(Updates share prices in eighth paragraph.)
Sept. 13 (Bloomberg) -- The Independent Commission on Banking had a warning for investors as the government-appointed panel published its report on the future of the country’s financial industry.
“If you live in a world in which the real rate of interest on safe government bonds, bonds that the world regards as safe, is about half a percent or less, you might wonder whether you can reasonably expect a reasonably safe return of 15 percent on equity in a bank,” Martin Wolf, one of five members of the commission and a columnist for the Financial Times, told reporters in London yesterday. Shareholder expectations “are just a little bit unrealistic,” he said.
U.K. banks are bracing for higher funding costs, increased competition and reduced profitability after the report recommended lenders should build firewalls between their consumer units and investment banks and raise up to what analysts estimate could be as much as 200 billion pounds ($316 billion) in additional loss-absorbing capital. The changes will require as much 7 billion pounds a year in implementation and funding costs, said the commission, which was headed by former Bank of England Chief Economist John Vickers, 53.
“We are seeing a return to a more simple 1950s style of retail banking, where it is perceived as more of a basic utility with low return on equity for shareholders,” said Jon Pain, co- head of KPMG’s Regulatory Centre of Excellence in Europe in London.
Government Approval Needed
Vickers’ proposals must be approved by the government and lobbying from banks remains intense as lenders struggle with declining revenue and the threat of losses related to the European sovereign debt crisis, which is raising the cost of borrowing in the wholesale money markets. The plan is to be implemented by 2019 under the commission’s proposed schedule.
“These reforms are likely to make it more difficult for the U.K. banks to return to their already modest target levels of return on equity,” said Leigh Goodwin, a bank analyst at Citigroup Inc. in London. “The U.K. has the toughest liquidity requirements and among the toughest capital requirements. There has to be an impact on lending and on the competitiveness of U.K. banks.”
Bank Shares Decline
Return on equity at Barclays Plc, the U.K.’s second-biggest bank by assets, was 5.2 percent at the end of the first half of the year. In February, the bank reduced that goal to 13 percent from an average of 18 percent over the past three decades. Lloyds Banking Group Plc, the U.K.’s largest mortgage lender, and Royal Bank of Scotland Group Plc, Britain’s biggest government-controlled bank, are targeting return on equity of 14.5 percent and 15 percent, respectively. Lloyds and RBS both reported losses in the first half.
Barclays and RBS shares have both fallen 46 percent, while Lloyds lost 53 percent. The 46-member Bloomberg Europe Banks and Financial Services Index declined 37 percent.
“Although the rules are designed to make the sector safer in the long run, which we welcome, complex, costly regulation imposed unilaterally risks the international competitiveness of the U.K. banking sector,” said Jeremy Whitley, who helps manage 186 billion pounds as head of U.K. and European equities at Aberdeen Asset Management in London.
The biggest threat to lenders is a jump in the cost of funding for their investment-banking divisions as the implicit government guarantee is removed, say analysts. Goodwin estimates the new rules will mean banks may have to pay an additional 1 to 2 percentage points interest when issuing debt, eating into profits. Investors are also likely to demand higher returns if rating companies downgrade banks once the subsidy deriving from implicit government support is removed, Goodwin said.
“Fifteen percent return on equity is not a realistic return,” said Ismail Erturk, a senior lecturer of 24 years on banking at Manchester Business School in Manchester, England. “It has never been sustainable. It is market pressure on banks to deliver this return, which puts pressure on banks to take lots of risk.”
If the recommendations are implemented, the so-called ring- fenced units will include all checking accounts, mortgages, credit cards and lending to small- and medium-sized companies, the report said. As much as a third of U.K. bank assets, or about 2.3 trillion pounds, will be walled off, while trading and investment-banking activities will be excluded. Ring-fenced banks should have an independent board, the report said.
New Capital Levels
The commission also recommended that the largest U.K. banks bolster equity capital ratios of 10 percent with an added layer of 7 percent to 10 percent of risk-weighted assets in unsecured bail-in bonds, which leave investors liable for losses if a lender gets into trouble, or contingent convertible bonds, which convert into equity if capital falls below a specific level.
“There is no clarity on how banks are supposed to reach this 17 percent to 20 percent loss-absorbency level by 2019,” said Ian Gordon, head of banks research at Evolution Securities Ltd. in London. “They seem to be assuming there is some deep, liquid, well-priced market for bail-in bonds. There is no market for senior debt at the moment, let alone demand for a hybrid instrument with equity features when nobody wants them. The costs of implementation are clearly going to be material. The whole thing is bad news for the banks.”
Costs at Record
European banks’ costs as a proportion of market value are already at a record, according to Deutsche Bank AG analysts, who say lenders will have to undergo a process of “serious rationalization” and cost cutting before they will be considered attractive by investors again. Costs at the 47 European banks that Deutsche Bank covers have increased to 314 billion euros ($426 billion) from 302 billion euros in 2008, analysts led by Matt Spick said in an Aug. 25 note to investors.
“Any further reform measures adopted by the U.K. authorities need to be carefully analyzed and compared with those agreed internationally,” the British Bankers’ Association said in a statement yesterday. “It is vital that the full impact any further reforms will have on the economy, the recovery and banks’ ability to support their customers in the U.K. is understood.”
Chancellor of the Exchequer George Osborne, 40, said the government will pass a bill by the end of the current parliamentary session in 2015.
“We should not confuse the interest of bank shareholders with those of British taxpayers,” Osborne told parliament.
--With assistance from Kevin Crowley in London. Editors: Steve Bailey, William Ahearn.
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