Michael Hall:
Welcome to the Industries in Motion Podcast from RBC Capital Markets, where we will be exploring what's new and what's next in today's fast moving markets and industries to help you stay ahead of the curve. Please listen to the end of this podcast for important disclosures. I'm Michael Hall, Head of European Research here at RBC Capital Markets, and today I'm joined by Benjamin Toms. Benjamin has been with us since 2015 and is responsible for coverage of the UK banks, but also the large cap Spanish banks.
Michael Hall:
A previous experience at Barclays, where he worked in their internal financial planning team reporting up towards the group, and also Deloitte, where he qualified as an accountant. So Benjamin, thanks for your time today. Really keen to catch up on a couple of your recent pieces. We've portrayed, I think, a far more cautious view on the macro environment and the risk to the banking sector than consensus. Not negative, but just more cautious. So I'd like to delve straight in and start talking around that. But also, start off with a question. What's the number one question investors are asking you when looking at the UK banks right now?
Benjamin Toms:
Hi Mike, and thank you for having me. I think the question the investors are asking themselves most of the moment is, there's two competing interests that are kind of jutting against each other. So firstly, we've got the fact the rates are going up, and that's generally considered to be good for banks. But on the other side of that, we've got a consumer that's squeezed by higher energy prices, food, and potentially higher mortgage rates, which has implications for asset quality. Also, you have to consider that in terms of bank valuations, and we tend to think about bank valuations in price to tangible book terms, on one year four basis, banks are trading at 0.6 times tangible book value, and that's a 30% discount to historical average levels. So at first glance, this sector looks cheap, but there are lots of things that are competing against this to think about.
Michael Hall:
Okay, interesting. You talked about weakening environment, particularly with consumer. Despite the valuation, what do you think the biggest risks or how do banks tend to perform, if we have a consumer led recessionary outlook?
Benjamin Toms:
I think it's probably worth just setting out what we put in as our assumptions for UK banks. So we model a recessionary environment in the UK at the beginning of 2023, a shallow recession, not a deep recession. And a slow down, but not a big price correction in the housing market. We generally expect banks to underperform in recessionary environments, but starting with valuations are quite low at the moment, so we have to consider that as well. We actually think though, the banks will still underperform. If we go back and look at historical periods when rates are going up and PMI is coming down, more often than not, banks underperform in those situations. And actually, valuations go as low as 0.4 times tangible book value and earnings fall by about 50%. So those kind of valuations would be below where we are currently. And actually, because consensus hasn't moved up yesterday in terms of earnings expectations, 2023, it would also be a headwind earnings.
Michael Hall:
Okay, interesting. So let's break that down into specifics and the risks. What are the P&L lines where you think the banks were you most impacted by slow down?
Benjamin Toms:
Well, we've already downgraded our impairment numbers for 2023, where we thought consensus just looked too low at 24 basis points for the sector. We've moved our numbers to more like 36 basis points, which it actually still is relatively low, if you consider the historic average and recession of '60s, 90 basis points, but there are another other factors to take into account.
Michael Hall:
Okay, explore those. What are the caveats, other factors? What do we need to consider?
Benjamin Toms:
Well, there's a number of things here to really think about. So firstly, you've got unemployment that's currently very low and actually that's the normally the biggest single driver of cost of risk. Secondly, although rates have increased meaningfully on a [inaudible 00:04:01] basis, they're still actually very low in historical context. Thirdly banks still are holding a large amount of COVID-19 overlays. They're worth about 15% of impairments for UK banks at the moment.
Benjamin Toms:
A fourth, the credit card levels are still well below where they were before coming into COVID-19. So the mix, the balance sheet for banks is slightly better. Fifthly, LTVs for mortgages back book are about 50%, that's well below where they were, when we went into the last financial crisis. And lastly, if you think about the more affluent consumer in the UK, they've been building up a nest egg of deposits through COVID-19, that'll act to some kind of buffer as well.
