The media consensus is that the UK's banks are profiteering off the back of British consumers, says Jody Clarke. But the truth is, the banks are actually making most of their money outside Britain - here's how you can profit from the trend.
If the headlines gracing some British newspapers this week are anything to go by, the country's bankers should be heading for the hills. "The shame of the banks"; "How the banks take revenge"; and our personal favourite here at MoneyWeek, "Revealed: total cost of the great bank robbery £7.2bn".
Yes, it's banking results season again. We are told that the banks are making enormous fortunes off the backs of their long-suffering customers and employing increasingly underhand tactics to squeeze yet more money out of them, even though 2006 profits for UK banks are expected to hit a record £40bn.
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Are banks unfairly profiting from customers?
The hordes of enraged pundits do, to a degree, have a point. Most banks offer miserly interest rates on current accounts, and when the Bank of England hikes rates, you can be sure the cost of your mortgage will rise to match it much more quickly than the rate you are paid on your savings. As recent probes have revealed, bank charges for various transactions, such as occasionally dipping into the red at the end of the month, are far out of step with the amount it costs them actually to deal with these errors. These charges, which have been deemed illegal, are estimated at anything between £1.5bn and £4.7bn a year, and the newspapers have been full of advice guides on how to reclaim these costs, while at the same time fretting over the end of free banking'.
Little wonder that, according to a recent report from the Liberal Democrats, the banks are making twice as much from their customers as they were ten years ago. Each personal account now earns the banks £232 a year, against £127 in 1997, say the Democrats. Over the same period, the combined profits of the UK's top nine banks have risen an astonishing 150% to £30.7bn. Vincent Cable MP, the party's finance spokesman, proclaimed: "An annual profit per customer of £230 is completely unjustifiable." To have near doubled profit per customer in such a short timescale in what is, ultimately, a very competitive industry would be impressive and an attractive investment story. But with growth at UK retail operations slowing considerably, how on earth can the banks be making almost twice as much from their customers?
Dig deeper and you discover that the figures are just plain wrong. A quick call to their treasury adviser, Will De Peyer, reveals that the party's financial wizards simply divided the banking sector's total profits by the total number of customers, using figures from the British Bankers Association. But, of course, the majority of those profits weren't made from UK retail banking they weren't even made in the UK. Which brings us to the most accurate headline of the week (if not quite as amusing), from The Observer: "Our banks are certainly coining it. But not from us".
How UK banks are cashing in on overseas markets
During 2006, for example, more than half of Barclays' profits came from its overseas operations, boosted by a string of foreign takeovers over the past three years. In 2004, overseas operations accounted for just 20% of profits. Meanwhile, Barclays' investment banking and fund management arms also performed impressively. Pre-tax profits at Barclays Capital rose 55% to £2.2bn, while Barclays Global Investors saw a 32% rise in profits from £540m to £714m. Overall, the bank saw full-year profits jump 35% to £7.1bn. But by contrast, its UK credit-card unit, Barclaycard, suffered badly. Pre-tax profits at the unit slid 40% to £382m, as British consumers took out less credit (partly because the bank is now turning away more than 60% of unsecured lending applicants), and an increasing number of people walked away from their debts, resorting to either individual voluntary arrangements or bankruptcy.
And what about the other banks? Their UK operations are hardly posting stellar returns. Lloyds TSB's retail banking unit grew by 5% last year, while, at the time of going to press, Royal Bank of Scotland was expected to report growth at its UK operations of 3% last year.
The truth is, it's not going to get much better any time soon. For a start, paying back all those illegal charges could cost the banks as much as £7.2bn. And although they are trying to put a brave face on it, it's by no means certain that the soaring growth in bankruptcies has levelled off yet. British consumers are sitting on top of a £1.3trn debt mountain, at a time when higher household bills and rising interest rates are putting pressure on personal finances.
The banks have tightened up on unsecured lending now, but that hasn't prevented the questionable lending policies of a few years back from continuing to have an impact. In the first half of 2006, UK banks wrote off more than £3.3bn as more of their customers defaulted on their debts. Lloyds lost £1.56bn last year because of bad debts, and Barclays £2.15bn. And with banks now being more careful about whom they give credit to, total credit-card borrowing is also falling: according to Euromonitor International, the average amount spent on credit cards in the UK fell for the first time ever last year, from £1,978 per person in 2005 to £1,900. Meanwhile, overall growth in unsecured consumer credit (including personal loans) has slowed from an annual rate of around 10% at the start of last year, to just over 6% in December.
