Spotlight on the banking sector

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The UK's banks will be delighted to have put another bruising results season behind them for not one of them enhanced their reputations.

There were further losses at Royal Bank of Scotland (RBS) and Lloyds Banking Group (LLOY), missed forecasts at HSBC (HSBA) and barely-adequate figures from Barclays (BARC) and Standard Chartered (STAN) marred by regulatory failures. More controversy over bankers' bonuses added to the bitter taste.

It might be a surprise, therefore, to learn that the banking sector has been a remarkably strong performer over the past 12 months. As investors' appetite for stockmarket risk has returned, the banks have soared. Over the year to 5 March, Lloyds shares were up by 46% while HSBC put on 25%. Barclays managed 18% while Standard Chartered and RBS added 13 and 11% respectively.

Can the banks keep it up? Bulls argue that the worst of the eurozone crisis is behind us and that we have entered a more benign economic environment in which global growth is creeping upwards. The bears focus on the headwinds the banking sector still faces - not least a challenging regulatory outlook and, in the case of Lloyds and RBS, the hugely political question of when the state might sell its stakes.

"The sector isn't for the faint-hearted," warns Helal Miah, an investment research analyst at The Share Centre, a stockbroking firm. "The European debt situation and possible defaults hang over the banks, and in the short term the decisions made by politicians are likely to be the key driver."

However, Peter Tasou of Investec Wealth & Investment, says the banks are still relatively cheap by historical comparisons. "With Barclays, Lloyds and RBS continuing to trade at material discounts to book value, investors may have scope to profit further from the sector," he argues.

There are reasons to be positive. One is that the UK's banking reforms now look likely to be less disruptive than many had feared. Sir John Vickers' proposals for a ringfencing regime that would insulate banks' retail operations from difficulties with their investment banking arms are to be implemented in a way that banks feel comfortable with. Barclays chief executive Antony Jenkins - in contrast to his predecessor Bob Diamond - now says publicly that ringfencing will cause his bank few problems. HSBC is no longer threatening to leave the UK over the reforms.

Another factor in the banks' favour is the sector's ability to deliver a rising income stream, which is appealing to many investors in this low interest rate environment. In 2007, before the financial crisis broke, the banks accounted for more than a fifth of all dividends paid by UK companies. The sector is still well down on that figure - banks paid 10.6% of all dividends last year - but payouts are rising.

In the hullabaloo over executive remuneration, it has gone largely unnoticed that shareholders' rewards are on the increase too. HSBC's fourth interim dividend, unveiled in March, was up by 29%, and the bank has promised increases of 10% in its next three interim payments too. Barclays promises to increase the proportion of its earnings it pays out as dividends to 30%. Standard Chartered too is expected to raise dividends this year.

The question now is when Lloyds and RBS, both of which have paid a big fat nothing since their state bailouts in 2008, might restart dividends. Both banks are keen to do so, not least because they regard it as an important step in the journey back to the private sector, but there are significant obstacles in their path.

RBS did manage to begin paying dividends on its preference shares last May and has been dropping hints about reinstating payments on its ordinary shares in 2014. The message from Lloyds has been even more overt, with the bank confirming reports that 2014 is its target too for a return to dividends.

City regulators, however, may prevent that. Both the Bank of England and the Financial Services Authority have accused the banks of failing to devote sufficient sums to bolstering their balance sheets. It is possible that the FSA - or its successor - would block moves by RBS and Lloyds to restore dividends until the banks' capital strength has improved.

In fact, balance sheet strength remains an issue across the sector. The Bank of England warned in November that all four UK high street banks may need to raise further capital. One issue is that despite deleveraging in recent years, there is still widespread scepticism that the banks' provisions for bad debt are realistic - and low interest rates have meant there has been no need to crystallise these losses. Another unknown is what the final regulation will look like as the UK implements the Basel III reforms that address balance sheet strength. Though the timetable for full-scale compliance has been relaxed, it is not clear that Britain's banks are ready to meet the higher capital ratios required.

Despite years of wrangling, which has produced some progress, regulatory uncertainty remains a threat to the sector, warns Steven Lewis, lead analyst at Ernst & Young's global banking & capital markets centre. "The regulatory landscape may be less opaque now, but it is certainly no less challenging," he says. "Some aspects of the change agenda remain unknown, and there is a worrying shift toward a more nationalist approach by supervisors across a range of jurisdictions."

The banks' remarkable ability to self-sabotage does not help. Individual lapses last year included HSBC's failure to comply with anti-money laundering regulation, which saw it fined £1.25 billion, and Iran sanction-busting at Standard Chartered, generally a saint among sinners in the sector, which landed it with a £440 million penalty.

Those cases are at least done and dusted, which is more than can be said for a series of other banking misdemeanours. HSBC and Lloyds have yet to settle investigations into their role in the Libor-rigging scandal, which has already proved expensive for Barclays and RBS. All four banks continue to make heavy provisions for mis-selling of payment protection insurance (PPI) and interest rate swap contracts.

The scale of the latter scandal is still being uncovered and while PPI has been a running sore for several years now, the consumer group Which? believes the banks are still not making sufficient provisions for the cost of compensating customers. Lloyds' announcement in March that it was adding £1.5 billion to its provisions, rather proved the point, with its rivals also forced to increase the size of their compensation funds too.

There is, then, plenty of room for nasty surprises on both the economic and political fronts - witness the EU's latest plan to cap bonuses.

That is not to say, however, that the banks can make no progress. Former Barclays boss Bob Diamond was wrong to declare that "the time for remorse is over" - and one way to provide some payback would be to deliver further share price growth while managing the banks responsibly.