U.K. banks are on track to post strong profits in 2022 thanks to rising interest rates, but economic and political turmoil threaten to weigh them down.

There are particular worries about the banks' share prices and raised concerns about pressure on asset quality.

Uncertainty about the economic and policy landscape in Britain further increased on Oct. 20 with the resignation of Prime Minister Liz Truss after just 44 days in office. Bank share prices have been on a rollercoaster ride since Sept. 23, when Truss' government announced a controversial budget proposing £45 billion in unfunded tax cuts. Most of the plans in the so-called mini-budget have been scrapped since then-Chancellor Kwasi Kwarteng was sacked and replaced with Jeremy Hunt.

Media reports that Hunt is considering hiking bank taxes in the next budget, set to be announced at the end of the month, dealt a fresh blow to lenders' shares on Oct. 18. Shares in Britain's four largest banks — HSBC Holdings PLC, Barclays PLC, Lloyds Banking Group PLC and NatWest Group PLC — have lost between 8% and 12% of their value over the past month and underperformed the FTSE 100 index.

The latest official figures showing U.K. inflation rising above 10% in September and gross domestic product shrinking by 0.3% in August spell further pain for bank stocks as markets price in the risk of potential loan losses.

Higher interest rates are a big revenue driver for banks but will become more of a drag as mortgage affordability deteriorates, particularly given the unique nature of the U.K. mortgage market, where most of the lending is on a two- or five-year fixed basis, John Cronin, an analyst at stockbroker Goodbody, said in an interview.

Having a swathe of borrowers refinancing in the relative near term, especially during an economic downturn, raises concerns about debt service capability and bank asset quality as a result, Cronin said.

Credit default swap spreads on the four banks' five-year senior debt are at their highest level since early 2020 as yields on five-year U.K. government bonds remain elevated, standing at 3.87% on Oct. 20, compared to only 0.81% a year ago. This increases banks' funding costs and affects mortgage pricing.

Rate benefits

The stress, however, is not expected to show in banks' 2022 profits as the sector benefits from rising interest rates and unemployment remains low, analysts said. Provisions and operating costs will likely grow, but this will take time to feed through to the profit and loss accounts, Vitaline Yeterian, senior vice president of global financial institutions at DBRS Morningstar, said in an email.

The four largest U.K. banks' 2022 net interest income is projected to surge well above the prior-year level, with HSBC seen booking the strongest increase of more than 30% year over year, analyst estimates compiled by S&P Capital IQ show. Of the group, HSBC is the least exposed to the U.K. market and generates most of its profit from Asia.

HSBC is also expected to post a year-over-year increase in net income of about 18%, the data shows. While 2022 net income at the other three banks is expected to decline year over year, their profits will remain well above the pandemic year 2020 and close to or above pre-pandemic levels in 2019.

The banks will also have to absorb an increase in loan loss provisions, compared to provision reversals, which helped profits in 2021, the data shows.

Consensus estimates for the banks' net income and revenue in 2022 have not been affected by recent market jitters about the U.K.'s fiscal policies and their economic impact. NatWest exhibits the most stable trend in mean consensus forecasts, which surged in July after second-quarter earnings were reported and have remained almost unchanged in the past two months.

Longer-term impact

The outlook for U.K. bank earnings in 2023 and beyond is less clear.

Interest rate benefits would outweigh headwinds for banks from rising funding costs or a potential rise in loan losses, Berenberg analysts said in an Oct. 14 note. Even if loan loss growth accelerated to 50 or 60 basis points in 2023, from the low level of 17 bps expected in 2022, and if mortgage lending declined by 2.4%, 2023 earnings consensus for U.K. banks would remain broadly stable due to the interest rate benefit, the analysts said.

Yet Cronin noted that diminishing borrower affordability could pose higher risks for some banks. Mortgage rates for Lloyds customers, for example, have risen to 6%-6.5% this year, he said, while at the same time energy bills and other household expenses have soared. A year ago, the two- and five-year mortgage rates in the U.K. stood at 2.25% and 2.55%. "It's not difficult to see how arrears are going to start building up in that environment," said Cronin.

Asset quality deterioration will likely emerge from banks' exposures to U.K. small and medium-sized companies, consumer loans, and ultimately from the U.K. residential mortgage loan books throughout 2023 and 2024, DBRS Morningstar's Yeterian said. Lloyds and NatWest are more exposed to the U.K. market than HSBC or Barclays, but all banks have inherent challenges, the analyst added.

The extent to which banks benefit from rate hikes will also depend on the speed at which they are raised. "As a result, it is difficult to predict the full impact on banks' net profits in 2023," Yeterian said.

The Bank of England raised its base rate to 2.25% on Sept. 22 and is expected to hike the rate further, to at least 3%, at its next policy meeting on Nov. 3. Current analyst estimates expect the bank rate to peak at 5.25%, according to Reuters.

U.K. banks start reporting third-quarter earnings from Oct. 24.