In response to the economic shock triggered by the new coronavirus, and sharp falls in asset and commodity prices, both the Bank of England (BoE) and the U.K. government have made significant announcements intended to immediately support U.K. businesses and households, with the banking system expected to play its part. The BoE stated that economic activity is likely to weaken materially in the U.K. in the coming months. Most notable, from a banking perspective, is the reduction in the countercyclical capital buffer, and the reopening of the BoE's Term Funding Scheme.

S&P Global Ratings believes the healthy balance sheet profile of the rated U.K. banks will support their credit profiles through the economic downturn. In particular, we think that U.K. banks' current capitalization provides a significant cushion to withstand the economic shock and support the real economy, aided by the initiatives announced by the BoE. That said, asset quality will inevitably deteriorate and could pressure bank ratings if the temporary slowdown turns into a protracted recession. The funding and liquidity profiles of the banks are robust, further underpinned by the proactive BoE action, which will be especially beneficial for the smaller, unrated lenders.

The coronavirus outbreak adds further pressure to banks' earnings prospects. Principally, reduced economic activity and the 50 basis point cut in the BoE base rate will further constrain banks' net interest income and fees. We are yet to see how client activity and credit demand will evolve, notwithstanding the best efforts of the authorities, and the scale of additional loan impairment provisions arising from changed economic assumptions and actual credit problem cases. We currently see sufficient headroom within the earnings prospects of the rated U.K. banks to withstand these pressures and to remain comfortably profitable, and we expect shareholder distributions to bear the brunt of reduced earnings prospects. Our current ratings can withstand a temporary period of weaker earnings relative to our previous expectations, but a sustained squeeze could lead to negative outlook or rating actions.

Key elements of the BoE's package, announced on March 11, include:

• The Monetary Policy Committee (MPC) of the BoE unanimously voted for a reduction in the base rate to 0.25% from 0.75%. While not wholly unexpected, nor intended on its own to support the demand for credit, it is a negative development for banks' net interest income. At the margin, in the near term, the lower cost of debt servicing will support asset quality.
• In order to mitigate some of the negative aspects of the base rate cut, the MPC also voted for the BoE to introduce a new Term Funding Scheme with additional incentives for small and midsize enterprises (TFSME). Over the next 12 months, the TFSME will offer four-year funding for banks, with incentives to encourage new lending to businesses. The BoE states that the experience of its previous Scheme (TFS), which was launched post the 2016 EU Referendum and closed to new issuance in February 2018, could provide in excess of £100 billion of term funding. We think that this initiative supports the funding profile of the banks, should global wholesale funding markets remain weak, with a particular benefit to the smaller U.K. banks.
• The Financial Policy Committee (FPC) of the BoE has reduced the U.K. countercyclical capital buffer rate to 0% of banks' exposures to U.K. borrowers with immediate effect. The rate had been 1% and was due to reach 2% by December 2020. The FPC expects to maintain the 0% rate for at least 12 months. The BoE states that the release of the capital buffer will support up to £190 billion of bank lending to business. To put this into context, the BoE states that is equivalent to 13 times banks' net lending to businesses in 2019. We believe this policy demonstrates the flexibility of U.K. banks' capitalization to support the economy.
• From a supervisory perspective, in addition to the capital buffer release, the Prudential Regulatory Committee (PRC) of the BoE emphasized that banks can draw down on their liquidity buffers as necessary to support the economy. The BoE states that major U.K. banks hold £1 trillion of high quality liquid assets, enabling them to meet their maturing obligations for many months. In addition, the supervisory expectation is that banks should not increase dividends or other distributions, such as bonuses, in response to these policy actions. We think the proactive supervisory approach is indicative of the robust institutional framework of the U.K. banking system, which contrasts with the difficult times that the authorities had to work through during the 2008 financial crisis. This time around, the authorities hope that the financial system helps the economy, whereas before it was the source of the subsequent difficulties.

Separately, the Chancellor of the Exchequer's budget, announced on the same day, pointed to £12 billion of specific coronavirus-related policy actions and additional fiscal loosening of £18 billion over the next 12 months, equivalent in total to approximately 1.3% of GDP. Various banks have also announced measures to support affected borrowers including payment holidays and other forms of forbearance.

