Despite the prolonged state of political and economic limbo in the U.K., S&P Global Ratings believes that banks remain broadly resilient in the run up to Brexit. Recent half-year results from the major U.K. banks show robust asset quality metrics, stable capital, and healthy liquidity and funding. Together, these strengths provide a stable foundation from which to weather uncertainties arising from the outcome of Brexit, or other factors such as trade tensions threatening a global economic slowdown.

Having achieved end-state capital levels in prior years, many banks met our expectations and increased capital distributions. We think that our current view of stable ratings remains appropriate, albeit with a heightened awareness of the more nuanced operating environment anticipated for the remainder of the year.

Bank management has referenced more risk-averse behaviour by large corporates, with higher deposits and moderating loan growth--symptoms of delayed investment decisions. While we see potential for a rebound in 2020 activity should a Brexit agreement materialize, we also anticipate an uncertain period dominated by a potential no confidence vote, snap election, and/or no-deal Brexit. Moreover, management tone suggests a general bias toward countering margin pressure with aggressive cost control, rather than increasing risk appetite.

Relentless competition in the U.K. mortgage market has squeezed net interest margin (NIM) for many quarters and we expect this could intensify as additional headwinds have emerged. Exceptionally low and inverting yield curves, and higher standard variable rate attrition, have accelerated the pace of NIM erosion beyond that induced by deployment of trapped liquidity by ring-fenced banks. U.K. GDP in the second quarter fell by 0.2%, led by declines in manufacturing--the first fall since 2012--albeit influenced by first-quarter stockpiling activity. With further political uncertainty and an elevated risk of deteriorating global growth likely in the second half of 2019, there are numerous earnings headwinds to overcome.

Our base-case economic forecast assumes that the U.K. will not leave the EU without a deal, and we expect U.K. bank ratings will remain broadly stable under this scenario. That said, our current ratings or outlooks are unlikely to be consistent with a disruptive Brexit. Banks are ultimately a function of the economy that they serve. For investment-grade ratings, we take a long-term view of an entity's creditworthiness and expect that a highly rated bank can withstand a typical recession, perhaps with only a one-notch downgrade during the period, absent bank-specific problems. Our generally supportive view of U.K. bank capitalization, asset quality, and funding and liquidity profiles supports this expectation.

A no-deal Brexit scenario resulting in severe macroeconomic weakness could lead to rising personal and corporate U.K. insolvencies and weaker collateral values. In time, this would likely play through to bank asset quality and activity, undermining earnings and, possibly, capitalization to a modest degree. In that kind of no-deal scenario, we see outlook revisions as more likely than downgrades in the near term and, in our view, these factors would be relatively greater for smaller lenders given their business focus on U.K. retail banking or property-related lending.

Benign, But Softening Domestic Economy Ahead Of Brexit Endgame

While U.K. macroeconomic data remains benign with very low unemployment and, more recently, upticks in real wage growth, the increased probability of a no-deal Brexit is coinciding with the emergence of weakening global economic indicators (see table 1 and chart 1).

Table 1

Chart 1

Chart 2

Business and consumer confidence has reached five-year lows and loan growth rates have moderated (see charts 2 and 3). While negative second-quarter GDP primarily reflects an unwinding of stockpiling in the first quarter, recent weakness in manufacturing PMIs (Purchasing Managers' Index), commercial real estate investment, insolvencies, and household savings highlight increasing pressure at the margins of the economy. We expect these themes will continue to weigh on earnings in the near term, although we believe that banks will be able to absorb higher loan loss rates and slowing loan growth.

Chart 3

In contrast to the 16 consecutive months of house price declines in London, the rest of the U.K. has only experienced an easing to 0.9% annual U.K. house price growth in the year to June 2019. The consistent volume of mortgage approvals to date reflects the stable household debt service ratio afforded by very low interest rates, low unemployment, and real wage growth (see chart 4).

Chart 4

The availability of unsecured credit continues to fall (somewhat driven by Bank of England policy), coinciding with small increases in credit card and other unsecured household loan defaults (see chart 14).

We reflect our view of the macroeconomic environment in our bank ratings through our Banking Industry Country Risk Assessment (BICRA). Our '4' economic risk assessment for the U.K. is weaker than many comparable developed markets, partly due to our conservative approach since the 2016 referendum result. The stable economic risk trend reflects our assumption of an orderly EU withdrawal and banks' increased resilience after managing down higher risk legacy assets.

