Is Lloyds the pick of the UK banking bunch?

As the Big Five get ready to report their annual results, Richard Hunter examines the preferred plays in the sector.

The full-year UK banks reporting season is imminent, and hopes are high for a continuation of the progress which the banks have been making after the dark days of the pandemic.

At the third-quarter reporting stage in October, the biggest theme of the season was a release of credit (bad loan) impairments, where the banks had overestimated the fallout of bad debts following pandemic lockdowns.

At the same time, the banks had been obliged by the regulator to cease paying dividends, and the excess capital which the banks were able to accumulate began slowly to find its way into shareholder pockets after this restriction was lifted.

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Indeed, the embarrassment of riches which the banks are holding augurs well for the reporting season as the excess capital will probably need to be deployed. The strength of the banks’ CET1 ratio – the capital cushion which the banks are required to hold – is in rude health, with all exceeding not only the regulator’s target but also their own.

As can be seen in the table below, the banks’ share prices have had a good run of late, although looking over a two-year time frame to pre-pandemic levels, the performances are more mixed.

At the same time, despite a return to the payment of dividends, yields remain significantly below those of March 2020, with bulls of the sector pointing to the fact that there is plenty of gas in the tank for further payment increases to be announced.

Often seen as a bellwether of the UK economy, the latest numbers saw pre-tax profit double to £2 billion from a year before in the third quarter, comfortably exceeding expectations.In terms of market consensus, Lloyds Banking Group (LSE:LLOY) is currently the preferred play in the sector.

Perhaps most promisingly, it was not the release of previous provisions, which solely contributed to these stronger profits. A release of £84 million over the quarter and of £740 million in the year to date compared with 2020 charges of £301 million and £4.1 billion respectively. The quarterly release has, of course, provided a tailwind for profit, but more notably net income rose from £3.4 billion a year previously to £4.1 billion for the quarter, again breezing past expectations.

Indeed, even before the impairment release, the third-quarter underlying profit was 27% higher than the previous quarter, representing some real progress as the bank readies itself for the next leg of the strategic journey.

In terms of share price performance, NatWest (LSE:NWG) and HSBC (LSE:HSBA) have been the out-performers over the last year.

For NatWest, the latest release showed that total income had surpassed estimates, rising to £2.8 billion from £2.4 billion the previous year. Underpinning the growth was an extraordinarily robust balance sheet, where the capital cushion had risen to 18.7% from 18.2% in the previous quarter, and where the Liquidity Coverage Ratio stood at 166%.

The destination for its surplus capital is not totally clear, although the ongoing reduction of the government stake and further returns to shareholders are most likely.

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Meanwhile, HSBC (LSE:HSBA) flexed its financial muscles as it continued to emerge from the horror show of 2020.

Again, the numbers were flattered by further bad debt releases, but the announcement of a share buyback programme was a positive endorsement of the bank’s own confidence in prospects.

Meanwhile the increased strategic focus in Asia, from where the bank already derives around 60% of profits, underlines not only its historic presence in the region but also its aspirations of future growth.

Overall, generally strong mortgage volumes reflected the strength of the housing market at present and the mortgage availability which the banks provide. There was also an increase in consumer spending in both the UK and the US as some pent-up demand was released following the general easing of lockdowns.

Less positively, there is still evidence of a cautious UK consumer continuing to pay down debt where possible, impacting lines such as credit card balances, where the margin is higher. There has been some increase in similarly profitable retail overdrafts facilities, but for the most part the historically low level of interest rates – despite the recent hikes - will continue to hamper the traditional “positive jaws” within the sector.

Even so, there are reasons to believe that the banks have comfortably weathered the latest economic storm and are now positioned to update investors on their plans for the next leg of growth.