Strong Balance Sheets Shore Up Banks' Performance

The financial results of the eight largest U.K. banks were generally disappointing in 2019. For the ninth year running, payment protection insurance (PPI) charges weighed on statutory earnings (see chart 1). Moreover, banks' management teams typically indicated lower returns on tangible equity (RoTE) in 2020 than they had anticipated, or in some cases, significantly revised their expectations. Most notably, HSBC Holdings PLC (HSBC) and The Royal Bank Of Scotland Group PLC (RBS) announced further restructuring charges, as well as revising their RoTE targets. The evolving threat of the new coronavirus--and the recent collapse in the oil price--compounds our cautious perspective on U.K. bank rating prospects.

Chart 1

The view is brighter from a balance sheet perspective, as the eight largest U.K. banks reported benign asset-quality metrics, have comfortable funding and liquidity profiles, and saw little meaningful change in their solid capital ratios from 2018.

U.K. bank ratings are already underpinned by our view of their solid balance sheets. Therefore higher bank holding company ratings and hybrid instrument ratings appeared unlikely anyway in light of the 2019 results. Equally, with the exception of HSBC, which has a negative outlook, we have stable outlooks on the other bank holding companies, pointing to limited ratings downside absent a material deterioration in the U.K. or global economies, or setbacks in individual banks' strategic plans. The results from the BoE's 2019 stress test, which all the major U.K. banks passed, reaffirmed our view that U.K. banks are well-positioned to manage a global economic slowdown. The stress test incorporated a severe global shock with significant drops in GDP across major economies, well beyond our recently revised GDP forecasts (see chart 2).

Chart 2

Strong balance sheets buy time for banks' management teams to improve RoTE. However, U.K. banks' equity valuations are generally poor, demonstrating that investors are alert to the profitability issues that arise amid low interest rates, a low-growth domestic economy, a lack of meaningful credit growth, and the evolving threat of the new coronavirus. The recently announced cut to the BoE's base rate, further tempers our earnings expectations.

Our latest economic forecast assumes real U.K. GDP growth of just 0.8% in 2020. Even discounting potential unexpected shifts in the U.K.'s economic performance or adverse macro developments--including the ongoing negotiations between the U.K. and the EU on a new trade deal--there is little to console U.K. banks' management teams. However, we give credit for the banks' proactive approaches to innovate, invest, and restructure, and their avoidance of material drift down the credit curve to maintain "positive jaws"--income growth exceeding cost growth. Until their external environment brightens, there is not much more that U.K. banks' management can do.

This report covers the U.K.'s eight largest banking groups--Barclays PLC, HSBC, Lloyds Banking Group PLC (Lloyds), RBS, Santander UK Group Holdings PLC (Santander UK), Standard Chartered PLC, Nationwide Building Society (Nationwide), and Virgin Money UK PLC. Table 1 highlights the headline results for the six largest banking groups, each of which has a Dec. 31 year-end. Our analysis in this report includes HSBC and Standard Chartered, even though the former generates the majority of its revenues outside the U.K. and the latter almost all its revenues. The table excludes bank holding company Virgin Money UK, whose year-end is Sept. 30, and Nationwide, whose year-end is April 4, and whose performance we analyze to Sept. 30, 2019.

Table 1

Net Interest Margins Are Down, Loan Loss Ratios Are Up

The 2019 results of the eight largest U.K. banks reveal the following common themes:

Net interest margins fell

All eight banks reported lower net interest margins (NIMs) than in 2018. In 2020, we expect further NIM compression, reflecting the lowering of interest rates and mortgage market competition, although new mortgage pricing appears to be more benign than a year ago.

Noninterest income was generally flat to negative

This is consistent with our view that the domestic banking market and business activity (including investment banking) are not conducive to growth.

Control of operating expenses was good

Six of the eight banks reported positive jaws, with the main negative outlier being Santander UK. In some cases, operating expenses fell in absolute terms as the benefits of previous restructuring paid off and the effects of the shift to digital banking became more apparent.

Large-scale restructuring costs were typically absent

Exceptions were RBS and Virgin Money. However, in addition to the new restructuring plans that HSBC and RBS have announced, we think that restructuring costs across U.K. banks will remain an earnings factor as a function of ongoing rapid technology change and investment.

