As the UK braces itself for the previously undiscovered natural phenomenon of a “weather bomb”, known locally as winter, the UK banks are preparing for their own chill wind, as stress test results are due next week. While these tests tell us little about what will actually happen in the next crisis, which no one seems able to forecast very far in advance, they do reveal how the regulators view the sector and hence will have an impact on the returns of banks and their shareholders.
The UK’s stress tests are designed to be harsher and more relevant than the EU stress tests that four listed UK banks have already passed. In practice, this means higher loss ratio assumptions for exposures to households and to mortgage debt in particular. Household debt is just under 100% of GDP, a substantial portion of mortgages are high debt to income loans and with 65% of mortgages on a variable rate, the UK is more susceptible to rising interest rates than comparable economies. This has led to lots of chatter that Lloyds is most likely to be blown off course next week, but do the actions of market participants suggest that they are battening down the hatches?
The Cost of Credit
We would expect the first signs of worry to show in the CDS market, where creditors insure their loans to companies. Should the stress tests reveal banks to have less capital than previously assumed, then the courses of action open to the firms are shrinking, disposals and ultimately equity raising. None of these are good for the ability to repay debt and interest, hence the cost of insuring debt measured by the CDS should be rising if investors fear a disappointing outcome.
Lloyds’ CDS has narrowed 7% in the last five days and 25% over the past month. This means a lower cost to insure the bank’s debts and hence a greater degree of comfort about its credit worthiness. At 44 bps the cost is at extremely low levels relative to peers across Europe, as shown in the chart below. Any rise post the stress test results is more likely to be due to the extreme relative levels that Lloyds has fallen to, rather than because of the outcome of the tests themselves.
The CDS of Barclays and RBS are both even further below the average relative level than that of Lloyds, while HSBC is mid range and Standard Chartered at elevated relative levels. The Asian focused group also has the highest cost of credit among UK banks. As Standard has no UK household debt exposure, the threat of the UK stress tests is highly unlikely to be the cause of this.
Standard Chartered also exhibits high absolute and relative volatility, which is a measure of the range in which the share price is expected to trade three months hence. The average European bank is expected to trade +/-14% by mid March, which is the same as for Barclays. Uncertainty at Standard Chartered is slightly higher than this, while RBS is lower and HSBC markedly so. Lloyds has no liquid, exchange traded options market.
Overall option investors do not appear to be expecting problems for UK banks through the festive season and beyond and RBS actually trades at an unusually low level of implied volatility compared with Europe as a whole.
Declining Short Interest
Short interest in all five banks has fallen over the past week and the drop at Standard Chartered over the past month is one of Europe’s most extreme examples of factor divergence from share price, which is also down over the period. Short interest is up 10% in a week at TSB, which is the purest banking play on UK households, but which was over capitalised on listing and where the major issue is most probably the difficulty of making a decent near term return on its balance sheet. Consensus RoA for 2015 is 0.2% and RoE 4.7%, compared with UK banks’ averages of 0.5% and 9% respectively. Lloyds has the highest forecasts on both measures.
A Greek Tragedy would be more stressful
Annual stress tests enable regulators to find work for their armies of post crisis recruits and to claim that they are vigilant in their oversight of the banking sector. The outcomes of these tests are always likely to be less than satisfactory, because the precise nature and timing of the next downturn is not known in advance, nor do we know how consumers and banks will react and interact when that crisis arrives. Any assumptions are simply that and have to be shoehorned into whichever models are flavour of the month.
What the stress tests do show us is how concerned regulators are likely to be when reviewing banks and in particular allowing them to pay dividends and make acquisitions. On this front RBS might appear to have the greatest immunity, because if it pays a dividend in the next 12 months, analysts only expect the most paltry of payouts. Standard Chartered and HSBC have the highest yields at over 5.6% each, while Barclays and Lloyds are in the 3.5-4.0% range. All the dividends are comfortably covered by earnings forecasts.
However much media and analyst attention is drummed up by the stress tests, investors across asset classes are approaching this event with a distinct air of benign neglect. The risk in Europe appears to be another wave of uncertainty and credit contraction brought about by the sudden Greek election. Whether Mario Draghi has German permission to use the big gun in battling deflation should European politics take a turn for the worse (in market terms), is likely to have a greater bearing on UK bank share prices than the Bank of England’s annual number crunching fest.