Could banks finally be on the cusp of being interesting again? Until recently many would’ve answered no, but with talk of inflation and rising interest rates becoming a more realistic scenario, banks could well be an attractive investment option in the not too distant future.
Banks are a tough sell to anyone who has not been investing prior to the Global Financial Crisis (GFC). It has literally been one challenge after another for those investing in British and European banks for more than a decade.
Perpetually low interest rates have destroyed the profitability of banks since the net interest margin (the difference between what the banks borrow and lend at) has shrunk, while competition in the core mortgage market has also limited returns.
The heavy losses incurred during the GFC also resulted in significant regulatory changes, as attempts were made to shore up balance sheets. The likes of the European debt crisis and the Covid pandemic have both hit the sector hard since then.
Detractors would now say banks have become little more than utilities struggling to meet their cost of capital – you could even take this a step further and say they do not have the same guaranteed returns or dividend characteristics of the utilities sector. The regulator has shown they can – and will – stop dividends at the first sign of trouble in the banking sector.
Other challenges can be met head on
The aforementioned are areas the banking industry has no control over, but there are others where a more proactive stance can be taken. This is specifically in response to the disruptive threats to the industry.
In FX, companies such as Wise (recently listed) are eating into one of the banking sector’s most profitable operations; while the likes of Klarna and other buy now pay later (BNPL) services are threatening their credit card business.
The government has also been encouraging competition and new start-up banks, such as Starling, Monzo and Revolut, are taking more customers away from the incumbents. Unlike the old players, they are not weighed down by a large legacy of costly branch networks, which are becoming a major liability.
There are also challenges in the wealth management space, with fintech companies taking a greater market share by offering a cheaper and more customer friendly service than old bank share dealing services. The gap between both technology and price needs to be addressed.
We have seen more attempts by banks to fight back. For example, JP Morgan recently bought digital wealth manager Nutmeg* and Lloyds is set to buy retirement solutions provider Embark. I would argue that we need to see more of this as banks look to address the challenges posed by disruptors.
Reasons for optimism
Recent headlines have been more positive. Take the UK for example – banks accounted for 30% of the £44.8bn decline in dividends paid to investors over the 12 months to the end of March 2021*. However, the likes of Lloyds, HSBC, NatWest and Barclays all began paying dividends in April and May this year. These dividends should continue and hopefully return to pre-pandemic levels.
I recently read an article from Twentyfour Asset Management portfolio management partner Gary Kirk, who says banks are sitting with an abundance of excess capital and will use some of it to repay share-holder support, he also points to recent data which indicates banks are willing to lend. He feels the next catalyst for banks must be rating changes, citing that the rating agencies’ assessment of bank capital is out of synch when compared to their evaluations of the less-regulated corporate universe in high yield**.
Ultimately, I believe it will boil down to inflation and how close we are to raising interest rates. The net interest margin is the key for banks and at the moment they’ve been completely subdued by quantitative easing and low rates. But that could change if inflation does become a long-term reality – which would make banks a really attractive long-term solution for the first time in a long time.
Funds to consider
Investors may want to consider a number of value funds, like Schroder Recovery or the ES R&M UK Recovery fund, both of which have a number of banks in their top 10 holdings^. While a bond fund like Liontrust Monthly Income Bond also has a number of well-known banks among its largest holdings****.
Managed by Guy De Blonay, the Jupiter Financial Opportunities fund has also been a strong performer in recent years. Around a quarter of the funds’ underlying holdings are in the banking sector, with the majority in American names like Bank of America, Goldman Sachs and JP Morgan****.
*Source: Link Dividend Monitor – Q1, 2021
**Source: Twentyfour Blog – Bank Balance Sheets Continue to Strengthen – July 2021
^Source: Provider factsheets at 30 June 2021
