We have to think of three different things when we consider UK banks – Lloyds (LOY), NatWest, (NWG) Barclays (BARC) and HSBC (HSBA). Well, OK, just three things after these useful details to know if traders have enough toot to dust off cleavages and other essentials.
The first essential for banks is interest rate margins, the second is how much are they going to lose to people who go bankrupt (this being different from cleavages) and the third is how focused are they on the UK United ? With these three, and these three alone, we have a pretty good guide to how UK bank stocks should perform.
Like any simplistic metric, it is not perfect. Management can still surprise us by screwing up, they might let a trader go like Barings did Nick Leeson and so on. But the three main things we want to worry about, which should guide us in valuations, are these three: interest rates, the recession and the UK.
How do you feel about LYG?
Vote to see the sentiment of traders!
Lloyds Banking Group (LLOY) share price
How British are UK banks?
The British part here is indeed not essential as a banking component. The other two are for all banks everywhere, all the time. The UK part of banking is that it allows us to apply these other two to our four main vehicles listed here, as they have different exposures to the UK retail banking economy.
- Lloyds Bank, for example, is almost entirely based on the British economy. A pencil sketch, rather than an accurate representation, Lloyds takes deposits from Britons, in sterling, and then lends them, in sterling, to British home buyers. True enough that we can model Lloyds this way.
- NatWest is close to that, but with a little more exposure to wholesale banking – large corporates, etc.
- Barclays is split between a national sterling banking operation, much like NatWest, but with a global investment bank stuck on top of it.
- HSBC is, again, a national and sterling company allied with extensive operations in the Far East in Hong Kong, China and everything in between.
The fact that British Lloyds, NatWest, Barclays and HSBC are British allows us to apply our intuitions about the British economy and the pound to them, that’s all.
Impact of rising interest rates
Lloyds said in its first quarter report “net interest margin benefited from increases in bank base rates” and in the first half “good performance in its core businesses, including increased lending combined with higher interest rate”.
NatWest (NWG) stock price chart
It was much the same for NatWest: “Bank net interest margin (NIM) of 2.72% was 26 basis points higher in the first quarter of 2022, due to the impact of rate hikes basic” ; and at HSBC: “Adjusted revenue increased 4% to $25.7 billion, driven by higher net interest income, reflecting higher interest rates.”
Everyone says that rising interest rates increase margins – why? Banks live on the difference between what they borrow and what they lend with the interest margin.
This has been depressed for the past 15 years or so because interest rates have been made artificially low through quantitative easing. Few will deposit money in a bank in order to lose money with a negative interest rate, so the effective floor of the deposit rate (in sterling at least) has been zero. But lending rates have been pushed down again and again – falling rates meet an unmovable base, margins squeeze.
As interest rates rise, these bank margins rise again. Let’s get back to what they should be – in theory at least. This means they are expanding. A few tenths of a percentage point makes a hell of a difference and we see it quarterly given the pace of rising interest rates.
Another way to describe the same effect is with float. A lot of the money in the banks doesn’t stay there very long – our salaries for example. The account can start the month with £5,000 (hey, journalism pays well), by the time the mortgage is exhausted, bills, expenses, it reaches £5 at the end of the month (good, okay, not so good).
But for the bank it’s an average of £2,500 across millions and millions of accounts and they don’t pay us interest at all on current accounts. They can pool and lend that average – which they do – and they earn more doing it as interest rates go up.
So higher interest rates increase bank profits – because those interest rate margins, the things they live off of, increase.
Barclays stock price chart (BARC)
Add the recession effect
This is not, however, to insist that bank stocks have only one path to the upside.
It’s because we have this other problem. In a recession, some people and businesses will go bankrupt – and some people who go bankrupt do so because of bank money, which means loan losses increase during recessions.
Banking, then, is more of a game of scooping up those pennies – millions and billions, it’s true – as interest rates rise, and then seeing how many hundreds of millions of pounds are lost during the recession.
The problem being that rising interest rates is the thing that is likely to cause the recession. In fact, that’s why the Bank of England raises interest rates, to bring on recession times that will drive inflation out of the economy.
This is what makes bank stocks difficult or attractive to trade. The event – rising interest rates – that increases profits is the very thing that is likely, over time, to produce those losses on loans to bankrupts.
HSBC share price (HSBA)
Exposure to the UK economy
Which then brings us back to how a bank is British. If we think the UK recession is going to be less severe than elsewhere then we would favor Lloyds, NatWest, Barclays, HSBC in that order. Or, if we think that interest rates on the pound sterling will rise more than elsewhere, but will not cause a recession, we would be for the same order.
Alternatively, if we think the Far East economy will continue while the UK spins around the bunghole, then we reverse our prediction: it becomes HSBC at Lloyds.
Which brings us back to how much each of the four, Lloyds, NatWest, Barclays, HSBC, depend on Britain’s domestic economy – and the pound – for their profits.
It’s pretty much – as it all is – in this order: Lloyds, NatWest, Barclays and HSBC. The more we think the sterling economy will manage through rising interest rates to some form of stability, without the disaster of a deep recession, the more likely we are to value Lloyds over HSBC, and less the reverse is. . So, trade carefully, but always remember our warning: past performance does not guarantee future results.
It’s also possible to stop thinking about stock prices and think about the UK economy itself, to which the right reaction is almost certainly: Jeez, God Save all who sail in her.