RECENTLY a leading Portuguese bank, Banco Espirito Santo, served up a reminder of the bad old days, whence a financial institution could spread nerves amongst global markets with news of financial instability.

Losses sustained during the brief correction which ensued have now been clawed back and the effects on the stock market were short term, but it was a timely reminder of the systemic importance of these institutions. The consequences of financial distress affecting a single company in another sector would no doubt have been confined to the shares of the company in question, possibly with sympathetic losses of a lesser magnitude for sector peers. But when such matters originate from prominent financial house the likelihood is that markets, both domestically and internationally, will be affected.

Thus, the health of the financial sector matters. And whilst that applies on a global level we are naturally more concerned about the health of our domestic banks. A functioning system moves capital to where it is needed most and gives everyone confidence that their economic efforts will be underpinned by a sturdy financial infrastructure.

Any comparison between Eurozone-based banks and our own needs to be qualified by saying that, despite the fact they share the need to preserve and build capital buffers, the two economic systems are at different stages of their cycles and are beholden to the policy of two different central banks facing contrasting economic environments.

The UK listed bank sector has underperformed the wider index significantly over the past year, but broadly trades on the same valuation as the market in general, indicating that maybe this underperformance was just the sector returning to an appropriate level after a period of post-crisis exuberance.

The headwinds are clear. The UK economic environment, positive though it certainly is, isn’t really conducive to stellar profit-making if you’re a bank. Profit margins on lending are wafer-thin thanks to incredibly low interest rates. Rates have remained static for some time, and for those banks with investment banking arms this has led to greatly reduced profit on interest rate derivative contracts. Indeed, a benign market environment has not been good for investment banking, whose operations welcome volatility as far as it induces trading.

Add to this the seemingly endless litigation (PPI, LIBOR rigging, and lawsuits from US regulators) and constantly having one eye on your capital requirements and this paints a pretty challenging picture.

However, whilst it is clearly a sector not without risk, there are potentially positive trends and opportunities for selective success. A real catalyst will be an environment of rising rates, improving net interest margins. There is a likelihood that rates offered on bank deposits will rise at a slower rate than mortgage rates and the standout beneficiary in this case could be Lloyds, with over a quarter of the UK mortgage market on its books. Banks with investment operations will enjoy a more dynamic rate environment too.

Whilst the UK banking market is dominated by the big name established players, a new breed of bank will launch next year. Headquartered in Durham and backed by Middleton Enterprises (North East entrepreneur Jeremy Middleton’s investment firm), Atom Bank will be the UK’s first truly digital bank. The traditional banks will surely look on in envy at Atom’s low overheads, and this could be a real boon for the region, both for jobs, and for being seen as a breeding ground of innovation.

Nick Williams

nicholas.williams@brewin.co.uk

Nick Williams is an Assistant Director at Brewin Dolphin and offers advice on a wide range of financial services to private clients, trusts, charities and pension funds.

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