Should a disruptive Brexit become more likely, we could revise down the economic risk score in our BICRA, or revise the trend to negative from stable. We would also review our industry risk assessment, looking in particular at funding conditions (see “Credit FAQ: Explaining Our Banking Industry Country Risk Assessment For The U.K.” published on Nov. 15 2017). All else being equal, a downward revision in the BICRA economic risk score to '5' would result in a lowering of the anchor for domestically focused U.K. banks to 'bbb' from 'bbb+', and, in turn, could lower U.K. bank ratings by one notch.

Chart 5

Margin Pressure Is Driving Lower Profitability

U.K. banks have generally delivered stable earnings in the first half, although lower profitability could result from pressure on net interest margins and slowing loan demand (see table 2). Capital distributions have increased in most cases as banks look to prioritize investor returns during a broadly benign period in which common equity Tier 1 (CET1) ratios have either increased or end-state targets have been maintained (see table 4). Barclays and Lloyds have announced dividend increases with Lloyds and HSBC also executing buybacks. RBS has also announced its second large special dividend. Falling restructuring, litigation, and conduct costs--as well as one-off items, such as gains for RBS and HSBC from the merger of Alawwal Bank and Saudi British Bank----have helped sponsor these distributions and boost return on equity (RoE) to around 10% for many (see table 4).

We note that narrowing net interest margins have led banks to report lower operating revenue growth. Even where loan growth has been brisk--as with many of the building societies--net income has still fallen and may reflect the risk of more acute earnings pressure should growth rates ultimately ease.

Lloyds reduced its 2019 full-year statutory return on tangible equity (RoTE) forecast to about 12% from 14%-15% owing to a £500 million PPI charge in the second quarter and a generally weaker operating environment. Similarly, RBS acknowledged that delivering the 12.5% target RoTE by the end of 2020 was now very unlikely owing to difficult conditions. Despite achieving 6.8% year-on-year adjusted profit before tax growth and 11.2% RoTE, HSBC replaced its CEO seemingly in order to prioritize more aggressive strategic execution--much of which appears to focus on cost control.

U.K. banks with more limited international diversification have tended to experience larger revenue declines. Santander U.K. and RBS both saw pronounced falls in operating revenues of around 8% in first-half 2019 compared with first-half 2018. Though we expect an accommodative monetary policy would support asset quality through a period of persistent net interest margin pressure and/or a disorderly Brexit, access to diversified revenue streams may provide incremental ratings support.

First-Half 2019 Results For Major U.K. Banks

Table 2

Table 3

Major Banks Have Made Further Progress In Capital Distribution

Table 4

Mortgage Spreads Are Stabilizing, NIM Continues To Erode

While new mortgage spreads are stabilizing, NIM continued to erode over the first half as banks typically experienced rising SVR (standard variable rate) attrition, falling and inverting yield curves, and relentless pricing competition. Most banks experienced NIM erosion of around 5-15 basis points (bps) in the first half, with Barclays, RBS, and Santander UK reporting declines of 13, 17, and 11bps respectively. HSBC and Lloyds have outperformed and delivered more resilient NIM, similar to recent years (see chart 6).

Chart 6

Aggressive redeployment of deposits into the mortgage market owing to ring-fencing policy has exacerbated the "lower for longer" global rates theme in the U.K. Increased participation from non-traditional players such as equity release and other fintech are also compounding competition. We expect political and economic uncertainty to delay any potential Bank of England rate hike and with that relief in margin pressure.

Chart 7

Chart 8

The recent softening in global economic data has led to a meaningful rally in international bond markets. This has also played out in the sterling swap rate market where yields have been driven to recent lows and to curve inversion (see charts 7 and 8). These conditions, if sustained, will further strain NIM going forward.

The competitive environment is incentivising some lenders to increase exposure to higher margin mortgage products such as higher loan to value (LTV), loan to income (LTI), over 50s, and longer fixed rates. Premiums in all products are being compressed, although we see little evidence of material declines in lending standards in aggregate (see chart 9). Long-term mortgages (over 30 years) have been more commonly used to aid affordability. These themes represent an aggregate increase in risk that could heighten banks' vulnerability to exogenous shocks, particularly given the relatively high levels of household debt (despite U.K. mortgage arrears remaining exceptionally low--see charts 5, 10, and 11).

