Analysts and equity managers divided on future post Basel III

Bank stocks rally post-Basel III was symptom of short-term relief, but may not be sustainable

Fund managers and financial analysts are split on the outlook for bank equities in the wake of the Basel III regulations.

Banks will need to hold common equity and retain earnings worth 4.5% of their assets by the start of 2015, up from 2%.

By 2019 they must have a 2.5% capital conservation buffer of common equity to fall back on in periods of financial stress, taking the total to 7%. Without this buffer they will be prohibited from paying dividends.

Regulators are also set to test a tier 1 leverage ratio of 3%, which would limit banks to lending 33 times their capital.

Positive response

The new capital and liquidity rules, announced on 12 September, prompted a positive response from the markets the following morning as investor fears of more stringent regulations were allayed.

Lloyds, RBS, Standard Chartered, HSBC and Barclays all moved higher and US financials Bank of America and J.P. Morgan Chase were among the strongest beneficiaries stateside.

However, with the rally easing off as investors’ relief tempers, managers and analysts are questioning the long-term growth prospects of bank stocks.

Guy de Blonay, co-manager of Jupiter’s £1bn Financial Opportunities fund, welcomes the regulations, which he says will be positive for the markets.

“The recommendations seem designed to reassure both markets and bank managements that short-term capital calls are no longer the focus, that future earnings should be sufficient to meet most shortfalls, and that it is urgent to get banks to start lending again,” he says.

Catherina du Toit, global financial analyst at Sanlam Investment Management, says the recent boost to bank stocks was due to the new rules being more relaxed than anticipated.

Most banks already comply with the regulations from Basel II and therefore already fulfill the 7% requirement, she says.

“While in the short term the banks may have further upside, this is because bank stocks had been oversold and the rally was down to relief the rules were not so strict,” du Toit says. “We will not see a massive rally as investors will now focus on the fundamentals and look for stocks which are good value.”

However, du Toit says many banks are currently good value and their growth potential will not be hampered by the new rules.

“UK banks are not expensive, in fact on a long-term basis these banks are very cheap. While bank equities will be lower risk, they will be driven by economic growth and innovation, and if they have that they will see growth,” she says.

“Some banks will need to retain capital which will impact their dividends, while others will be able to release their capital, as dividends, such as HSBC which has excess capital. But banks will not increase their dividends immediately,” she says.

Cormac Leech, senior research analyst, financials at Cannacord Adams, agrees the rally was due to short-term positive sentiment as capital requirement ratios came in lower than investors expected, but says the rally will continue in some stocks.

“HSBC and Barclays both have upside, although Deutsche is risky as it is expensive on a relative basis. If HSBC and Barclays rise 15%-20% then they will be fairly valued. It is about selecting the right stocks now.”

“There is still a lot of uncertainty in the environment, but HSBC and Standard Chartered are longer-term bets as they have emerging markets exposure where the GDP growth will be higher,” he adds.

Capital requirements

Leech says the new capital requirements make sense, as if they had been any higher the banks would have been over-capitalised.

“This figure is enough capital to protect the banks but not too much to destroy returns. It would be counterproductive to over-charge customers, but this way the whole system works,” he says.

“We could start to see dividends by 2012 when there will be £5bn to £10bn of excess capital in the banks, but the question is will the regulator allow the banks to return dividends to investors?” he adds.

However, Gavin Oldham, chief investment officer of the Share Centre, says Basel III restricts competition in the banking sector and investors are likely to shy away until evidence of growth is seen.

“Until the Bank of England tells the banks to start competing again, it will see its attempts to stimulate liquidity thwarted by high margins designed to choke off lending and pay out big bonuses. Also, what price a double dip?” Oldham says.

“The regulators told the banks to retain their earnings to help rebuild their capital ratios, and that is a recipe for walking all over people. UK banks may already meet the international capital requirements, but until the mood music asks for growth it is making money that counts.

“Competition has taken a back seat as the banks are braced for massive debt rollovers in 2011, and money is not circulating,” he adds.

On a stock specific level, Oldham is bearish on RBS, which he says is permanently damaged and unlikely to pay a dividend for a long time, and says Barclays has made little progress over the past year and needs to restore dividends.

He is more positive on Lloyds, which he says may resume paying dividends in 2011, and most bullish on HSBC, which he says “has made good ground” and will continue to progress well.

Cost of reform

According to Jamie Dannhauser, senior economist at Lombard Street Research, the costs of the banking reform agenda over the short to medium term will be higher than the Basel Committee on Banking Supervision has allowed for.

Dannhauser says the BCBS has underestimated the interaction between the financial sector and the real economy, not allowing for the fact weaker output growth, by lowering bank asset quality, may make it harder for banks to raise the necessary capital and long-term debt.

“If banks are forced to operate with balance sheets funded to a greater degree by equity and long-term debt, then the banking sector will create a smaller amount of cash and bank deposits for any given amount of assets,” Dannhauser says.

“This would be an additional channel through which new banking regulations would reduce asset prices and the level of demand.”

Alister Hibbert, manager of BlackRock’s £372m European Dynamic fund, has been shifting the financial component of his portfolio from recovery plays to high-quality banks in recent weeks in anticipation of Basel III.

“We have been invested in recovery plays but as normal earnings power resumes the interesting stocks will be those which are strongly capitalised and are likely to pay dividends,” he says.

Hibbert says some of the well-capitalised banks could reinstate dividends earlier than expected, and there may even be special dividends and buybacks in the next year or two.

“The Nordic banks have strong capital ratios, and while the Swiss banks will have a higher hurdle when the local regulator implements a further capital requirement, they are still extremely well capitalised,” Hibbert says.

“Julius Baer will be over-capitalised and UBS and Credit Suisse may pay dividends, while in the UK Lloyds could reinstate dividends. Lloyds is over-capitalised given its earnings prospects, so dividends and buybacks may be on the agenda.”

However, in the long term Hibbert remains cautious on the banking sector.

“We are underweight financials and will continue to be,” he says.

“We think there are selective growth opportunities, especially in emerging market franchises, but among the core banks growth will be constrained, earnings will progress at low levels, and the banks will move back to being income producing-stocks.

“Dividends will be taken well by the market, but, longer-term, banks are not the most interesting part of the market. Standard Chartered, HSBC, Santander and BBVA are the exceptions, the rest are too domestic. Banks will not be an interesting place in three to four years’ time.”