Are UK bank stocks set to surprise to the upside?

It's been tough to get excited about banks over the past decade. Near zero interest rates have made it difficult for the sector to increase profitability and return profits to investors. However, following the string of interest rate hikes from the Bank of England over the past 12 months, UK banks are starting to look appealing again. 

Banking isn't supposed to be exciting. Banks essentially take money from depositors and loan this money out to borrowers at a higher interest rate. Since the financial crisis, regulators have discouraged them from speculating and trading in financial markets. While some (notably HSBC and Barclays) still do, most of the UK’s lenders focus on the relatively straightforward business of lending and accepting deposits. 

This means they’re highly sensitive to changes in interest rates. Banks can charge borrowers more if there's a significant increase in interest rates, although they don't have to pass on the rate increase to savers. 

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US banks have been publishing their earnings for the third quarter over the past week, and their figures give us some insight into what to expect from UK banks when they report earnings this week. 

US banks lead the way 

All three of the banks to report earnings first, JPMorgan, Wells Fargo and Citigroup, beat expectations mainly thanks to higher interest income. 

This group reported more than $22bn in profits for the third quarter, up more than a third from a year earlier. While all three of these lenders also reported additional profits from their trading arms, the bulk of the growth in third-quarter profit was driven by an increase in interest income. Wells Fargo and JPMorgan also said they expect net interest income to grow more than expected in 2023. 

Bank of America reported its numbers for the quarter shortly after, showing a 4% increase in net interest income year over year. And like its peers, expects earnings to continue expanding over the coming quarters. 

Another factor analysts were watching closely in the third quarter earning season for US banks was credit impairments. Credit impairments can provide a good indicator of the economy's underlying health as they show us how many consumers are struggling to pay their bills. For the most part, credit impairments across the most prominent US lenders increased but increased from very low levels, suggesting consumers are still relatively well off. 

The outlook for UK banks  

The UK bank earnings season begins on October 24, and UK banks are likely to report similar trends in their earnings regarding the net interest margin, although the trend is unlikely to be as pronounced. 

The UK banking market is far more competitive than the US, and the big lenders have faced far more pressure to pass higher interest rates onto consumers by the regulator. 

UK consumers have also faced more financial pressure than their US peers over the past 12 months, which is already filtering into loan impairments. In Lloyds Bank’s half-year results, the lender reported a 76% increase in loan impairments year-on-year.

Put these factors together, and the domestic-focused UK banks, including all publicly traded banks excluding HSBC and Standard Chartered, seem set for a very uneventful third-quarter earnings season. 

Bank capital return plans are likely to move the needle for investors and traders. 

Watch capital return plans  

NatWest has been leading the pack with capital returns this year. Alongside its half-year results, it announced an additional £500m share buyback in addition to the £1.3bn share buyback it completed in the second quarter of 2023, on top of an interim dividend of 5.5p. The stock trading at a price-to-book (p/b) value of 0.7 is a prime candidate for further buybacks. 

Lloyds is a prime candidate to announce further cash returns to boost its stock, trading at a p/b value of 0.6. It reported a Tier One Capital ratio of 14.2% at the end of June, far above its target of 12.5%. That gives plenty of scope for the lender to announce buybacks or special dividends. 

HSBC is the one outlier of the group. Most of its profits come from the Asia Pacific region, and it’s benefitting from this international diversification, reporting a 50% year-on-year increase in revenue for the first half, mainly thanks to higher interest rates, suggesting the bank is likely to report a similar trend for the rest of the year. It's also worth keeping an eye on potential cash returns. The lender is expected to return to its pre-pandemic level of dividend distributions in the next six months and additional share repurchases. Both are likely to be received favourably by investors. 

Barclays is also one to watch for additional cash returns. Barclays is the only remaining high street bank to maintain a large investment bank and its US peers, such as Bank of America, have reported double-digit jumps in trading income for the third quarter. If Barlcays has seen the same favourable trading environment, it could return more cash to investors to ignite its sluggish share price. The stock is the cheapest of the bunch, trading at a p/b of 0.4

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