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The Secret Truth about Lloyds, RBS and Barclays
Andrew Gibson, Head of Research 14th May 2012
discount of only 4%. And RBS was lagging behind with
50% Off Sale – while stocks last a 17% discount. So the discounts can evaporate quickly
Here we go again. After a strong start to the year, when the economic outlook improves.
Europe is threatening to spoil the party. Shares of the
Today’s steep discounts are certainly not specific to the
UK’s leading banks are under pressure once again.
UK banks either. The shares of many European banks
But the fact is the UK banks are in much better shape are trading at even bigger discounts. According to
than they were a few years ago. Balance sheets have Bloomberg, overall Italian and Spanish banks are
been shrunk, bad debts are falling and capital ratios are trading at a 60% discount to book value and French
looking a lot healthier. banks an astonishing 70% discount.
Yet right now, valuations remain at depressed levels. The discounts ultimately reflect that the stock market
The UK banks are trading at around half their book believes the book valuations are wrong and that
values – it’s a 50% off sale! mammoth losses are set to be reported in the future.
The table below shows a quick comparison between This is understandable to some extent. It’s not pretty
RBS, Lloyds and Barclays. out there. Europe seems to be sliding back into
Measure What's it tell us? Which way is best? RBS Lloyds Barclays
Core tier 1 capital Ability to absorb shocks Higher the better 10.8% 11.0% 11.0%
Net tangible asset value
Value of underlying assets Higher the better 48.8p 58.6p 391p
per share
Approx discount to book How cheap a share is relative to
Higher the better 55% 50% 51%
value the net assets
Book value is simply the value of a bank’s assets minus recession, which could trigger further losses from
its liabilities. Basically it’s the amount of money that property loans or corporate failures. And there is the
what would be theoretically left over if all assets were serious risk of a sovereign default across several
sold and all debts paid off. European countries (banks are big holders of
government bonds, so would face big losses).
All three banks are trading at hefty discounts to
But unless a bank is forced to raise additional capital,
their book value. it’s hard to see how these discounts can be justified.
These discounts are not a permanent feature by any Sure, some European banks may well need to
recapitalise soon. Don’t forget the EBA (European
means. For example, back in March 2010 investors were
full of optimism. Stock markets around in the world had Banking Authority) has set tough new capital rules – all
been in ‘rally mode’ for around a year - the FTSE 100 European banks must have core Tier 1 capital ratios of
9% or more by 30 June this year. Time is running out.
went from 3,500 to 5,700 over that period.
At that time, Barclays was actually trading at a 4% While 37 banks failed the EBA’s stress test last time
around, the UK banks sailed through. Not a single UK
premium to its book value. Lloyds was trading at a
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bank was required to raise a penny of additional capital. While many banks have already scaled back their
You can see from the table above that RBS, Lloyds and reliance on short-term and ratings-sensitive funding, it
Barclays all have decent headroom above the 9% doesn’t take much in this market to spark a run on
threshold. deposits. Institutions regularly move billions between
different banks with the click of a button. Any sniff of
And it’s not just capital ratio’s (solvency) that have been
trouble and a bank could face serious knock-on effects.
actively improved in the UK. The funding gaps (liquidity)
have now been largely tackled. A funding gap happens The fact is a bank’s credit rating affects both their cost
when a bank loans out more than it holds in customer and access to funding. Downgrades could mean a bank
deposits. needs to post greater collateral in the repo or
derivatives markets, squeezing liquidity. Some sources
Up until recently, the UK banks were reliant on short-
of funding may even be cut-off. For example, money
term loans from the UK government to bridge their
market funds could be unable to hold short-term debt
funding gaps. Worst of all was Lloyds. It was in a truly
that does not hold the highest rating from the agency.
shocking position, but has managed to make a fair bit
of progress.
For investors with physical shares, they may
Interestingly when you look back at many of the broker choose to hedge their positions.
research notes over the last few years, a common
argument for a bearish view was because the funding Hedging is where an investor who holds shares takes
gaps of the UK banks would be too big to overcome. out an opposite (short) position in the same shares
And that even if by some miracle external funding was using a CFD. Investors do this to lock-in gains or to
found to replace the government funding, it would be protect themselves from falls in the share price, without
so expensive that it would kill profits. So far these fears having to sell their existing shares. It can also be a way
have proved unfounded. of reducing portfolio volatility during a fluctuating
market.
Fear of the unknown
For those looking to profit from the relative movements
So what’s the main issue facing the UK banks today?
of two banks, they could take advantage of a ‘pairs
Fear of the unknown. There’s a lot of balls still up in the trading’ strategy. The aim of pairs trading is to match
air with the banks. Earnings visibility is poor. Balance two closely related shares (that have historically moved
sheets still aren’t trusted. Regulators continue to together).
introduce tougher rules.
