U.K. banks' earnings rebounded strongly in the first half of 2021 as the economy started to recover from the effects of the COVID-19 pandemic. The main factor was the release of part of the large credit provisions that the sector booked in the same period last year. Banks guided that their credit impairment charges will likely remain very low in the second half, and some may well report a provision release for the full year.

First-half pre-provision earnings were generally lower year on year, but customer margins showed greater stability in recent quarters, interest-earning assets grew, and strengthening economic activity should benefit fee income. Indicating confidence in their earnings prospects, banks increased dividends and buybacks following the recent withdrawal of regulatory limits on shareholder distributions. Still, S&P Global Ratings sees banks' shareholder return targets as stretching in the medium term without a tailwind from interest rate hikes, which may be on the cards. The Bank of England (BoE) recently signaled modest monetary tightening to counter rising inflation.

Loan arrears and defaults remain very low but may increase moderately in the second half as the U.K. government phases out temporary fiscal support. Banks maintain sizable management adjustments within their credit provisions to mitigate this scenario and other downside risks to the recovery. Although the pandemic is not yet over, our base-case view is that corporate defaults and unemployment will peak at lower levels than previously appeared likely.

As part of a broader review of European banks ratings in June, we improved the outlooks on most domestically focused U.K. banks on account of the strengthening operating environment (see "Various Rating Actions Taken On U.K. Banks On Recovering Economy," published on June 24, 2021). Banks' first-half results confirmed the rationale for our June outlook changes. In particular, we believe that weak structural profitability and residual economic risks are less of a challenge for rated U.K. banks than many of those in continental Europe. Among the larger U.K. groups, most outlooks are now stable, but we have positive outlooks on Barclays and Nationwide due to institution-specific trends.

Provision Releases And Deferred Tax Writeups Lift First-Half Earnings

At the onset of the pandemic, U.K. banks were more proactive than most European peers in lowering macroeconomic forecasts and recognizing IFRS 9 stage 2 loans. The resulting surge in impairment charges weighed heavily on earnings early last year. This picture reversed in the first half of 2021 as the economy recovered faster than expected, resulting in a release of credit provisions and a significant jump in pretax earnings (see chart 1).

Chart 1

The provision releases raised shareholder returns to levels that, in some cases, exceeded banks' medium-term targets, which are generally 8%-10% (see chart 2). A write-up of legacy deferred tax assets after the U.K. government announced an increase in the corporate tax rate also boosted certain results. This gain is set to reverse next year when the government will likely make an offsetting adjustment to the bank levy.

Chart 2

Of course, provision releases are not a sustainable earnings source and the performance of banks' core businesses will determine their medium-term profitability (see table 1). A year-on-year fall in most banks' pre-provision earnings was therefore notable but prospects for the second half appear more supportive. First-half revenue was lower due to interest rate cuts at the beginning of the pandemic and a slowdown in trading activity from last year's exceptionally strong level, but margins were broadly stable in the last few quarters. Higher variable compensation added to some banks' operating costs.

Table 1

Economy recovers strongly as lockdown restrictions ease

Following one of the largest economic contractions of any country in 2020, the U.K. is on track for a strong rebound this year. We forecast 7.0% GDP growth in 2021 with a reasonably smooth transition away from the government's COVID-19 furlough scheme and other fiscal measures. We project that unemployment will peak at a relatively modest 5.4% in the fourth quarter of this year, which would support banks' retail asset quality. Similarly, we think government support has averted large-scale corporate defaults and businesses should benefit from rising consumption and investment. There are risks to the economy if new COVID-19 variants emerge and lockdown measures are reimposed, but our base case is a strong consumer-led recovery. Banks' updated IFRS 9 assumptions show a similar picture (see table 2).

Table 2

The U.K.'s COVID-19 vaccination program had a fast start and has relatively broad coverage today (see chart 3). The effectiveness of the vaccines is evident from a weakening of the link from infections to hospitalizations and deaths (see chart 4). The delta variant triggered an increase in COVID-19 cases from May 2021, but the number is now falling despite the removal of most lockdown restrictions on July 19.

