Bank shares and stress tests: the value investor’s verdict
The Bank of England’s latest stress tests of the UK banking system attracted many column inches of space in the newspapers this week. The aim is calculate whether these institutions would have enough capital to withstand certain grim scenarios.
Moving away from some of the inflammatory headlines, it is worth looking in more detail at the findings, as is our way on The Value Perspective.
First, it’s important to understand the parameters of the test. These are the gloomy assumptions made:
- UK house prices fall 31%;
- Commercial real estate values fall by 42%, with prime values falling by 49%;
- UK unemployment doubles to 9.5% (it remained below 8% in 2008/9);
- Oil prices fall to $20 per barrel;
- The economy is gripped by recession: global GDP at -1.9%, with the UK GDP at -4.9%.
The first point to make is that these tests are far more severe than previous ones.
The test assumes that UK banks will make pre-tax losses of £44bn over the first two years. This is five times what they lost during the 2008/09 financial crisis and £100bn less than today’s market forecast for profits, over five years.
The second point is that banks are far better capitalised than they were in 2009. They have built significant capital and balance sheets have improved in each and every year since then. Even the low point for capital in these tests was better than in prior tests, despite this one being more severe.
There are further issues we’re happy to highlight.
Consider the assumptions made about the money needed to cover misconduct. The tests assume an additional £40bn of provisions on top of the £18bn already assumed by the auditors. Around £30bn would be paid in the first two years.
What does this mean?
This is comparable to a repeat of the total cost of the payment protect insurance (PPI) scandal. The Prudential Regulation Authority (PRA) believes there’s a 90% chance this misconduct estimate will not be exceeded. It also assumes that the bulk of these provisions will be levied on RBS due to the ongoing lawsuit over its US bank in the run up to the sub-prime credit crisis. This is why RBS has been impacted much more than the other UK banks.
As you can see, the stress tests are quite severe and to quote the Bank of England’s report:
“It is not a set of events that is expected, or likely, to materialise”
This is clearly a negative set of assumptions to all occur at once. Nevertheless, Lloyds, Standard Chartered, Nationwide, Santander and HSBC, all pass comfortably. Barclays passes the tests when their Alternative Tier 1 instruments fulfil their role of providing a buffer in a stressed environment, and convert into equity. In other words, they could raise the capital if needed.
It’s not all bad news for RBS either, despite the negative headlines. It could also meet the “hurdle rate” regulatory demand in the same way as Barclays, despite the additional misconduct fines.
However, it narrowly fails when another test - the Global Systemically Important Bank (GSIB) buffer - is overlaid on top. This buffer is designed to be used in a stressed environment, and explains why failing the GSIB buffer level is not an issue for the Prudential Regulation Authority whereas failing the hurdle rate would be, and why no additional capital would be required.
While it is possible that this set of circumstances occurs together, it is not an entirely plausible scenario. Nevertheless, the banks appear robust to this particularly harsh assumed environment, and appear well placed to weather future stress without recourse to shareholders. When one weighs the risks versus the potential rewards of these businesses, it could be viewed that the sector as a whole appears mispriced. The value investor should find compelling investment opportunities within it.
Fund Manager, Equity Value
I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials. In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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