Most of the time these shares move up and down at the
And now the credit rating agencies are set to fuel the same time, but by using a pairs trade, an investor could
fire. Moody's recently warned that 114 European banks take advantage of periods of divergence – one doing
are on downgrade review. better than the other.
When these divergences occur a trader takes a long
Nine of these banks are headquartered in Britain, position in the underperformer and a short position in
with Barclays and HSBC said to be among the the overachiever. If the pair reverts to normal, the
banks that might be downgraded by two notches. positions are then closed and an overall profit is made.
Pairs trading with CFDs is pretty straightforward as it’s
The reviews will begin in mid-May and be completed by easy to go long or short.
the end of June. It’s going to be a critical period for the
We’ll now take a specific look at RBS, Lloyds and
UK banks. There’s bound to be winners and losers.
Barclays.
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RBS
RBS continues to make good progress, but despite this, Another outstanding issue is the sale of the insurance
it’s still a complex beast. business. RBS is being forced to offload it as part of its
punishment from the European regulators. Although the
While RBS reported a headline loss of £1.4 billion, this
insurance business did nothing wrong, ‘bad banks’ like
was not a true number as it included some misleading
RBS were basically told they had to shrink. Selling the
accounting adjustments. The underlying operating profit
insurance business was part of the deal. Getting a good
was actually £1.2 billion, which was a good result.
price for it will be critical.
Bad debts, once the biggest number in RBS’s results,
A final key thing investors want to understand is how
shrunk by another 20%. And a key milestone has been
profitable the slimmed down investment bank will be.
reached: RBS has now repaid all its loans from the UK
RBS has slashed and burned many parts of its
government.
investment bank in the last few years. Right now it’s
hard to know what’s actually left, how much money it
The big talk lately has been about a possible exit
can make and how volatile its earnings will be.
strategy for the government.
The proposed 10 for 1 share consolidation is aimed
Rumours are that the government could sell up to a at bringing some ‘respectability’ back to the share
third of its stake to the Abu Dhabi sovereign wealth price.
fund, although sources close to the situation say any
sale would not happen until the end of 2013.
If RBS’s shares are trading at around 22p at the time,
RBS needs to become cleaner and simpler before it can then they would be re-valued at 220p, but shareholders
be “marketable” to big international investors. would be left with 10% of the shares they had
beforehand.
For a start, investors would like to see the dividend
resumed. RBS had been banned by Brussels from Fund managers would like a more solid looking share
paying dividends for three years. But that ban expired price, rather than a dangerous looking penny share.
in April this year. RBS recently announced it will begin Many private investors don’t see it that way and
to pay dividends again on preference shares, but has confuse a low share price with a cheap company.
not said when it will resume paying on ordinary shares.
Either way, it’s an artificial move and won’t have any
I think with the European debt crisis hanging over the lasting affect. If may actually put off short-term traders
sector, RBS, along with most other banks, will want to who like the volatility a low share price tends to bring.
keep hold of all the spare capital they’ve got. A dividend
Overall, credit must be given to Stephen Hester for
is a luxury they can do without for now.
getting things back on track. RBS is leaner and meaner
RBS is also keen to withdraw itself from the Asset today than many thought possible a few years back. But
Protection Scheme, which it was forced into when RBS still faces plenty of challenges ahead.
things got really bad during the financial crisis. If you
Long-term the shares look cheap, short-term they’re
remember, the government agreed to act as a backstop
only for the nimble.
for all of RBS’s really toxic assets. But it will need to pay
the UK government a few billion to free itself of this
‘insurance contract’.
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Lloyds
It used to be called “the world’s most boring bank”. While Lloyds’ capital position looks solid enough, we
How Lloyds longs for the good old days. don’t believe it can afford to be dishing out dividends
just yet.
Unlike RBS and Barclays, Lloyds is pretty much a pure
retail bank. Furthermore, most of its business comes “The balance sheet is the most important thing at this
from the UK whereas RBS and Barclays have substantial stage,” said Mr Horta-Osório predicting a “long and
foreign operations. difficult” recovery. It doesn’t sound like a man ready to
loosen the purse strings but it hasn’t stopped rumours
While this makes Lloyds a lot easier to understand, it
that the dividend will be back before the end of this
doesn’t mean its problems are any easier to fix. There’s
year.
not a lot it can do about the weak UK economy. The
fact is customers are borrowing less, not more. As a One thing that could bring some relief to the shares is
result, growth is very hard come by. the sale of Lloyds 632 ‘excess’ branches, known as
Project Verde. This saga has been dragging on for far
On the cost front, Lloyds is also facing an uphill too long. The Co-Op and NBNK have been battling it out
struggle. but must also get approval from the FSA, who are
imposing strict criteria that must be met.