Chart 3

Chart 4

Provision releases across the board

The improving economic outlook and benign credit environment resulted in provision releases across the sector in the first half (see chart 5). Our latest credit loss estimate assumed a 15 basis point loss rate on domestic loans for full-year 2021, and this is likely to prove conservative if the economic recovery remains on track.

Chart 5

Banks primarily released modeled and individually assessed credit provisions in the first half and maintained sizable IFRS 9 post-model management adjustments in respect of economic uncertainty (see chart 6). These adjustments primarily reflect residual COVID-19 risks and the possibility that fiscal support provided during the pandemic may delay rather than avoid some defaults. The number of jobs covered by the U.K. COVID-19 furlough scheme fell to 1.9 million on June 30, 2021, from a peak of 8.9 million in May 2020. The scheme ends on September 30 and the impact on retail credit quality should become clearer in the subsequent months. Virtually all repayment holidays have now expired with most borrowers resuming scheduled repayments, indicating that these arrangements were often requested as a precautionary measure. For wholesale loans, management adjustments focus on sectors that have been most affected by the pandemic, particularly those that depend on discretionary spending such as retailing, leisure, and passenger transport.

Chart 6

Banks guided that they will await economic data showing the effect of the fiscal tapering before considering whether to manage down their management adjustments. If the transition progresses smoothly, we expect releases could begin toward the end of this year and continue in 2022.

U.K. banks' stage 2 loans remain elevated relative to most other European peers' due to low thresholds to migrate assets from stage 1. The majority of stage 2 loans are fully performing and balances are gradually declining as the economy strengthens (see chart 7). Stage 3 loans are low, but we expect a moderate increase as temporary fiscal support is withdrawn.

Chart 7

Provision releases reduced coverage ratios from the elevated year-end 2020 levels, but they remain meaningfully above pre-pandemic levels and appear appropriate for the current economic circumstances (see chart 8).

Chart 8

Booming mortgage market presents opportunities and risks

Similar to the trends in many other countries, U.K. house prices have accelerated over the past year. As a multiple of earnings, the average price now exceeds the elevated level reached prior to the 2008 global financial crisis (see chart 9). Strong demand for housing reflects a combination of factors including a desire for greater living space in the wake of the pandemic, a temporary reduction in stamp duty that will shortly end, accumulated savings, and low borrowing costs. We expect demand will begin to normalize over the coming months and take some heat out of the market. We do not see a material risk of an abrupt price correction, but this could become a bigger danger if house price growth remains elevated through next year.

Chart 9

Losses and provision requirements on mortgages remained low through the pandemic. Alongside low unemployment and interest rates, a positive factor for the credit quality of these portfolios is the modest stock of high loan-to-value (LTV) loans (see chart 10). Banks tightened their underwriting criteria ahead of Brexit and again at the onset of the pandemic, but have reinstated some high LTV products in the last few months as the economic outlook brightened. However, we do not anticipate a dramatic change in the risk profile of new lending. Later this year, the BoE plans to review the macroprudential interventions in the mortgage market that it introduced in 2014. These measures limit high loan-to-income loan volumes and require lenders' affordability models to assume a three percentage point interest rate hike within five years, which looks unrealistically high despite rising inflation.

Chart 10

Stable customer margins and modest loan growth underpin revenues

The revenue environment remained challenging in the first half of 2021 due to the prolonged low level of short-term interest rates and subdued fee income. Net interest income in the first half of 2021 was lower year-on-year due to interest rate cuts by the BoE and other central banks at the onset of the pandemic. However, margins on customer assets have subsequently remained broadly stable (see chart 11). This is despite an adverse change in portfolio mix caused by net repayments of higher margin consumer credit during the pandemic. The BoE's monetary policy committee recently signaled a modest tightening of short-term interest rates, which should boost banks' revenues without materially affecting borrowers' repayment capacity.

Chart 11

Favorable mortgage pricing supported banks' margins through the pandemic. However, competition has returned this year and will be a headwind to margins in the second half of this year, though overall risk-adjusted returns remain attractive (see chart 12). Lenders raised spreads last year mostly to manage a surge in loan applications that followed the first COVID-19 lockdown. Mortgage volumes remain strong but have fallen back from the late 2020 peak, and rising swap rates have eaten into lenders' profit margins on new business. Loan fees partly mitigate growing competition on the interest rate paid by borrowers.

