Can UK banks keep raking in the cash?

It's been another record reporting season for UK banks. But with bad debts rising, can they keep increasing their profits, or is this as good as it gets?

After setting a new record for European banking profits this week, HSBC, Britain's biggest bank, said that it plans to spend nearly half a billion pounds creating 50 new branches in the UK, says Fiona Walsh in The Guardian. With profits coming in at the top end of analysts' expectations at £11.9bn on Monday (an 11% increase on its 2004 pre-tax figures), they can afford it.

HSBC's results rounded off a "bumper reporting season" for the big banks. HSBC may have been the largest earner, but profits of £4.8bn made by HBOS, £8.2bn by RBS, £5.3bn by Barclays and £3.8bn made by Lloyds TSB have all added up to total taxable profits for the sector in 2005 of just over £33bn.

Numbers like this make British banking a "very attractive place to be", according to Heather Connon in The Observer. This is despite years of fierce competition and the sharp fall in lending growth as over-borrowed consumers have cut back on their borrowing. And it's all led to "bid fever".

Just about every one of the high-street banks seems to be a potential target for predators, ranging from US giant Citigroup to Spain's BBVA, as well as banks in Germany, the Netherlands and Italy. And it's easy to make a case for bidding for any one of them. Royal Bank of Scotland and Lloyds TSB have low and tempting share prices: RBS has struggled with its integration of NatWest and Lloyds TSB has suffered from prolonged indigestion after its takeover of Scottish Widows. Barclays' international presence two-fifths of group profits already come from overseas could arouse interest, but HBOS could be an "even more attractive" target for an American predator, with its very successful range of UK businesses.

Not everyone's happy. The scale of the profits has led to a large amount of "bank bashing", with consumer groups and politicians criticising service levels and claiming banks are encouraging customers to take on too much debt at a time when personal bankruptcies are "soaring". There is even a call in some quarters for a windfall tax.

But this ignores the fact that the driving force for profit growth in recent years has come from corporate banking and overseas operations, says Jane Croftin the FT. In the past 12 months, corporate lending has grown faster than consumer lending and international operations are becoming a "big source" of profits for UK banks too. And, of course, it should not be forgotten that the financial success of UK banking adds about £10bn to the Government's coffers in tax every year, according to data from the British Bankers' Association.

So what of the future? While the banks' biggest problem at the moment might be to know what to do with all their money, only a decade or so ago they were weighed down by bad debts, says Christopher Fildes in the Evening Standard. They may say that they have a "sophisticated appreciation" of risk that will safeguard them against past mistakes, but it is worth bearing in mind that although the central banks have been keeping the global system awash with cheap money in recent years, the tap is now being slowly turned off. And when money becomes scarcer and more expensive and the weakest borrowers start to "go to the wall", the true levels of risk in the system will begin to become apparent. If this turns out to be the case, then last year's £33bn in profits could well be as good as it gets at least for a while.

The three biggest hitters in the sector

Royal Bank of Scotland (RBS) has been lagging behind the UK banking sector for the past three years due to concerns that it was planning to spend its "surplus cash" on acquisitions, says The Daily Telegraph. But after raising the final dividend by 29% to 53.13p last week and announcing the £1bn share buyback (see page 46) that the City has "long been calling for", those fears have been put to rest. This should give the stock a further boost. "Keep buying".

HSBC (HSBA) however, has resisted calls for a share buy-back and its 11% increase in the full-year dividend fell short of expectations, says The Daily Telegraph. But on a strategic level, with operations in 77 countries, HSBC is positioned to take advantage of various "global trends" in a way that none of its UK rivals is. On 13 times prospective earnings, the shares trade at a premium to the UK banking sector, but there is still room for "long-term upside".

At Barclays (BARD), says Investors Chronicle, the "star performer" was its investment bank, Barclays Capital, with a 25% profit increase to £1.27bn. But its main attraction is its expanding overseas interests, which make up about 13% of group profits. Even after stripping out the contribution from its stake in South Africa's Absa Bank, international business profits grew 21%. On a forward p/e of 11 times, the shares are "undemandingly" rated. "Buy."

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