In the face of an increasingly difficult U.K. and global economic environment, higher interest rates considerably strengthened the earnings of major U.K. banks. For the six major banks that recently reported first-half results (Barclays, HSBC, Lloyds, NatWest, Santander U.K., and Standard Chartered), aggregate profit before tax of £20.5 billion followed a strong acceleration in net interest income as net interest margins grew by 20 basis points (bps) on average, mostly from improved deposit spread.

Banks' average first-half impairment rate--13 bps of average customer loans--remained well below the system's long-term average. Management adjustments to provisions are sizable and increasingly reflect cost of living and supply chain pressures more than pandemic-related concerns, and provision cover is broadly in line with the pre-pandemic level, even as arrears and defaulted loans remain at multi-year lows. Together with conservative staging and economic scenario weighting, banks' balance sheets are cautiously positioned, in our view. That said, we expect impairment charges to rise toward the normalized through-the-cycle level in the second half of the year as economic conditions and projections weaken.

In S&P Global Ratings' opinion, strong earnings in first-half 2022 and banks' good financial flexibility suggest that the U.K. banking system can navigate the weakening domestic and global economic environments. U.K. banks also remain solidly capitalized on a regulatory basis and according to our risk-adjusted capital ratios. For those operating above their target ranges, material shareholder returns mean that regulatory capital should move comfortably within target levels this year. Led by strong earnings, those below their current target ratios should move back within their target in the next 12 months. As such, we do not anticipate sectorwide rating or outlook changes in the second half of the year, absent a marked deterioration in the operating environment. At present, Barclays (primary operating entities rated A/Positive/A-1) is the only U.K. bank we rate with an outlook that is not stable, reflecting its strengthening transatlantic franchise. We do not discount institution-specific rating actions elsewhere in the sector, where we see particular signs of resilience or susceptibility to the inflationary environment.

Amid A Gloomy Economic Picture, Banks' First Half Earnings Were Bright

Even as the U.K. economy slipped toward a recession and inflation moved above 8% through the end of the second quarter, U.K. banks reported strong profitability in the first half of the year. Pretax profit for first-half 2022 was not far below the exceptional earnings in first-half 2021--which were flattered by material provision release. Against the same period in 2021, the top four U.K. banks rode a net interest income tailwind of £5.5 billion in first-half 2022, more than offsetting the £4.7 billion increase in impairment charges year on year. The aggregate impairment charge of £1.8 billion was itself very benign, speaking to the banks' view that their existing stock of provisions was sufficient to navigate them through their forward-looking economic scenarios, as well as reflecting the stable asset quality of their loan books, with very few early signs of distress across lending portfolios.

Chart 1

The net interest income tailwind was primarily caused by low deposit betas, meaning that only a small portion of the Bank of England's interest rate hikes have been passed on to depositors. Average funding costs grew by only 10 bps on a reported basis, versus the 30 bp growth in asset yields (see charts 2 and 3). Going forward, deposit betas are set to increase as interest rates rise further, which we expect will reduce the pace of further net interest margin improvements.

Chart 2

Chart 3

Fierce competition in the U.K. mortgage market, where margins tightened considerably in late 2021, constrained growth in asset yields (see chart 4). Banks reported that this position had eased toward the end of first-half 2022 and margins on mortgage applications rose above completion margins. On top of the competitive market for new lending, banks also faced a barrier to earnings as their pandemic mortgage books began to roll off. These loans were written at exceptionally high margins (see chart 4) and, as they are refinanced onto lower margin deals, banks will see a drag on their net interest margins. Alongside this, growth was sluggish in banks' higher margin unsecured and commercial lending. If growth there were more fast paced, this would have supported additional interest income upside.

Chart 4

We think that NatWest's (NWG) first-half results summarize these trends well. NWG stated in its reporting that, out of the 26 bps of net interest margin growth in first half 2022, 34 bps of upside was attributed to improved spreads on retail deposits (20 bps) and commercial and institutional deposits (14 bps). By contrast, margins on lending reduced the group's overall margin by 8 bps, partly offsetting the benefits from low deposits betas.

Strong top-line growth drove robust first-half profit before tax, but stable costs were an important support to earnings (see chart 5). Against the first half of 2021, costs were flat to modestly higher, even in the difficult inflationary environment. This was driven by diminishing restructuring costs and the realization of efficiencies following the sector's rationalization and digitization over the past three years. Although growing technology investments and inflation will increase pressure on costs through the rest of the year, most U.K. banks have stuck to their overall cost reduction targets for 2022, providing further propulsion to earnings.

