to the real-estate and construction sectors totaled 214 billion pounds ($283 billion) at the end of May, Bank of England data show. RBS and Lloyds have the highest proportion of such lending, with 66 percent and 46 percent of their respective tangible net asset values, a measure of capital, tied up in the sector, JPMorgan estimated in a July 5 report.

“Plans for provisioning against tens of billions of CRE exposure will be scrutinized at the banks, despite healthier loan-to-value levels than in 2008,” Bloomberg Intelligence banking analyst Jonathan Tyce said. “Their pipeline and growth targets will surely also have to be revised.”

On passporting, executives will be asked if and when they’ll start moving jobs away from London to elsewhere in the EU. HSBC Chairman Douglas Flint has said since the referendum the lender will only follow through on a plan to relocate 1,000 employees if passporting rights are lost.

“It’s a bit early for big decisions, but cutting staff and branches” is likely, said David Moss, who helps oversee about $254 billion at BMO Global Asset Management, including shares of U.K. banks. He said British lenders may wait to see what stimulus packages the BOE and lawmakers develop, as well as look for more details of the country’s future trading relationship with the rest of Europe.

Lloyds is first to report earnings on July 28. Barclays follows the next day, and RBS reports on Aug. 5.

Brexit hasn’t been bad for all London-based banks, with HSBC Holdings Plc and Standard Chartered Plc seeing their shares rise. Last year both lenders were battered as China’s economy slowed. This year, the weak pound means reporting earnings in dollars helps, as do upgrades from analysts who now see Asian exposure as beneficial diversification away from Europe. Both companies report on Aug. 3.

HSBC CEO Stuart Gulliver will also face questions about the arrest of Mark Johnson, its global head of foreign exchange cash trading, for an alleged front-running scheme involving a $3.5 billion currency transaction in 2011.

“Standard Chartered remains our preferred U.K. bank given limited U.K. exposure,” JPMorgan pan-European banking analyst Kian Abouhossein said in a note last month. He also upgraded HSBC, calling it a defensive stock in the current market.

The Brexit vote occurred very late in the second quarter, when trends for investment banking and trading were largely set. Barclays and HSBC have the largest trading operations among the U.K. banks, and they may follow the tone set by their U.S. peers: JPMorgan Chase & Co., Goldman Sachs Group Inc. and the rest of the big five Wall Street banks beat estimates for revenue from fixed income in the period, with an average 21 percent jump.

Currency-trading desks may also see a one-time boost from post-Brexit volatility. Barclays CEO Jes Staley said his bank processed three times as many currency orders in the early hours of June 24 as it usually does in a day. RBS’s McEwan said his forex desk dealt with 30 billion pounds of trading, about five times the normal volume.

Other bright spots for the banks could come from the rally in crude oil and their gains from selling the Visa Europe Ltd. joint venture.

Banks rushed to cut their commodities exposure as prices plunged last year, with oil hitting a nadir of $28 a barrel in January. The worst-hit was Standard Chartered, whose total loan impairments doubled to $4 billion in 2015. The oil price has since recovered and has traded above $44 since May, meaning some provisions banks made for soured loans to commodity companies could be reversed.

Visa Inc.’s $23 billion acquisition of Visa Europe closed last month and the proceeds will be split among the 3,000 banks that jointly owned the network. That could net HSBC, RBS, Lloyds and especially Barclays at least 900 million pounds between them this quarter, with more to follow in subsequent periods, according to Sanford C. Bernstein.

Still, Barclays, RBS and Lloyds remain in rebuilding mode, eight years after the financial crisis. They have watched tens of billions of pounds get wiped from their market value since the Brexit vote, and they have less room to maneuver than they did on June 22.

"Cost cutting is the only thing they can do,” said Gary Greenwood, an analyst at Shore Capital. “It’s the only thing in their control.”

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