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22 Feb 2019 | By Rob James

Calm waters ahead for UK banks

Rob James, financials analyst and co-manager of the Merian Financials Contingent Capital Fund at Merian Global Investors is optimistic about the UK banking sector.

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The last few years have been pretty uncomfortable for investors in UK banks. While the course the banks were sailing was clear, the waters were extremely choppy.

Capital ratios needed to be built from a pre-crisis level of approximatly.4.5% to the current level of 13-14% of risk weighted assets, and when the changes in balance sheets are accounted for, that’s about a fivefold increase in capital. Unsurprisingly, given the task the banks were faced with, paying dividends was not top of the agenda for the sector. For example, RBS has only recently returned to the dividend list, following a 10-year absence.

Further, the government’s Term Funding Scheme (TFS), which offered cheap money to growing banks, allowed new entrants to compete aggressively for the little new loans business that was available, further damaging the incumbents.

And finally PPI, by far the largest of the redress problems (among several) sucked another £35bn out of the coffers.

But things are looking calmer on the horizon.

Capital levels now meet, or even exceed, the regulator’s requirements. Indeed banks are now being allowed to buy back their own shares, a sign that the PRA agrees that banks have surplus capital.

TFS has now ended. Those banks that took the money will have to pay it back over the next four years and replace it with other, probably more expensive, sources. With the cost of funding set to rise, we believe the ability of banks to offer new loans with rock bottom interest rates will ease. .

And finally the FCA has called time on PPI. There may well be a final flurry of claims, but of late, the monthly costs have been falling consistently. At least we now know when it will end.

So the headwinds are fading. This results season has seen the three domestic banks (RBS, Lloyds and Barclays) all pay dividends and announce share buybacks, or at least the intention of share buybacks. With low valuation multiples, we believe the total yield (both the dividend and the share buyback combined) could reach 10% per annum. for these stocks.

Of course, Brexit looms, but the capital levels are very high, preparation is good, and pre-emptive provisions have been taken.

We remain invested in the sector and look forward to smoother sailing ahead.

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