Loan loss ratios rose

In absolute terms, higher credit-impairment charges weighed on earnings relative to prior years. However, asset quality remains benign compared to historical norms. There was no sign of any asset-quality deterioration in the fourth quarter of 2019, despite the uncertain U.K. political backdrop at the time. As in 2019, we expect further instances of single-name loans becoming problematic, notably among U.K. retailers. Internationally, HSBC reported a rise in problematic Hong Kong wholesale Stage 2 loans in the second half of 2019, due to a period of social unrest.

PPI charges rocketed

PPI charges for the eight largest banks rose to around £6.3 billion in 2019 from around £1.8 billion in 2018, with Standard Chartered the only bank to be unaffected, as it has never had any related U.K. exposures. We don't factor any PPI provisions of note into our 2020 assumptions because the claims deadline passed in August 2019. More encouragingly, other conduct and litigation charges were significantly lower in 2018. At just over £1 billion in aggregate, these charges reflect the more typical annual run rate that we expect from now on.

Banks' Fourth-Quarter Performance Was Muted

Group revenue growth was typically muted in the fourth quarter of 2019, both quarter on quarter and year on year. Year-on-year comparisons were helped by the weak operating conditions for market-related business in the fourth quarter of 2018 (see table 2). On a constant currency basis, data for both HSBC and Standard Chartered were better than those reported. Encouragingly, the only additional PPI provision in the fourth quarter of 2019 was limited to the $179 million that HSBC booked.

Table 2

Several banks' management teams pointed to favorable business momentum in the early weeks of 2020, although we assume that the coronavirus outbreak will remove this upbeat tone at the time of their first-quarter results announcements. We think that market volatility in relation to the coronavirus could support banks' sales and trading revenues, but weaken their underwriting and advisory fees.

Banks Have Revised Their RoTE Targets

RoTE targets have become more muted across the board. A bank's achievement of its return target is not a ratings driver per se, but it often validates our view of the bank's business position. Moreover, earnings are the first line of defense in our capital assessment. The following RoTE revisions relate to the bank announcements in February--further revisions in light of recent developments seem probable.

Barclays

Barclays met its 9.0% RoTE target (excluding conduct and litigation charges) in 2019, up from 8.5% in 2018. It no longer expects to meet its 10% RoTE target in 2020, but expects a meaningful year-on-year improvement in 2020.

HSBC

HSBC's reported 2019 RoTE was 8.4%, down from 8.6% in the prior year. HSBC's interim CEO has announced a new strategic plan, which includes a reduction in gross risk-weighted assets of over $100 billion over the next three years. This could incur losses on asset disposals of $1.2 billion and broader restructuring costs of around $6 billion. In light of the new plan, HSBC now targets a RoTE of 10%-12% by 2022. By contrast, at the time of HSBC's previous strategy update in mid-2018, its reported RoTE target was more than 11% by 2020.

Lloyds

Lloyds' reported 2019 RoTE was 7.8%, down from 11.7% in 2018, although its underlying ratio of 14.8% is the highest of all U.K. banks. Lloyds now expects to achieve a statutory ratio in the 12%-13% range in 2020, which contrasts with its previous plan of 14%-15% from 2019.

RBS

RBS' reported RoTE was 4.7% in 2019, or 9.4% including foreign-exchange recycling gains. RBS' recently appointed CEO has announced a new strategic plan and believes this will support progress toward a 9%-11% RoTE in the medium-to-long term. Its previous plan was to achieve a RoTE of at least 12% in 2020. RBS has stated that its 2020 earnings will be burdened by £800 million-£1 billion of implementation costs and lower revenues in its NatWest Markets division. We note that the bank holding company will be renamed NatWest Group PLC later this year.

Standard Chartered

Standard Chartered reported an improvement in its underlying RoTE to 6.4% in 2019 from 5.1% in the prior year. However, it now sees headwinds in 2020 and believes that it will take longer to achieve the RoTE of at least 10% that it previously targeted for 2021.