Chart 5

Table 1

U.K. Growth Stalls As Inflation And Interest Rates Rise

U.K. banks' results came against a difficult backdrop as the U.K. economy felt the effects of sharp inflation and rising interest rates. Imported energy and input costs drove inflation, exacerbated by supply chain frictions. With real wage declines likely through 2022, households in the U.K. are experiencing a marked cost of living squeeze, reducing demand as well as the saving rate. Similarly, corporates are experiencing persistent increases in wages and core input costs. The continued climb in interest rates, which temper household demand and corporate investment, further enforce these pressures on demand. This broad-based pressure caused demand growth to slow to a trickle late in first-half 2022, and we expect that economic growth will experience the same later in the year. We anticipate that the U.K. will experience a brief technical recession later in 2022 that will be hidden in full-year growth statistics by the last vestiges of post-pandemic U.K. economic growth.

Table 2

Banks' International Financial Reporting Standard (IFRS) 9 base case scenarios are no more optimistic and point to the same picture of weak growth and double-digit inflation, but also of supportive housing and labor markets with persistently low unemployment (see chart 6).

Chart 6

Asset Quality Is Robust, But Banks Have Positioned Loan Books For More Stress

Underlying asset quality in U.K. banks' loan books remained benign, and impairment charges were low in the first half of 2022 (see chart 7).

Chart 7

Nonperforming assets are about 1.8% of gross lending on a simple average for major banks. Early indicators of weakening asset quality, like 30-day arrears and the proportion of credit card borrowers making the minimum monthly repayment, are yet to see any meaningful deterioration. Furthermore, the staging of loans is now more conservative than the sector's pre-pandemic level, with material movements in stage 2 lending in anticipation of a potential weakening in asset quality (see chart 8). While provision coverage on stage 2 balances has generally fallen since 2019, the overall stock of provisions in the system remains broadly the same (see chart 9).

Chart 8

Although indicators of credit risk are currently supportive, we expect further signs of credit deterioration in the second half of 2022 and in 2023 as the full effects of inflation and further energy price hikes hit household and corporate budgets. We would expect underperformance in revolving consumer credit and small and midsize enterprise lending to be the catalysts for U.K. banks' impairment rates to move back toward pre-pandemic levels. Additionally, and as the deterioration in the Bank of England's latest forecast shows, risks remain to the downside in banks' IFRS 9 scenario weightings and forecasts. As such, a downward revision in macro forecasts through the remainder of 2022 could act as a further catalyst for rising impairment rates.

Over the past 24 months banks have used post-model adjustments (PMA) to build out their provisioning where economic effects, like the withdrawal of pandemic-related government support or a stagflationary economic environment, can't be fully captured by core provisioning models. Importantly, these are a significant portion of U.K. banks' provisions and, as COVID-19-related PMA have been withdrawn, they have been replaced with inflation, cost of living, and supply chain-focused overlays. When compared with pre-pandemic levels, this highlights that PMAs are a crucial tool to hold up provision stocks as strong economic indicators (like low unemployment and rapid house price growth) encouraged modeled provisions to remain constant or even move downward (see chart 9).

Chart 9

Finally, the economic shock required to precipitate material loan losses and a meaningful earnings or capital event is very large at this stage. In particular, mortgage books are positioned at low loan to values and form about 50% of U.K. bank lending. This means that even if the probability of default goes up, losses on defaulted assets will be contained--excluding a steep fall in house prices. Crucially, we believe that any increase in losses will be affordable as earnings are propelled forward by rising interest rates.

Regulatory Capital Positions Can Absorb Economic Pressure And Accelerating Shareholder Returns

The combination of expected regulatory changes, risk-weighted asset growth, and shareholder distributions brought U.K. banks' Common Equity Tier 1 (CET1) ratios into, or near the top end, of their target ranges (see table 2). HSBC is the exception, largely due to fair-value losses on its hedge portfolio bonds recognized directly in equity, and it expects the CET1 ratio to return within its target range in the first half of 2023. Strong earnings enabled material new capital distributions at the half-year point. Interim dividends to shareholders totaled £4.6 billion including NWG's extraordinary dividend of £1.75 billion, alongside £900 million of announced share buybacks. Whilst these distributions represent a sharp increase in capital distribution against half-year 2021, we do not believe they will necessarily weaken banks' robust S&P Global Ratings-adjusted or regulatory capital positions. NWG is an exception to this, because its announced capital distributions, combined with future distributions and asset growth, will move its risk-adjusted capital ratio below 10% over the next 12 months, which is already factored into our rating. As with international peers, the U.K. bank regulator prohibited capital distributions during the height of the COVID-19 pandemic and a repeat appears highly unlikely during the current downturn.

Table 3

Banks maintain large deposit and liquidity surpluses, which will support them through the next 12 months of turbulence. While quantitative tightening could result in less liquidity in the system, we would expect comfortable headroom above the regulatory minima to remain a feature of banks' balance sheets.

Chart 10