Bank shares and stress tests: the value investor’s verdict

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The Bank of England’s latest stress tests of the UK banking system attracted many column inches of space in the newspapers last week. The aim was to calculate whether these institutions would have enough capital to withstand certain grim scenarios.

Moving away from some of the inflammatory headlines, it is worth looking in more detail at the findings, as is our way on The Value Perspective.

First, it’s important to understand the parameters of the test. These are the gloomy assumptions made:

• UK house prices fall 31%;

• Commercial real estate values fall by 42%, with prime values falling by 49%;

• UK unemployment doubles to 9.5% (it remained below 8% in 2008/9);

• Oil prices fall to $20 per barrel;

• The economy is gripped by recession: global GDP at -1.9%, with the UK GDP at -4.9%.

The first point to make is that these tests are far more severe than previous ones.

The test assumes that UK banks will make pre-tax losses of £44bn over the first two years. This is five times what they lost during the 2008/09 financial crisis and £100bn less than today’s market forecast for profits over the next five years.

The second point is that banks are far better capitalised than they were in 2009. They have built significant capital and balance sheets have improved in each and every year since then. Even the low point for capital in these tests was better than in prior tests, despite this one being more severe.

There are further issues we’re happy to highlight.

Consider the assumptions made about the money needed to cover misconduct. The tests assume an additional £40bn of provisions on top of the £18bn already assumed by the auditors. Around £30bn would be paid in the first two years.

What does this mean?

This is comparable to a repeat of the total cost of the payment protect insurance (PPI) scandal. The Prudential Regulation Authority (PRA) believes there’s a 90% chance this misconduct estimate will not be exceeded. It also assumes that the bulk of these provisions will be levied on RBS due to the ongoing lawsuit over its US bank in the run up to the sub-prime credit crisis. This is why RBS has been impacted much more than the other UK banks.

As you can see, the stress tests are quite severe and to quote the Bank of England’s report:

"It is not a set of events that is expected, or likely, to materialise."

This is clearly a negative set of assumptions to all occur at once. Nevertheless, Lloyds, Standard Chartered, Nationwide, Santander and HSBC, all pass comfortably. Barclays passes the tests when their Alternative Tier 1 instruments fulfil their role of providing a buffer in a stressed environment, and convert into equity. In other words, they could raise the capital if needed.

It’s not all bad news for RBS either, despite the negative headlines. It could also meet the “hurdle rate” regulatory demand in the same way as Barclays, despite the additional misconduct fines.

However, it narrowly fails when another test – the Global Systemically Important Bank (GSIB) buffer – is overlaid on top. This buffer is designed to be used in a stressed environment, and explains why failing the GSIB buffer level is not an issue for the Prudential Regulation Authority whereas failing the hurdle rate would be, and why no additional capital would be required.

While it is possible that this set of circumstances occurs together, it is not an entirely plausible scenario. Nevertheless, the banks appear robust to this particularly harsh assumed environment, and appear well placed to weather future stress without recourse to shareholders. When one weighs the risks versus the potential rewards of these businesses, it could be viewed that the sector as a whole appears mispriced. The value investor should find compelling investment opportunities within it.

Important Information: The views and opinions contained herein are those of name, Kevin Murphy, Fund Manager at Schroders and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The sectors and securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.