Banks Have Enhanced Their Environmental, Social, And Governance Reporting And Initiatives

The number of new announcements by U.K. banks relating to climate change this year signal their growing commitment in this sphere. We think this is indicative of growing stakeholder pressure and the U.K. government's plan to reduce greenhouse gas emissions in the U.K. to net zero by 2050--the first major nation to propose this target. Moreover, the BoE's 2021 biennial exploratory scenario will examine the physical and transition risks associated with climate change. Examples of the banks' plans include:

• Barclays has stated that it provided £34.8 billion of social and environmental financing in 2019, taking its total to £63.3 billion, close to halfway toward its £150 billion goal. It plans to publish a full suite of environmental, social, and governance- and climate-related disclosures later this year, including an updated climate change position.
• HSBC has stated that it is more than halfway toward its target to provide and facilitate more than $100 billion of sustainable financing and investment by 2025.
• Lloyds has announced that it plans to help reduce the carbon emissions from companies it finances by more than 50% by 2030.
• RBS has announced a full phase-out of coal financing by 2030 and £20 billion of funding and financing in 2020-2022 for climate and sustainable finance initiatives.
• Standard Chartered has refreshed its commitments on climate change, including only supporting clients who actively transition their business to generate less than 10% of earnings from thermal coal by 2030, with interim thresholds. The bank also states that it is reviewing activities in other sectors with high carbon dioxide emissions.

Our Low U.K. Economic Forecasts Offer Little Hope For Banks

If our forecast of just 0.8% real GDP growth plays out in 2020, this will be the fifth straight year of annual growth below 2% in the U.K. (see table 3). Moreover, we recently shaved 20 bps off our U.K. GDP forecast due to the coronavirus outbreak. (See "The Coronavirus Will Shave 50 Basis Points off Eurozone Growth," published March 4, 2020).

Table 3

Following the conclusive outcome of the U.K.'s general election in December 2019, domestic economic activity has been picking up, albeit modestly. Consequently, the BoE kept its base rate unchanged in its January monetary policy committee meeting, which would have come as a relief to the banking industry. The March 11 50 bp cut in rates won't have been in bank budgets and will be negative for banks' earnings. That said, market conditions are fluid. The outcome of the next scheduled MPC meeting will be announced on March 26, 2020.

We remain cognizant of the evolving economic effects of the coronavirus, and now estimate it will now take 0.5 percentage points (ppts) off our 3.3% global GDP growth baseline from December 2019 (see "Global Credit Conditions: COVID-19's Darkening Shadow," published March 3, 2020). We also estimate that China's GDP growth could slow to 4.8% in 2020, compared with our pre-outbreak forecast of 5.7%. We have cut our forecast for euro-area growth in half to 0.5%, with Italy taking a harder-than-average hit. Finally, we expect the more-insulated U.S. economy to expand by 1.6% this year, 0.3 ppts less than our pre-outbreak forecast.

We continue to believe that U.K. loan growth will be in line with the forecasts of low-single-digit annual growth that we published in December (see "Low For Longer: Our Credit Loss Estimates For U.K. Banks," published Dec. 5, 2019), supported by the recent BoE package of initiatives.

We forecast nominal house price growth of 2.5% in 2020--lifted by a base effect--and a still-modest 2.0% rise in 2021. We think that any market dynamism in evidence at the beginning of the year may be relatively short-lived. A still-high degree of pent-up demand should underpin a minimum degree of price growth, barring any significant shocks. For example, the U.K. and EU's failure to reach agreement on the form of their relationship from January 2021, or an evolution of their trade negotiations in a way that increases the risk of such a failure materially, could depress buyer confidence and renew downward pressure on prices before the end of the year.

Peer Analysis

The eight largest U.K. banks lag their international peers in terms of relative economic risk and historical earnings, but capital, asset quality, and funding and liquidity are at least in line with the peer group. In the following sections, we compare the eight largest U.K. banks across selected metrics, and show the weighted average for the eight banks compared with seven international peers. We chose these international peers primarily because each has a group stand-alone credit profile in the 'a' category, which is higher than the 'bbb+' anchor for a domestically focused U.K. bank. The peers reflect a variety of geographies and business models.

