UK banks: interest rate benefits for banks drawing to an end

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For the past couple of years, UK banks have provided an unusual inflation hedge. Concerns about inflation have pushed the Bank of England to rapidly raise interest rates, leading to good share performance for banks. Yet risks for them are rising.

Fears that the BoE cannot quell a looming inflation spiral have damaged its reputation. Its decision on Thursday to raise its base rate by half a point nods to that concern following higher-than-expected figures this week. Notably real estate and bank stocks fell the most on the day.

The promise of higher interest rates has presaged higher profits for banks. The FTSE 350 banks index has climbed 70 per cent including dividends over three years, more than double the return of the broader market index.

The biggest beneficiaries of higher rates are the UK’s largest retail banks Lloyds and NatWest, via net interest margins — roughly the spreads made on deposits and loans.

This margin at Lloyds held firm at 3.22 per cent in the first quarter. NatWest gained just two basis points, taking NIM to 3.27 per cent. The latter has the most exposure to the BoE’s base rate. It has a larger share of non-interest bearing current accounts and variable rate commercial loans. Analysts expect its earnings per share to compound annually at 12 per cent from 2022 to the end of 2025.

Perhaps, but shareholders must have doubts. Though the BoE base rate has jumped 150 basis points to 5 per cent since January, NatWest’s share price has dropped like a stone, 26 per cent.

Shares in NatWest and Lloyds (admittedly offering less growth) trade at 4.8 and 5.6 times forward earnings, respectively. These valuations were last seen during the Covid-19 panic in March 2020 and are not far from 2008 financial crisis lows.

So far, the market has not priced in much concern about the assets of either bank. At price to tangible book ratios of 0.8 times, both sit roughly in line with their five-year averages. That could well change in the weeks ahead as investors query the rising risks to borrowers after such a sharp jump in interest rates.

This is no trivial concern for portfolio managers. UK financials, of which banks make up the largest portion, represent 17 per cent of the FTSE 350. In Europe the figure is similar. Financials are the largest bet for investors. That makes the growing risk on banks difficult to ignore much longer.