Fear stalks the banking sector – but should it?

The UK's five top banks reported record profits last week, churning out combined profits of £21bn for the first half of the year. But it didn't do much to raise the spirits of investors. After the recent turmoil in global markets, the only thing that shareholders in UK banks are feeling is fear. The prospect of a financial forest fire spreading to the UK, stoked by the crisis in US subprime mortgages, has soured any optimism about the sector.

The banks can take a lot of the blame for the underwhelming response to their bumper earnings reports. They haven't done themselves any favours over the last few years buying up tranches of debt backed by dodgy subprime mortgages, funding massively leveraged buyouts across every sector and handing out money on the high street to anyone passing. British consumers have built up a £1.3trn mountain of debt in the process and they can expect to feel the full brunt of the recent interest-rate rises as the fixed-income mortgages they took out with banks come to an end in the near future. In the next ten months, £155bn of fixed-rate mortgages will re-price, with the average increase in monthly interest payments peaking at close to 40% by autumn, says Citigroup.

That reckless lending has fuelled a property bubble every bit as crazy as the US's and the UK now faces its own subprime crisis, says Matthew Lynn on Bloomberg. There has been a 30% jump in the number of property foreclosures in the first half of 2007, according to a report by the Council of Mortgage lenders. This is "largely due to an increase in subprime lending". If the US crisis is anything to go by, mortgage banks such as Northern Rock and Bradford & Bingley have a tough year ahead. The turmoil in the credit markets caused by subprime will also hit other areas where the banks have been generating big profits. Barclays may struggle to maintain the 38% annual growth in its investment banking profits, while the juicy fees that HBOS's corporate banking arm has earned from leveraged buyouts will be a lot harder to come by going forward.

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Currently, it seems the only tangible boon for the UK banking sector is the expansion of services overseas. As China and India's cities swell with a consumer class that can afford cars, fridges and electronic goods, UK banks have scrambled to open branches on their high streets. More than half of Barclays' profits came from overseas operations last year, and two-thirds of Standard Chartered's operations are focused abroad. This has already proved profitable for the banks, with Standard Chartered's Chinese profits tripling last year. Revenue from Asian financial services will grow by 20% to 30% over the next five years, according to Credit Suisse analysts. "This could generate up to 50% revenue growth for the banks that have sufficient exposure," says Credit Suisse analyst Ivan Vatchkov.

Concern over fines for overcharging also looks a little overdone. The levels of payout have been variable, with some analysts putting the final industry bill for the illegal fees at about £500m, says Martin Flanagan in The Scotsman. That's a long way short of the £7.2bn payout originally mooted. And when the Office of Fair Trading does introduce caps on bank fees, it's likely banks will change the way they charge customers levying an annual lump sum instead of individual fees, for example rather than how much they charge. So while the sector has experienced a derating in recent months, the market is failing to discriminate between banks, say Citigroup analysts. We look at the ones to consider below.

The two best bets in the UK banking sector

One bank whose valuation has been hit by subprime fears is HSBC (HSBA), with the bank's bad debts rocketing 63% to more than £3.4bn last year. But HSBC has a strong position in Asia, where it generates a third of profits, so the writedown in its value looks overdone. It might have written off £16m a day in irrecoverable loans in the first half, but underlying profits still rose by 5%, says Patrick Hosking in The Times. Hong Kong in particular is showing strong growth, where profits grew by 25% in the first half. The bank also owns significant stakes in Chinese financials, such as Bank of Communications and Ping An Insurance. The shares trade on a p/e of 11.4 for the year end, offering a 4.9% dividend yield.

The UK bank with the biggest exposure to foreign markets is Standard Chartered (STAN), which generates 75% of its profits overseas. The bank beat hopes with a 30% jump in half-year profits, despite the considerable growth of its Chinese and Indian units. Corporate lending in India rose 85%, while in China it rose 92%, says Forbes. "Standard's emerging markets positioning provides attractive growth and execution has been strong," say analysts at JP Morgan. The bank is also looking at more acquisitions, with a reported interest in South Africa. It also looks likely to avoid the worst of the credit crunch, with bad loans rising just 3.4% this year. The shares trade on a 2008 p/e of 14 and yield 2.2%.