The mega-merger with HBOS was meant to bring vast A recent wildcard has been rumours that Lloyds may
cost savings. They have delivered these to an extent, sell Scottish Widows, its life assurance, pensions and
but Lloyds is still facing shrinking profit margins. Why? investments business. Its certainly a prized asset, but
One of the reasons is that it’s hard for any UK retail Lloyds is not in need of the money and it would only
bank to make much money when interest rates are at make their strategy even narrower.
record lows (they prefer a higher rate environment). While 2012 and 2013 are unlikely to be vintage years
But the main reason is that Lloyds is in the process of for Lloyds, looking further out its well positioned to
replacing cheap state funding with more expensive benefit from a recovery in the UK economy.
commercial funding.
Because of rising funding costs, Lloyds’ net interest Lloyds has leading positions in current accounts,
margin fell below 2% in the final quarter of last year for savings, mortgages and personal loans as well as
the first time since 2009. What’s more, management strong positions in business banking, insurance
expects it to fall further in 2012. and fund management.
Like RBS, Lloyds recently reported a big headline loss -
While we have short-term reservations, over the longer
£2.8 billion. But when all the one-offs and accounting
term, we think Lloyds has plenty of recovery potential.
adjustments are stripped out, the core bank actually
The bank has a good track record of delivering cost
made a profit of £2.7 billion.
savings and paying out juicy dividends. For those with
The management issues also seem to be behind them. patience, I think Lloyds will emerge as a serious cash
After a health-scare, CEO António Horta-Osório says he cow when economic conditions improve.
feels fully recovered and is now “sleeping like a baby”.
The one thing that would really get shareholders
buzzing would be a reinstatement of the dividend.
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Barclays
Is Barclays hard done by? Its shares are at a similar rivals. But business levels have failed to bounce back.
discount to both RBS and Lloyds yet it has no state Diamond needs to get out the axe and cut costs.
ownership, has not incurred anything like the level of
bad debts and pays a decent dividend. The question is The European crisis has yet to cause any major
why? issues for Barclays, but has the potential to do so.
One issue is trust. Barclays have always taken a more While RBS and Lloyds have been massacred in
bullish view on things. Confidence can be good in times Ireland, Barclays Achilles heel is Spain.
of growth but the flipside is that some investors accuse
Barclays of being slow to recognise losses when times Most of the headline numbers you see refer only to
are tough. exposure to sovereign debt. But that doesn’t include the
exposure to private sector debt (eg mortgages).
Aggressive accounting combined with a huge and Barclays is the largest foreign bank in Spain with a
complex balance sheet means it’s hard for million customers and a network of 550 branches. It’s
investors to believe that what you see is what you not an enviable position given that Spain is effectively in
get. a depression.
Overreliance on investment banking, exposure to
Another issue is strategy. Since the late 1990s, Barclays Europe, and regulatory risks mean Barclays is
has gradually built up its investment banking unit from vulnerable to credit downgrades. Moody’s have already
a niche player in bonds to a global player that can highlighted Barclays as a bank at risk.
compete with the biggest names on Wall Street. The
purchase of Lehman’s Brother’s (US operations) has In the next few years Barclays must brace itself for
cemented Barclays in the world’s top tier. a regulatory overhaul.
The result is that the bulk of Barclays’ profits now come
from trading debt, commodities and currencies. Implementing the Independent Commission on
Earnings from these areas tend to be fairly volatile at Banking’s recommendations for ring-fencing investment
the best of times and big losses can come out of banking operations could be painful. It will also create a
nowhere. lot of uncertainty, which won’t go down well with
investors.
The recent $2 billion trading loss announced at JP
Morgan is yet another example of this. It is more But a healthy pickup in the performance of the UK's
ammunition for regulators looking to turn the screws on retail banking division and Barclaycard demonstrates
investment banks, particularly those such as Barclays that there’s more to Barclays than just BarCap. And its
that are housed together with a retail bank. majority stake in Absa - the largest consumer bank in
South Africa – continues to deliver strong growth.
The CEO Bob Diamond says he is fully aware that
Barclays must reduce its reliance on its investment In summary, Barclays looks in better shape than RBS
bank, known as BarCap. But that’s hard to believe and Lloyds. Its problems are more perceived than
because it’s ‘his baby’ – he’s spent the last 20 years of proven. And because it’s not had to radically
his life building it up. restructure, it remains largely intact. Meaning if the
economy bounces back, Barclays would be off to the
BarCap has also been criticised for its heavy cost base.
races. But regulators look set to enforce restructuring,
In the depths of the financial crisis it went on a massive
unless lobbying efforts can dilute their efforts. Its going
recruitment drive and paid top money to lure staff from
to be a cloudy couple of years ahead but the shares
look cheap.
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About Galvan
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