Chart 12

Customer lending grew modestly in the first half due to mortgage demand, while volumes were subdued in other loan categories (see chart 13). Credit card spending recovered as lockdown restrictions eased but there is a lag to the formation of interest-bearing balances, which are now growing modestly. Travel is an important contributor to card fees and credit card balances and is hampered by restrictions on passengers moving across national borders. Non-banks' "buy now, pay later" products also cannibalize traditional consumer credit, although the U.K. conduct regulator is taking a closer interest in these offers. Small businesses are deleveraging after borrowing heavily from government-guaranteed loan programs last year. Similarly, larger corporates are paying down facilities drawn at the beginning of the pandemic and obtaining new finance from capital markets more than banks.

Chart 13

Rising inflation has pushed up long-term interest rates and stabilized yields on structural hedges (see chart 14). Deposit inflows increase banks' hedge capacity, which partly mitigates pressure on net interest income from mortgage competition and elevated liquid assets.

Chart 14

Within non-interest income, retail and commercial banking fees have been dampened by the pandemic but should improve gradually as economic activity builds. First-half trading income and other capital markets revenue were generally favorable but fell from last year's exceptional level. Lower fixed income trading volumes offset growth in origination and advisory fees.

Variable pay raises costs

Cost-to-income ratios generally deteriorated slightly in the first half (see chart 15). Stronger profitability pushed up variable pay and banks invested further in technology and other strategic programs. For most banks, these factors exceeded ongoing efficiency savings. There were also structural actions to reduce future costs including rationalization of head office property and selective branch closures.

Chart 15

Regulatory capital ratios remain solid, but face manageable headwinds

Banks' regulatory capital ratios strengthened during the pandemic, aided by the expanded IFRS 9 transitional arrangement, low risk-weight on government-guaranteed loans, and regulatory constraints on shareholder distributions. The BoE recently lifted its restrictions on distributions and banks responded by raising dividends and buybacks (see "Bulletin: U.K. Banks Are Freed To Increase Shareholder Distributions," published on July 13, 2021).

We expect increased payments to shareholders will contribute to a managed decline in common equity Tier 1 (CET1) ratios in the coming quarters. Other factors include the unwinding of IFRS 9 transitional relief, pension contributions, expected loan growth, and various regulatory methodology changes beginning in January 2022. The latter include the deduction of software intangibles, which is an example of the U.K. regulator selectively diverging from the EU regulatory approach following Brexit. Banks have headroom to absorb the expected dilution in their CET1 ratios because they comfortably exceed minimum regulatory capital requirements and medium-term management targets (see table 3). The BoE expects to maintain its countercyclical capital buffer at zero until at least December 2021, which implies minimum regulatory requirements should not change materially before at least December 2022. Our risk-adjusted capital ratios should be more stable than CET1 ratios because our approach is unaffected by the IFRS 9 transition and regulatory methodology changes.

Table 3

In the fourth quarter, the BoE will publish full stress test results for the eight participating groups (Barclays, HSBC, Lloyds, Nationwide, NatWest, Santander UK, Standard Chartered, and--for the first time--Virgin Money). It published a desktop stress exercise last month in connection with its decision to lift limits on shareholder distributions, and it found the eight groups' aggregate CET1 ratio would remain comfortably above the 7.7% minimum requirement in the event of a further economic shock (see chart 16). We see the BoE's assumed 'W'-shaped GDP shock as a demanding scenario, although it notably differed from the gradual but persistent contraction in the recent European Banking Authority stress test (see "2021 EU Bank Stress Test: More Demanding, Better Resilience," published on Aug. 2, 2021).

Chart 16

ESG topics gain further prominence

Sustainable finance is cemented as a top priority for banks' senior management and is becoming more embedded in operating procedures, including risk management decisions. The U.K. will host COP26, the UN climate change conference, in November and therefore environmental issues are likely to be high on the political and news agendas.

