Find out why there's 'considerable upside' for UK bank shares

Our equities writer examines analyst reports on the prospects for bank stocks such as Lloyds Banking Group.

The “considerable” upside potential for UK banks and Lloyds Banking Group (LSE:LLOY) in particular has been highlighted in research anticipating the impact of rising interest rates.

Deutsche Bank analyst Robert Noble said virtually none of the benefits for net interest income were in current City forecasts, creating the potential for substantial revenue revisions.

His favoured stock is Lloyds, which he says has increased its interest rate sensitivity considerably in the last two years, including through the accumulation of current accounts.

The potential upside comes as economists bring forward their expectations for higher interest rates, with Deutsche Bank's own analysis pointing to a 15 basis points hike in February followed by a 25 basis points rise in November.

Since Bank of England policymakers last met on 23 September, two-year swap rates have increased by 12 basis points to provide “considerable benefits” for UK-listed lenders.

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Their shares have increased by between 3% and 4% since that meeting, but so too have counterparts in Europe even though there's been no change in the euro rate environment.

Noble said: “UK banks have actually underperformed the sector which is perplexing.”

One explanation is the fear that rising borrowing costs, energy prices and personal taxation will be enough to significantly disrupt the UK's economic recovery.

However, Noble believes there's minimal danger to banks from an asset quality or capital perspective because unemployment is not an issue and most of the issues appear to be around a lack of labour supply.

The generally higher inflation outlook and substantial wage growth could lead to higher-than-expected costs offsetting the rate rise benefits. But Noble has already factored this into estimates and says that Covid has also opened up opportunities for restructuring through digital banking and a reduction in physical branches.

This trend was highlighted today when Virgin Money UK (LSE:VMUK) said an acceleration of its digital strategy would mean the potential closure of 31 branches out of its 162-strong network. It is also moving to cloud-based infrastructure which will streamline and automate key processes.

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Noble said he viewed the risk of recession as an acceptable one when UK banks are currently trading on 0.6 times tangible book value. Based on Deutsche Bank's estimates, higher interest rates could add 9% to net interest income and push the return on tangible equity to above 10%, compared with the average forecast for 2022 of 9.4%.

He added: “If anything we would look to buy more if share prices are suppressed by a near-term downgrade to growth.

“Our preference is Lloyds which has increased rate sensitivity in the last two years. Shares have underperformed recently and continue to offer good value, in our view.”

Lloyds shares today rose 0.27p to 46.71p and Barclays (LSE:BARC) added 1.74p to 189.52p, but NatWest Group (LSE:NWG) eased 0.3p to 224.2p.

FTSE 250-listed Virgin Money slid 4% or 7.8p to 205.4p after revealing that its accelerated digital strategy will mean an additional £45 million of restructuring charges in the fourth quarter, which ends today.