UK banks have enjoyed a renaissance in 2024. And, while the snap UK election put paid to plans for a big share sale in NatWest (NWG), anticipation of a ‘Tell Sid’ style offer definitely put the spotlight on the sector.

As such, now is a perfect time to take an in-depth look at the banks’ relative merits, particularly off the back of their annual 2023 and first-quarter 2024 results.

It’s worth saying making comparisons isn’t that easy because they each have different business models and different moving parts, so while they all have a high-street presence and we may think of them just as somewhere to put our wages or our savings they do a lot more besides.

Ultimately, though, from an investor’s perspective, banks are no different to any other business – what matters is how well managed they are, how they control their costs and whether they offer an attractive risk-adjusted return.

EARNINGS ARE CYCLICAL

The first thing to flag is banking is a fairly cyclical business, in as much as demand for loans both from individuals and businesses tends to depend on the state of the economy and how confident people are feeling.

When times are good and companies and households are borrowing the banks can turn a tidy profit, but when there is a downturn some of their loans inevitably turn bad and they have to put aside provisions for credit losses.

Unlike most businesses, UK banks don’t tend to put aside money for bad loan provisions when they are making hay, they seem to wait until they start losing money to do it, which can make their earnings even more cyclical.

However, since the pandemic they have maintained or grown their loans and deposits at a steady clip, and so far at least there don’t seem to be any signs of strain in terms of credit quality, meaning provisions are generally much lower than in 2020.

TAILWIND FROM HIGHER RATES

One of the key measures of how well a bank is doing is how much net interest income it is making, that is the difference between the amount it charges people to borrow money and the amount it pays out on deposits.

If we compare how much the Big Four made in 2020 with how they did in 2023, net interest income increased by around 30% at HSBC (HSBA) and Lloyds Banking Group (LLOY), around 40% at NatWest and by more than 50% at Barclays (BARC).

In every case except HSBC, net interest income grew faster than total income over the period thanks not just to the banks lending more money but also to the rise in interest rates which allowed them to increase their lending rates by more than they increased their deposit rates.

Net interest margins – or the difference between the interest rates the banks charge on loans and the rates they pay on deposits – increased by around 0.3% or 30 ‘basis points’ at HSBC, 0.5% of 50 ‘basis points’ at Barclays and Lloyds and an impressive 1.3% or 130 ‘basis points’ at NatWest.

In other words, the banks had a big tailwind from higher interest rates at the same time as demand for loans increased substantially, but the general consensus is that ‘golden period’ is now over, and as competition for deposits increases the scope for net interest margins to continue rising is minimal.

KEEPING A LID ON COSTS

Given, as we said at the outset, banking is fairly cyclical, the fact the UK economy seems to have avoided a ‘hard landing’ despite a significant rise in interest rates is a big plus for the Big Four, but their top lines aren’t likely to grow as fast as they have in recent years so there is an increasing focus on costs – which is one of the reasons they are all shutting so many branches, sadly.

You might think banking as a business is fairly low cost when all it involves is moving money around, yet the Big Four have a fairly high cost-to-income ratio across the board.

The best performer is HSBC, where costs account for ‘just’ 48.5% of income, while the worst is Barclays where costs account for 67% or more than two thirds of income.

To put these in perspective, using a Terry Smith analogy, on average it costs the banks more than 50 pence to generate one pound of revenue, which is a pretty poor margin and explains why there are no bank stocks in his popular Fundsmith Equity (B41YBW7) fund.

If shareholders want to see profits rising, and more cash handed out in the form of dividends and buybacks, then they need to see progress on the cost front.

BEWARE OF HIDDEN LIABILITIES

For the time being, credit quality seems to be reasonable and the banks aren’t worried about the prospect of bad loans coming out of the woodwork, although as we said previously instead of provisioning counter-cyclically – i.e. putting money away when times are good, which would be the sensible thing to do – they seem to leave it until the last minute which exacerbates the volatility of their earnings.

There are other costs investors should be aware of too, notably for litigation and poor conduct, which despite the banks describing them as ‘exceptional’ actually seem to be a recurring theme through the years.

Having not long consigned the PPI (payment protection insurance) scandal to the history books, the banks now face a regulatory probe into car loans which while not as big as PPI still has the potential to cost them real money in ‘remediation’ charges if they are found to have given consumers a poor deal.

Lloyds has put aside £450 million of cash as a contingency, as its Black Horse agency is a major provider of motor finance, although some estimates put the bank’s potential liability at up to £1 billion, while NatWest is reckoned to have the least exposure.

Meanwhile, charges for litigation and previous poor conduct can also eat into shareholders’ returns, with Barclays having to take a £1.6 billion provision in 2022, a third more than it took in bad loan provisions that year.

In contrast, HSBC didn’t publish a figure for 2023 but set aside three pages of its annual report for the various legal proceedings which could have a ‘material’ impact, from fixing interbank rates to foreign exchange, precious metals, gilts trading, tax and even film finance cases, so it pays to take a good look at the notes to the accounts.

VALUATIONS ARE UNDEMANDING

Despite their decent stock-price performance this year, shares in the Big Four banks don’t look expensive relative to the market or to their history.

Returns on tangible equity are in the mid-teens percent for three of the four, which is highly respectable, although Barclays clearly has some catching up to do which is why its shares trade at a big discount to tangible net asset value while the others trade at a small premium.

Barclays also trades at a discount when measured on a PE (price-to-earnings) basis with a ratio of 6.2 times earnings for the coming 12 months, according to Stockopedia, and a prospective 4.1% dividend yield.

By comparison, HSBC is on 7.1 times with a prospective 8% yield, Lloyds is on eight times with a 6% yield and NatWest is on just below eight times with a yield of 5.3%, all of which compare favourably with 14.4 times and 3.2% for the FTSE 100 benchmark.

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