Profitability prospects this year are now uncertain

U.K. banks' earnings were generally weaker in 2019 than in 2018, with margin pressure weighing on revenues and an increase in PPI charges weighing on statutory profit. We believe that ongoing pressure on NIMs, modest credit growth, flattish noninterest income, and an upward drift in loan impairment charges will weigh on 2020 earnings, notwithstanding good cost control. However, in 2020, the absence of PPI charges, and the likelihood of no other material litigation charges, could yet support better headline earnings in aggregate.

Across the top four U.K. banks, in aggregate, exceptional items represented a significant 13% of their operating revenues in 2019. This was largely led by PPI charges and a $7.3 billion goodwill impairment at HSBC (see chart 3).

Chart 3

Net interest income to revenues.   Reported NIMs have been on a downward trend across U.K. banks (see chart 4). Reflecting the significant role of investment banking, Barclays has the lowest reliance on net interest income, while its NIM is higher, reflecting its larger and higher-margin consumer credit loan book than its U.K. peers (see chart 5). On a weighted-average basis, U.K. banks rely more on net interest income than the peer group (see chart 6).

Chart 4

Chart 5

Chart 6

Noninterest expense to revenues.   U.K. banks rank slightly lower than the international peer group in spite of their efforts to better manage their operating efficiency (see charts 7 and 8). While the U.K. weighted-average noninterest-expense-to-revenues ratio improved to 58% in 2019 from 61% in 2017, some international peer banks also demonstrated improvements. Partly due to its scale and bias toward mortgage lending, Lloyds comfortably has the lowest efficiency ratio among U.K. banks, a status we expect it to maintain. The metrics for Virgin Money are somewhat distorted as the ratio in chart 7 excludes the impact of its significant merger-integration charges.

Chart 7

Chart 8

Impairment losses to revenues.   This metric has typically been in the single digits since U.K. loan loss rates fell below their long-term average from 2014. Low loan losses remain U.K. banks' silver lining as they partially offset the negative effect on revenues from the low interest rates. In particular, loan losses on U.K. mortgages remain close to zero. Notwithstanding the uptick in the loan loss rate in 2019 to a weighted average of 32 bps, U.K. banks compare quite well to the international peer group, and we expect this to remain the case (see charts 9 and 10).

Chart 9

Chart 10

Operating income after loan loss provisions to revenues.   Comparing U.K. banks' pre-tax profit margins to those of their international peers is not that meaningful for U.K. banks, owing to the negative impact of PPI and other exceptional charges in 2019 and prior years. Looking at the profit metrics before exceptional items, U.K. banks' profitability is better (see charts 11 and 12). Among the U.K. banks, Lloyds ranks highest, helped by its superior efficiency. Nationwide lags its U.K. peers owing to its customer-owned mutual model.

Chart 11

Chart 12

Capital ratios should remain credit supportive

On a regulatory basis, U.K. banks' common equity Tier 1 (CET1) and leverage ratios remained robust in 2019 and not much different to the prior year. Shareholder distributions were much lower than in 2018, as PPI in particular reduced the scale of the distributions that we might otherwise have expected (see table 4). There were no changes of note to capital targets, other than HSBC stating that it now targets a CET1 ratio of 14%-15%, compared with more than 14% previously. Moreover, HSBC now expects its CET1 ratio to remain at the top end of this range over the next two years, partly because it does not plan to conduct any share buybacks over the period.

We note that the BoE's revision of the countercyclical buffer to 0%, from its previous plan to increase the buffer to 2% in December 2020, does widen the distance between the banks' CET1 ratios and their minimum distributable amount (MDA) threshold levels. This development eases the potential for hybrid instruments ratings to be lowered.

Table 4

We have yet to calculate S&P Global Ratings' globally comparable end-2019 risk-adjusted capital (RAC) ratios for each of the U.K. banks. However, based on our preliminary view of the data, we doubt that the final ratios will deviate from our current expectations. Quality of capital is a more important factor when the RAC ratio is close to one of our thresholds. We base this ratio on adjusted common equity to total adjusted capital. Nevertheless, the U.K. weighted average of just over 80% in 2019 ranks below that of the international peer group. Virgin Money has the lowest ratio among U.K. banks, at 78%. Based on the U.K. banks' planned net hybrid issuance over the next two years, as per their fixed-income investor presentations, we expect them to marginally improve this metric.

