The UK banking cartel
- There has been a profound structural change in the UK banking industry following the credit crunch. As new entrants have disappeared, the six big lenders have strengthened their grip. They now control 85 per cent of the market and have regained significant pricing power.
That’s not the Liberal Democrats’ Vince Cable speaking, but the banks team at Citigroup advising clients on Wednesday morning to ‘buy’, ‘buy’, ‘buy’ UK financials. And specifically: Barclays and, Lloyds.
We believe that a profound and permanent structural change has occurred in the UK banking industry, and that this will drive further earnings upgrades and a re-rating of the UK banks. This, in turn, should drive the shares further ahead as the market comes to terms with what is happening. Many commentators still seems to be focusing on a potential increase in wholesale funding costs of a few basis points as central bank liquidity support programmes are withdrawn, or on the possibility of new bank levies. This strikes us really as being in the category of ‘not seeing the wood for the trees’ when it comes to the shift in the industry structure and margin expansion dynamic.
We’re not describing any collaborative or usurious behaviour by the banks here; just a return to rational pricing, and the type of competitive environment that prevails in countries such as Australia and Canada, and which used to characterize the UK. The momentum of margin expansion is largely embedded in current loan pricing, especially in mortgages. We estimate that blended portfolio mortgage margins could rise by a further 1% without any change in current loan pricing, due to the progression of customers from front- to back-book rates lenders are reporting
And some graphics to back up those claims:
But what, we hear you cry, of the new, new entrants to the market?
Won’t Virgin Money or Tesco seek to undercut the big five with cheap loan and mortgages deals?
Well, they might try, says Citi, but they face formidable barriers to entry, the biggest of which is funding:
The new entrants and margin-killers of the decade or so leading-up to the crisis generally relied upon the securitisation market for funding. We cannot see the UK RMBS market coming back in a significant scale, for the reasons we have discussed in earlier reports. The fact is that the UK banks became a victim of their own success in developing a market for their variable rate RMBS product in the UK – principally, bank treasury departments (who considered these to be ‘liquid’ assets for the purposes of liquidity risk stress testing, for many years), conduits and CDOs – that relied upon leverage and cheap, LIBOR-based funding; and has now largely disappeared.
Should we be wrong, then new entrants have more of a chance of undermining the pricing power of the established major players in the UK. But then it would be the established players that would be the first to exploit that RMBS market to reduce their funding costs.
So there you have it. The UK banking industry is set to be a cosy cartel once again.
Of course, the irony here is that the government helped create this situation by waving competition rules and letting Lloyds buy HBOS.
But no matter. What’s important here, says Citi, is that UK banks are cheap given the new backdrop:
The domestic UK banks still look undervalued. They continue to trade at a considerable FY10e price-to-Gross Operating Profit (P/GOP) discount to the European banks sector (3.4x versus 4.1x) and the 20-year average of around 5x. We also glean insight into the scale of the upside potential of the shares of the UK banks over the next 3 years from analysis of the ratios between FY13e profits and FY07 ‘peak’ levels, and between current market cap and the previous 1Q07 peaks. Dividing the first ratio by the second gives us our ‘Valuation Upside Ratio’. Should P/E ratings by 2013 be of a similar order of magnitude to where they were in early 2007, then we could see the share prices of Barclays and Lloyds double from current levels, while RBS could rise by 60%. Discounting that back to today’s value, suggest potential upsides of 50-60% for Barclays and Lloyds and 10% for RBS.
(Apologies for the valuation jargon)This entry was posted by Neil Hume on Wednesday, April 21st, 2010 at 9:35 and is filed under Capital markets. Tagged with barclays, citigroup, Grupo Santander, hbos, hsbc, Lloyds Banking Group, rbs, vince cable.