Notwithstanding these trends, we expect most management teams to prioritize aggressive cost cutting to combat margin pressure given the uncertain macroeconomic environment. Recent digitalization and technology investments will ultimately enable incremental headcount reductions and drive permanent efficiency gains.

Chart 9

Chart 10

Chart 11

Banks' Sizable Technology Investment Clouds Cost Cutting

Cost-to-income ratios have tended to drift higher so far in 2019 as banks have prioritized technology investment and are failing to deliver income growth (see chart 12). The lower profitability outlook will only intensify the focus on delivering efficiency gains. Institutions that have insufficient margins to sustain critical investment risk being left behind in what is an increasingly competitive market place.

Chart 12

Normalization In Credit Losses From Lows

Banks' credit losses remained benign in the first half with specific corporate situations driving small increases in impairments (see chart 13). There is growing evidence of gradual weakening in corporate credit quality, albeit from a very low base. Our base-case expectation is for further normalization in impairment rates, assuming an orderly Brexit. Under a no-deal scenario, we would anticipate a more meaningful increase in credit losses, particularly given the forward-looking recognition of IFRS 9 that will result in more volatile provisioning should economic forecasts require abrupt adjustment.

Chart 13

Corporate insolvencies and credit card arrears have begun to increase through 2018 and first-half 2019 (see charts 14 and 15), although credit quality in the U.K. remains relatively benign with near record low arrears levels. Reports of financial distress/plant closures have been concentrated in certain high-profile manufacturing firms and high street retail, but weakness is also present in property and autos.

Chart 14

Chart 15

Household debt levels are returning to pre-2008 levels with expanding student debt accounting for the majority of the increase (see chart 17). Student debt is provided by the government in non-recourse form, but it impacts the banking system indirectly by raising leverage and debt capacity. Individual insolvencies appear to have stabilized around recent elevated levels following the rise in individual voluntary arrangements (see chart 15).

Chart 16

Chart 17

The exceptionally low rate environment, while supporting debt affordability, may also present the need for innovative monetary and/or fiscal policy should an exogenous shock occur before rates are returned to normalized levels. We could see a more sensitive credit loss reaction function to recessionary economic conditions should rate cuts not be passed on to borrowers due to low absolute levels.

PPI Payouts Pick Up As Deadline Looms

Most banks have reported a material increase in PPI claims in recent months as claimants rush to reach the Aug. 29, 2019 deadline. Lloyds and HSBC booked further PPI provisions in the first half (£650 million and $615 million, respectively), while other banks indicated existing provisions had incorporated an elevated third-quarter 2019 payout. Since 2011, PPI payouts by U.K. banks and other lenders has totalled £35.7 billion through June 2019, according to the Financial Conduct Authority. Over the last five years, total PPI refunds have averaged over £4 billion a year and as such will represent relief from a material earnings drag going forward (see chart 18).

Chart 18

Capital And Funding: Prepared For Volatility

The first half has been business as usual from a funding, liquidity, and capital perspective. Most of the top 10 institutions are now at or very close to end-state capital ratios, having completed over 75% of full-year 2019 funding programs. The Bank of England has been clear in its ability to support the financial sector through any period of stress and we expect the term funding scheme would be reopened in the event of market stress. The roughly £300 billion of pre-positioned collateral for Bank of England lending operations is further evidence of credit support (Financial Stability Report, July 2019).

We note that a number of the smaller ("challenger") banks have MREL/TLAC (total loss-absorbing capital) issuance still to execute. In a more disruptive Brexit scenario, the associated cost of accessing markets may well add more earnings pressure.

Ratings and Capital And Earnings Scores For U.K. Banks

Table 5

Rating Components For Rated U.K. Financial Institutions

Table 6

Related Research

• Comparative Statistics: Top 25 U.K. Banks, June 24, 2019
• U.K. Banks: Looking At The Facts Rather Than Received Wisdom, March 4, 2019
• Countdown to Brexit: Rating Implications Of A No-Deal Brexit, Feb. 6, 2019
• Banking Industry Country Risk Assessment: United Kingdom, Nov. 5, 2018