At midnight on Aug. 29, 2019, the deadline for lodging claims regarding mis-sold payment protection insurance (PPI) passed. This was a landmark moment for the U.K. banking industry. PPI provisioning has been a constant theme of U.K. bank earnings since 2011, and each time that a bank announced a big top up in its provisioning needs, the mainstream media responded with further negative headlines.

Assuming that no further legal issues arise, the closure of the PPI saga therefore means that from 2020, one material constraint on U.K. bank earnings will have eased.

However, it has left an indelible mark on the U.K. banking industry, in S&P Global Ratings' view. Positively, it forced the U.K. banks to overhaul their conduct standards, product sets and pricing, remuneration and reward policies, and compliance culture. We see this as likely to mean that the sector is now generating more sustainable earnings than before. That said, although no new PPI-style misconduct event seems to be waiting in the wings, U.K. bank earnings will continue to feel the effect of a steady flow of low-level regulatory fines, the permanent shift to more complaints-driven customer behavior, and sustained aversion to the risk associated with advice-driven sales that continues to constrain sources of fee income.

PPI Shifted From Support To Millstone

The Financial Conduct Authority (FCA) estimates that as many as 64 million PPI policies were sold in the U.K. on personal loans, credit cards, and other forms of debt. Most were sold between 1990 and 2010. The product was designed to cover repayments in certain circumstances, such as redundancy or illness, when repayments become harder.

By the mid-2000s, the growth of PPI had made it a valuable source of income for U.K. banks, though numbers were rarely disclosed. We suspect that cross-selling PPI substantially offset lenders' lower margins on personal loans and other loans. Since 2011, when the industry chose not to further contest mis-selling claims, not only has that income effectively been forgone, but banks have had to pay redress and process a huge volume of complaints. In addition, claims management companies have compounded the number of claims through their activism in this area.

According to the FCA, PPI payouts from 2011 to June 2019 totaled £35.7 billion (see chart 1). Bank PPI provisions have been even higher than the PPI payouts to date, because they relate not only to the cost of paying redress to retail customers in respect of past sale of policies, but also to the banks' related administration expenses. We estimate that bank provisions now exceed £45 billion.

Chart 1

When presenting their latest interim results, bank executives have pointed to a recent pick-up in information requests ahead of the August deadline. This is partly due to the industry-funded but FCA-led advertising campaigns. We therefore assume that when they report their third- or fourth-quarter results, several banks will announce a further top-up in their provisioning. That said, we doubt that any individual bank's provisioning top-up will materially affect our capital projections. As of June 30, most banks had a stock of unutilized provisions; for example, the four largest U.K. banking groups had a combined £2.5 billion in unutilized provisions.

In absolute terms, Lloyds Banking Group has been the most affected U.K. banking group (see chart 2). Despite their large provisions, U.K. bank ratings have been resilient in recent years as their ability to withstand the financial impact has been partly aided by a sustained period of low loan credit losses, among other factors.

Chart 2

The Saga Brought Unexpected Side Benefits

Ironically, since 2011, PPI has acted as something of a support to the U.K. economy. Individuals have typically received a cash sum of £1,000-£3,000--in some cases, they received much more. On receiving this unexpected fillip to their finances, many have spent it (for example, to buy a car), but others have wisely chosen to pay down debt. In turn, this has helped bank asset quality as these individuals may inherently be more prone to indebtedness. Moreover, the PPI industry has been a useful employment boost. These side benefits will fall away over the coming months, although we assume that claims management companies will pursue other sectors or products.

PPI Was Not the Only Charge On The U.K. Banking Sector

Earnings in the U.K. banking sector have been weaker than they would otherwise have been, which has weighed on our view of the system, relative to other banking systems. Moreover, PPI occurred on top of other conduct and litigation charges, which included:

• Interest rate hedging products (around £5 billion in provisions over the 2012-2015 period);
• Other retail conduct charges; and
• A range of lumpy investment banking-related litigation charges.

With the benefit of hindsight, we now know that 2015 proved to be the peak year for total industry conduct and litigation charges. We estimate that in that single year, charges totaled about £16 billion--the cumulative figure since 2011 is probably around the £100 billion mark, a staggering amount.

Although conduct and litigation charges are likely to be much reduced in size and scope in the future, we now treat them as a normal part of doing business for the U.K. banking industry. Chiefly, this stems from customers' greater willingness to raise complaints, and the voracity of claims management companies. It also reflects a regulatory focus on treating customers fairly; a more-intrusive regulatory approach that benefits customers, rather than banks; and strong media attention.

We acknowledge that banks have worked hard to address the culture and conduct issues that PPI, and other conduct and litigation cases, have exposed. Examples of initiatives that should stand the industry in good stead for the future include:

• Product design: to ensure that products sold today do not lead to problems down the line.
• Reduced complexity: product portfolios are smaller and simpler, and focus on a good customer outcome.
• Evidence: Banks' focus on providing evidence that they are doing the right thing for customers.
• Sales: Changed sales practices that are less-aggressive or short-termist in nature, including changed remuneration practices.
• Risk management: the greater role and measurement of conduct issues within banks' risk appetite framework.
• Prominence: Chief compliance officers are now typically executive committee members and often report directly to the bank CEO.
• Accountability: The FCA's senior managers regime aims to reduce harm to consumers by making key individuals more accountable for their conduct and competence.

The Jury's Still Out

We see relatively few signs that other banking systems are dealing with their past failings on the scale we have observed in the U.K. Similarly, we see limited evidence that other countries will introduce more-stringent consumer regulation based on the U.K. model. That said, the pain inflicted on the U.K. banking industry by these changes may simply indicate that the scale of its misconduct was far greater than that in many other banking systems.

Although at first glance the positive developments outlined above might imply that the U.K. banking system is on a better long-term footing that many other banking systems, we have yet to be convinced. Moreover, the U.K.'s initiatives cannot fully mitigate against mis-selling or conduct risk, they can only be part of a solution. If new conduct and litigation issues arise in the U.K. we could view it as evidence that risk management has not improved. This could lead to negative rating actions on the bank concerned (or the banking system, if material), given that we currently incorporate improved risk management into our rating analysis.

Related Research

• Limbo State Lingers For U.K. Banks, Aug. 28, 2019
• Carry That Weight: The Top Four U.K. Banks Are Still Burdened By Conduct And Litigation Charges, April 27, 2015