Similar to other leading European regulators, the BoE seeks to explore and quantify banks' exposure to climate risk and promote better disclosure (see "Climate Risk Vulnerability: Europe's Regulators Turn Up The Heat On Financial Institutions", published Aug. 2, 2021). It is currently running a climate stress test that assesses the challenges to banks' and insurers' risk profiles and business models from three long-term scenarios. Unlike the cyclical stress test that informs banks' capital requirements, the climate exercise is an exploratory process intended to improve understanding of the issue. The BoE expects to publish the results in May 2022.

Central banks ensure ample liquidity

Banks and financial markets remain very liquid and deposit balances grew further in the first half of the year (see chart 17). This trend encourages mortgage market competition as ring-fenced banks look to deploy their funding surpluses in capital-efficient assets rather than lower-yielding liquidity portfolios. Deposit churn is likely to increase because customers have more possibilities to spend accumulated balances now that most COVID-19 lockdown restrictions have ended. Nevertheless, total system deposits are set to remain high because monetary policy is still accommodative.

Chart 17

Banks have the option of drawing cheap term funding from the BoE's Term Funding Scheme with additional incentives for SMEs (TFSME). At the last reporting date, there was £88 billion outstanding under TFSME and a further £23 billion under the predecessor Term Funding Scheme (most of which is likely to be refinanced through TFSME). Rated banks have significant capacity to borrow more from the TFSME before it closes to drawdowns at the end of October. Deposit growth and the availability of TFSME means that banks' recent term debt issuance has focused on refinancing capital and other loss-absorbing capacity instruments.

Across Europe, the combination of high deposit balances and low interest rates creates opportunities for banks' wealth management businesses. U.K. banks are not major players in this sector but have expanded wealth propositions as they have become more comfortable with regulatory conduct-of-business expectations. Lloyds, for example, is building out a joint venture with Schroders and recently announced the acquisition of Embark, a direct-to-consumer investment and retirement platform.

Mostly stable outlooks on our U.K. bank ratings

We revised the economic risk trend on our U.K. Banking Industry Country Risk Assessment to stable from negative in June because the recovering economy reduces downside risks to domestic asset quality. This change to the economic risk trend resulted in improved outlooks for most domestically focused banks. Our current outlooks are mostly stable but there are selective positive and negative outlooks driven by institution-specific factors (see table 4). The positive outlook on Barclays reflects our view that it is more effectively realizing the potential of its diversified business model and delivering a stronger, more consistent performance. The positive outlook on Nationwide reflects its improving profitability given modest credit losses, elevated but normalizing new business mortgage margins, and further cost reduction. The positive outlook on AIB Group (UK) and negative outlook on FCE Bank mirror the outlooks on their respective parents.

Table 4

Except for the banks on positive outlook, we see limited upside potential in ratings from the current levels over our two-year outlook horizon. This is due to residual COVID-19 risks, uncertainty over the economy's ability to transition smoothly away from the fiscal stimulus, and continued pressures on the medium-term profitability of banks' core business models. Equally, except for the bank on negative outlook, we see little downside risks to ratings unless economic prospects deteriorate materially.

Related Research

• 2021 EU Bank Stress Test: More Demanding, Better Resilience, Aug. 2, 2021
• Climate Risk Vulnerability: Europe's Regulators Turn Up The Heat On Financial Institutions, Aug. 2, 2021
• Bulletin: U.K. Banks Are Freed To Increase Shareholder Distributions, July 13, 2021
• Comparative Statistics: Top 25 U.K. Banks, June 28, 2021
• Various Rating Actions Taken On U.K. Banks On Recovering Economy, June 24, 2021
• Early Momentum Boosts The U.K. Recovery, June 24, 2021
• As Near-Term Risks Ease, The Relentless Profitability Battle Lingers For European Banks, June 24, 2021
• Default, Transition, and Recovery: The European Speculative-Grade Corporate Default Rate Could Fall To 5.25% By March 2022, May 26, 2021
• United Kingdom 'AA/A-1+' Ratings Affirmed; Outlook Stable, April 23, 2021
• Banking Industry Country Risk Assessment: United Kingdom, Nov. 17, 2020