Asset quality is benign

U.K. banks' asset quality is currently benign. In some respects, this is surprising as U.K. political risk reached its apogee in 2019, and there were numerous examples of weaknesses on U.K. high streets. The benign reported asset-quality metrics across all the banks demonstrate the power of low debt-servicing costs for both retail and wholesale customers, and the U.K.'s high employment rate.

However, there was an uptick in loan-impairment charges in 2019, driven by pressures on individual companies in the domestic market, and with some banks making provisions for increasing uncertainty in their operating environments, both in the U.K. and Hong Kong.

In terms of their stock of problematic loans, the top four U.K. banking groups have seen an improvement across each loan stage over the two years since the introduction of International Financial Reporting Standard 9 on Jan. 1, 2018 (see chart 13). The weighted-average nonperforming loan ratio for U.K. banks of 210 bps is broadly in line with that of the international peer group.

Chart 13

Funding profiles are favorable and liquidity is high

Compared to their international peer group, U.K. banks generally have more favorable funding profiles, with less reliance on short-term wholesale funding and lower loan-to-deposit ratios. Furthermore, since the 2016 EU membership referendum, U.K. banks have maintained high liquidity balances, which comfortably cover maturities of wholesale funding.

The final 2022 minimum requirement for own funds and eligible liabilities (MREL) will become known later this year once the Bank of England reviews the MREL calibration along with the Pillar 2A requirements. However, U.K. banks are well placed to meet their end-state MREL requirements, and we expect net issuances in 2020 to be lower than in prior years and to typically relate to refinancing.

Net customer loans to customer deposits.   Standard Chartered and HSBC rank highest on this traditional funding measure, reflecting their relatively strong deposit franchises in certain international markets. Mortgage-biased U.K. lenders rank lower. On a weighted-average basis, U.K. banks compare well with their international peers (see charts 14 and 15).

Chart 14

Chart 15

Short-term wholesale funding/funding base.   U.K. banks have relatively modest reliance on short-term wholesale funding. The weighted-average proportion of short-term funding relative to the funding base fell to 17% in 2019 from 24% in 2017, aided by reductions at Barclays and HSBC. Virgin Money has the lowest reliance among the U.K. peer group (see charts 16 and 17).

Chart 16

Chart 17

Finally, U.K. banks' S&P Global Ratings-calculated funding and liquidity metrics compare favorably to those of their peers (see chart 18).

Chart 18

Recent Rating Actions

Since our last U.K. banks report card in August 2019 (see "Limbo State Lingers For U.K. Banks," published Aug. 28, 2019), we have taken the following rating actions:

• In November 2019, we revised to negative from stable the outlook on HSBC Holdings and certain subsidiaries, including HSBC Bank PLC and HSBC UK Bank PLC.
• In January 2020, we affirmed our ratings on Virgin Money and maintained a stable outlook. However, we revised the outlook on the operating bank Clydesdale Bank PLC to positive from stable, reflecting substantial progress by Virgin Money in raising additional loss-absorbing capacity (ALAC) buffers.
• In January 2020, we affirmed the ratings on Nationwide and maintained the positive outlook. However, while we raised the ALAC uplift in the long-term rating, we offset this with a negative adjustment notch based on a rating comparison with global peers.

Table 5

Related Research

• Coronavirus Impact: Key Takeaways From Our Articles, March 12, 2020
• Economic Research: The Coronavirus Will Shave 50 Basis Points off Eurozone Growth, March 4, 2020
• Global Credit Conditions: COVID-19's Darkening Shadow, March 3, 2020.
• Economic Research: Europe's Housing Market Inflation Is Losing Pace, March 2, 2020
• United Kingdom: Brave New World, Jan. 30, 2020
• U.K. Banks Ease, Rather Than Roar Into The 2020s, Jan. 7, 2020
• United Kingdom Outlook Revised To Stable; 'AA/A-1+' Ratings Affirmed, Dec. 17, 2019
• U.K. Banks' Latest Stress Tests Confirm Balance Sheet Resilience, Dec. 17, 2019
• Banking Industry Country Risk Assessment: United Kingdom, Dec. 5, 2019
• Low For Longer: Our Credit Loss Estimates For U.K. Banks, Dec. 5, 2019
• Limbo State Lingers For U.K. Banks, Aug. 28, 2019