Michael Hall:
Okay. Interesting. One thing we didn't touch on was that, it was appearing across lots of sectors is obviously inflation and cost inflation. How does that materialize in terms of a bank's P&L?
Benjamin Toms:
Yeah. If you think about inflation in the UK, this year's expected to be somewhere around eight and half percent. Next year, it's likely to be around something like 5% and wage growth is running about 6% in the UK. That's only included bonus measure. And actually for the financial services, the numbers running much higher, it's more like 11%. And then if you think about how banks' cost line is made up, about 50% of all costs relate to wages and salaries, and actually banks locked in wage increases for 2022 at the beginning of this year, at about 4%.
Benjamin Toms:
And they've subsequently had to announce some kind of top-ups to try and keep that number with pace, with the squeeze that their employees are feeling. We do think though, however, the consensus estimates for cost growth do not reflect the commercial realities that we're seeing. And actually the 1% decline that consensus has baked in for 2023 for costs, for the sector as a whole looks a bit too optimistic in our view. If you think about average cost growth over the last year, 10 years for banks, it's been about 3% and that's been a less inflationary environment where we have than we have today.
Benjamin Toms:
And actually financial services pay is typically an increased 4% per annum on average over that period.
Michael Hall:
Okay. So the outlooks slightly big on bleak on the cost front. Looking at the rates then, and thinking about the mortgage environment, can you talk around how much is split? How much is variable, when the consumers are going to feel the pressure? And also potentially how that timing or that feeding into the banks' net interest margin?
Benjamin Toms:
And every market around the world has a different mortgage market and their products are slightly different. In the UK, we typically think about the stock of UK mortgages being about 20% variable product and about 80% fixed. And there's a mixture generally of between two year and five year products. The split, however, of the flow of mortgages over the last 10 years has varied over time. And actually historically banks have written more variable rate a more two year product than sits on their books today. If you think about the UK consumer already feeling a bit squeezed due to higher energy and food costs, higher mortgage costs, they're going to add to that pain we think, and actually timing's important here. And although very great mortgage products will price to a higher base rate for those on fixed rate products, that's going to take some time to bear out.
Benjamin Toms:
In our recent note, what we really wanted to try and do is understand when that mortgage roll off profile in the UK will take place, to ascertain at what point the consumer really starts to fill the squeeze of high rates from mortgages. And what we did is we looked at the product flows in the last 10 years and modeled how these products will roll off going forward. And actually our conclusion was it will take about seven quarters for the majority, and that's about 50% of mortgage borrowers to feel the impact of higher Bank of England base rates, that is over 1%.
Michael Hall:
Okay. So we talked about, you touched on the pressure the consumer is feeling from higher fuel, higher food, cost of living [inaudible 00:08:01] going on, thinking and extending it to future generations. If I was a generation younger and trying to get on the housing market now with mortgage rates going up, what's the impact for me? Do we have a whole generation who won't get it onto the mortgage ladder?
Benjamin Toms:
Yeah. Well you better hope they have rich payment parents who can help you fund that house, because it is quite difficult at the moment for youngsters to get onto that property ladder. And interestingly mortgage payments relative to disposable incomes are in line with historical averages. So once you've got your mortgage, customers are not that stretched and they're less stretched, you'd imagine. Although it's likely that situation's going to change over the next 18 months with high fuel and food costs.
Benjamin Toms:
However, for the first time buyer, it's more difficult than ever to get on that property ladder. And that's an area that we are keeping a close eye on, because you think about first time mortgages making up about 20% of mortgage volumes. This is the charge that we think will come under pressure in the near term and that's going to impact bank volumes.
Michael Hall:
Okay. For experienced bank investors, this is going to be a simplistic question, but I'd like to take the opportunity to ask a couple of simplified ones for myself and for other readers on the journalist front. You've talked a lot about term deposit betas, and you've talked about that in context of rising rates and the impact on banks. Could you just explain what this term means and quantify where we are?