Why banks are seeking growth abroad
Shrinking lending growth and rising costs do not make for a profitable banking environment. Which is why banks like Barclays are moving operations abroad. While it has closed branches in the UK, it set up 150 overseas last year and plans to open 350 more in Portugal, Spain, UAE, Africa and, possibly, India, as it chases the far more enticing growth prospects overseas.
Take the Russian market, where HSBC and Barclays have already applied for retail licences to start operating. Ordinary Russians, as opposed to the oligarchs we never stop hearing about in the London society pages, are only now beginning to enjoy the consumer goods we have long taken for granted here in the West. Also, with earnings per head growing at a rate of 10% a year, it looks like they'll have more and more money to spend in the future. And as a population's appetite to spend develops, so too does its desire to borrow money.
According to a recent study from the European Bank for Reconstruction and Development, Russia's ratio of mortgage debt to GDP is just 0.2%. By contrast, the ratio in Estonia is 17%, 11% in Croatia and 10% in Hungary, all of which are still tiny levels compared to the UK, on around 70%. This leaves a huge growth opportunity for the banks that can gain a foothold in Russia, which is "severely under-banked", as Frank Mosier of Kazimir Partners, a Moscow asset-management firm, tells The Economist.
Looking further afield, the opportunities get even better. In China, sales of mobile phones and electronic goods rose by around 20% to 40% last year, reports The Economist, while car sales surged 30%. According to figures from Goldman Sachs, by 2040 there will be 29 cars for every 100 Chinese people. Today, that figure is two. Similarly, the figure for India is 21 for every 100 citizens.
The message is quite clear: future growth in banking lies abroad, not here in the UK. "The markets of the East are of more interest to us than the markets of the West," said Barclays chief executive John Varley last week. It's easy to understand why he thinks this. In the box (see left), we look at which UK banks are set to benefit from the move abroad, and which will be left behind.
Which banks are making most overseas
Standard Chartered (STAN) has by far the greater exposure to foreign markets, with two thirds of its business now focused abroad. By the end of this year, it plans to double its number of branches in China to 40 and expand its private banking network in Singapore, Hong Kong, the UAE and India. The recent sell-off on the Chinese stockmarket (see page 8) has hit the share price, but that could prove a lucrative buying opportunity; profits for 2006 came in well ahead of City expectations, rising 19% to a record $3.18bn. Chief executive Peter Sands says the bank plans to continue investing heavily in China. "Over the last year we doubled our revenue and tripled our profits in China. This year we will be investing heavily in the consumer market and hope to be operating from 40 locations by the end of the year," he told The Guardian. The group increased its dividend to 71.04 cents, up from 64 cents in 2005. Continued bid speculation around the bank means it trades on a comparatively high p/e of 17 and yields 2.3%. But its strong growth prospects, with good exposure to Asia's major markets, including South Korea and Taiwan, justify the higher rating.
HSBC (HSBA) and Barclays (BARC) are also worth a look. HSBC has incurred £5.4bn worth of bad debt charges because of slack credit controls at its US mortgage unit, which will hurt forthcoming results. But as MoneyWeek tipster Paul Hill pointed out in a recent issue, the group has broad exposure to global markets, generating a third of its profits in Asia, and is extending interests in China. The shares trade on a forward p/e of around 12, and yield 4.2%. Meanwhile, Barclays may have had its problems with Barclaycard, but with half of its profits now generated outside the UK it looks a good bet, trading on a forward p/e of 10.6 and yielding 4.0%.
Less attractive is Lloyds TSB (LLOY). The group held its dividend flat for the fifth year in a row and reported "a pretty grisly set of full-year figures", says the FT. Profits met expectations, but largely down to cost cutting; analysts at Dresdner Kleinwort asked "Where have all the profits gone?" Richard Hunter at Hargreaves Lansdown said that the bank's "exposure to the UK consumer has traditionally been seen as a drag on major growth", saying there are "better opportunities elsewhere in the sector". We're also not too keen on HBOS (HBOS). It beat hopes with a 2006 underlying pre-tax profit of £5.54bn, but profit margins were squeezed by rivalry in the mortgage market. Further pressure on margins is expected this year.
Royal Bank of Scotland (RBS) had yet to report at the time of writing, but is expected to announce profits of £9.16bn. The group trades on a forward p/e of 10.7 and yields 3.5%, which is reasonable. But it generates 60% of its earnings in the UK, leaving HSBC and Barclays as better, higher-yielding bets for overseas exposure.
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