U.K. banking is operating in an especially unpredictable environment. Forecast trajectories for U.K. interest rates swing wildly, partly due to mixed economic signals. While headline consumer inflation overshot projections recently, services inflation was lower than expected.
This hasn’t changed the view of RBC Capital Markets specialists that the central bank will hold course. “The Bank of England is likely to remain on a steady quarterly cutting cycle,” believes Kofi Oteng, Head of Flow Rate Sales, EMEA.
Geopolitical shocks add another factor to the mix. However, Ofteng notes some “tariff fatigue” after the initial trade tariff announcements of the new U.S. administration, and says U.K. reaction is already diverging from that of the E.U.
“The U.K.’s trade with the U.S. is skewed towards services,” he points out, “while goods trading is usually where the tariffs land.” Central banks will wait for the detail on tariffs before responding, he suggests.
“The U.K.'s trade with the U.S. is skewed towards services, while goods trade is usually where the tariffs land.”
Kofi Oteng, Head of Flow Rate Sales, EMEA
Outperformance set to continue
Meanwhile, banks in the U.K. and throughout Europe continue to prosper, outperforming the sector by around 10%. Key drivers of this success area bear steepening curve, the subsidence of political risk, and a stable macro environment.
While rate volatility has seen banks pause their debt issuance plans, this is a supply rather than a demand problem, says Ben Toms, Director, European Banks Equity Research. He expects issuance to pick up later in 2025.
Rates are currently expected to fall to around 4% by the end of the year. While this would theoretically cut margins, banks have various tools to deal with that pressure.
“Firstly, they have the infamous structural hedge, a book of interest rate swaps that take away from the P&L as rates go up, and give back as rates come back down,” Toms says.
“Secondly, U.K. banks have been leaning into risk, which has been benefiting their net interest margins. For example, they've been lending higher up the risk curve in mortgages.” He sees further support coming from rising mortgage volumes as rates fall.
Other strategies include M&A, with targets likely to emerge in the wealth space, and restructuring exercises, with employee losses potentially supported by artificial intelligence.
Toms sums up: “While lower rates will create top-line pressure, once you consider all of the moving parts in the P&L, rates in the 2 to 4% range with a slightly upward slanting curve could actually be considered a sweet spot for the U.K. banks.”
“Rates in the 2 to 4% range with a slightly upward slanting curve could actually be considered a sweet spot for the U.K. banks.”
Ben Toms, Director, European Banks Equity Research
A softening regulation scene
In an abrupt change after fifteen years of mounting regulation, the sector also finds itself in a favorable regulatory environment. In part, this is influenced by the new U.S. President’s push for lower bank regulation.
However, the U.K. government itself is also exerting pressure as part of its economic growth agenda.
Domestic changes include the removal of the head of the Competition Commission, a delay to Basel 3.1 until 2027, and a change to mortgage limits that allows banks to lend more and higher up the LTV spectrum.
“The net effect is that we have probably the best regulatory environment for U.K. banks post the financial crisis,” Toms declares.
Any softening of the supplementary leverage ratio, which measures banks’ tier one capital against its debt exposure, could be significant, Oteng adds: “An adjustment could be extremely supportive for fixed income assets.”
“We have probably the best regulatory environment for U.K. banks since the financial crisis.”
Ben Toms, Director, European Banks Equity Research
Support through uncertainty
In this fast-changing environment, RBC clients have a new tool to help them track a key factor in net interest margin.
The Vault is an online app that tracks more than 10,000 residential buy-to-let mortgage and deposit products across more than 75 banks operating in the U.K. – providing bank profitability insights in advance of results.
“U.K. mortgage rates are effectively priced off the sterling interest rate swap curve, and activity from mortgage hedges and new housing activity is a huge driver of that curve,” Oteng notes. “So providing that content to our clients helps them arrive at the most appropriate investment decisions.”
Themes and risks for 2025
Stable bank profits should provide a high degree of confidence in the U.K. sector for 2025, Toms believes.
“Not only are U.K. and European bank dividend yields attractive relative to other sectors, they should also be relatively sustainable,” he says.
“On top of this, softening regulation means we could finally see U.K. bank cost of equities moving back towards the 10% level, which should continue to be additive to bank valuations.”
However, he highlights a potential risk in April’s U.K. Supreme Court hearing on motor finance mis-selling: “The wrong outcome from this event could end up costing the sector billions in litigation.”
“A well thought-out macro view can quite easily be disturbed by a headline or a comment that comes out of the U.S.”
Kofi Oteng, Head of Flow Rate Sales, EMEA
Oteng’s note of caution focuses on political influences from abroad: “A well thought-out macro view can quite easily be disturbed by a headline or a comment that comes out of the U.S.”
