Why it's time to bale out of the big banks

published 17 November 2006

Britain's high-street banks have a problem more and more of their customers are going bust. As many as three million people struggle to meet regular debt repayments, according to the Financial Services Authority, while the Government's Insolvency Service said that individual insolvencies in England and Wales in the third quarter totalled 27,644, a 55% jump on the same time in 2005. The figure was made up of 15,416 bankruptcies, up 26.6%, but the big leap was in the number of Individual Voluntary Arrangements, which more than doubled to 12,228.

The major banks have chafed against the lack of regulation of firms that offer IVAs, which they believe are being marketed as an easy way to escape debt. The Big Five' HSBC, RBS, HBOS, Barclays and Lloyds TSB had to write off £2.3bn of bad debts in their UK retail banking arms in the first half of 2006 alone. But Goldman Sachs says worse is to come. Its expects bankruptcies to rise a further 40% in the next two years, aided by plans for next year to simplify the IVA application process. Already, data provider Experian reports that "mid-income families, particularly those living in affluent areas of the south, such as the M4 corridor" are twice as likely to be tempted by an IVA than suffer bankruptcy, says the FT.

With British consumers already "grappling" with debts of more than £1,200bn, should investors sell their UK bank shares? asks Grant Ringshaw in The Sunday Times. Goldman thinks so analysts James Chappell and Julian Livingston-Booth say that bankruptcies and IVAs account for the majority of rising bad debts that have swallowed 85% of UK banks' retail revenue growth in the past two years. With "some clever number crunching", says Ringshaw, Goldman's analysts reckon as much as £36bn in bank lending could be at risk.

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That figure "looks a bit extreme", but emphasises the huge exposure faced by the big names. Goldman suggests the tougher outlook hasn't been priced into the sector and that most domestically focused banks face a rough ride over the next 18 months. With banks outperforming the UK market by 3% in the past six months, this means several big names look pricey at current levels (see the box below), although in the short term, shares may be supported by what are expected to be solid trading statements next month, particularly if they suggest that growth in bad debts eased off in the second half.

However, despite signs that Britons are cutting back on credit-card spending, the report sees "no end in sight" to credit deterioration and there will be a time lag before the banks benefit from any pick-up in savings and investment. And while Goldman is more relaxed about secured credit, suggesting that mortgage banks are less vulnerable than clearing banks, we're not so sure. More buy-to-let properties are being repossessed and sold at auction over 8,000 were taken into possession in the first half of 2006, a 76% rise on a year ago, says the Council of Mortgage Lenders, while the British Property Federation is alarmed by the number of lenders offering buy-to-let loans where rents only match interest payments. With unemployment continuing to rise, and interest rates set to do the same, the pressure on both householders and unsecured borrowers is likely to grow in the coming months bad news for the entire sector. We look at some stocks to avoid below.

Goldman Sachs has an outright sell' on four big-name UK banks: HBOS (HBOS, 1080p), Lloyds TSB (LLOY, 561p), Alliance & Leicester (AL, 1118p) and Bradford & Bingley (BB, 450.25p). The investment bank believes they face "a difficult balancing act". Revenue growth in the next two years is unlikely to be much changed from the 5% average over the last few years, whereas growth in bad debt level is set to rise, squeezing profit margins.

Goldman isn't as concerned about Northern Rock (NRK, 1181p), as the bank has less exposure to unsecured lending compared to its peers, which means impairment provisions are expected to be lower in the second half than the first. But mortgages account for 90% of Northern Rock's total loan book. Rising interest rates will put pressure on profit margins and, if there is a slowdown in the housing market, or a sharp rise in the repossession rate, the bank could be particularly vulnerable. Goldman also reckons that Northern Rock is among the UK banks most exposed to the crackdown on payment protection insurance. With those kind of headwinds, the forecast p/e of 11 looks too steep a price to pay.

Graham has spent the past three years as a cash management editor at Deutsche Bank. Graham started off as a Risk Management Professional editor at Perspective Publishing for two years, then became a writer at The Treasurer for 5 years and then an editor at gtnews.com for 5 years. He then freelanced for 5 years where he reported on corporate treasury issues, risk management, insurance/reinsurance and pensions. Graham has a degree in English Literature from the University of Bristol and he has contributed to MoneyWeek’s share tips.