Benjamin Toms:
Sure. So deposit betas basically means how much base rate rises are passed onto bank deposit holders and how much is kept by the banks themselves. So historically by the end of a rate rise cycle, we expect betas to go to 90% for corporate deposits and 70% for retail deposit holders. So for example, 70% of the base rate rise gets passed on to a retail deposit holder. In this cycle deposit betas have been much lower so far, with only about 20% of rate rise is being passed onto deposit holders so far. Although, we do expect that will meaningfully increase from here.
Michael Hall:
So no, I'll do that. So okay, got you. So the banks are retaining a disproportionate amount of rate rises themselves at the moment?
Benjamin Toms:
At the moment, that's true. Yes.
Michael Hall:
Got you. Okay. And then if I think about results days and we're always talking about discussions around mortgage spreads, just give me a quick summary on those.
Benjamin Toms:
Sure. So another technical term here, but mortgage spreads are the measure of the difference between the rate that a bank writes [inaudible 00:10:33] and the prevailing swap rate at the time that the mortgage is written. Now swap rates are important, because banks in the UK typically run a structural hedge to reduce their interest rate risk. Now, mortgage spreads been very low in recent quarters due to the speed at which swap rates have been increasing, and mortgage pricing has not been able to kind of keep pace with those rate rises.
Benjamin Toms:
However, if we think about swap rates now, maybe starting to stabilize, we do expect that spreads will start to increase from here, as they catch up with the swap rates. In fact, actually we've seen that happening when we look at our latest data in our latest scorecard. Actually we think that the importance of mortgage spreads is also a little bit overdone and we prefer to focus on the customer spread and that measures the difference between mortgage rates and deposit rates, and because of the low deposit betas we discussed previously, that's looking much more healthy at the moment.
Michael Hall:
Okay. Well just so standing back, look, you're not outright bearish or cautious, you're deflecting the growing risk and I fully appreciate that, and the balance you are playing against valuations. What's your [inaudible 00:11:45]? Which sectors do you think will perform better and worse, if our central case of a mild recession plays out?
Benjamin Toms:
Sure. And actually I think it's worth saying here, re-highlighting that we're assuming not a large house price correction with what I'm about to say, but we actually prefer the banks at the moment. They've got exposure to buy, to lending. A fundamental view going into a recessionary environment is that, if people can't afford to buy and we've talked about affordability, then they choose to rent. And actually more over in times of stress, [inaudible 00:12:18] asset quality holds it better than other types of mortgage lending. And that's for a couple of reasons. So firstly, an interest coverage ratio for a professional buy select lender is typically around two times, or you can put that another way.
Benjamin Toms:
Landlords can afford for half their tenants not to pay their rent and they still can afford to make their mortgage payments to the bank. Secondly, when the housing market softens, rental yields tend to go up and that further supports landlord's ability to pay those mortgages.
Benjamin Toms:
And thirdly, in the event of a landlord, not being able to afford to pay their mortgage, there's a slight nuance with buy select lending. And that's the ability for the bank to step in as a receiver of rent. Now, what this means is rather than in a normal situation, the bank for closing and having to sell that property and normally making a loss on it, because you're selling it a time, normally when house prices are going down. In this instance, the landlord drops out the picture and the bank steps in, becomes the receiver of rent and starts collecting the rentals off that property themselves. In effect, if a lot of landlords stop paying all at once, they run a rental portfolio, which means they limit their losses.
Michael Hall:
Great. Thank you very much for your time, Benjamin. Really enjoy hearing your thoughts and you being able to simplify some of these complex issues, as we look into the rest of this year into 2023, really appreciate your time. Thanks.
Benjamin Toms:
Thank you for having me.
Michael Hall:
What else lies ahead in today's ever evolving markets and industries. We will be keeping track right here on Industries in Motion. Make sure you subscribe to Industries in Motion, wherever you listen to your podcast. Thank you for listening to today's episode.
Speaker 3:
This content is based on informational available at the time it was recorded and is for informational purposes only. It is not an offer to buy, or sell, or a solicitation and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.