Should you back banks now they CAN pay dividends?

Investors in the leading banks have endured a hair-raising year. At times, Lloyds, NatWest, Barclays and HSBC have seen their share prices dwindle to under half what they were 12 months ago. But are they now turning a corner? 

Banks were this month given the green light to restart paying dividends – a huge relief to shareholders who rely on their holdings for an income. In March the industry regulator, the Prudential Regulation Authority, had asked banks to freeze dividends to private investors and pension funds. Instead, banks were told to use the payments to build up a cash pile as a buffer against potential loan losses. 

The go-ahead to resume dividends is a sign the banks now have sufficiently strong balance sheets to withstand any potential shocks from bad loans. While share prices have risen tentatively on the news, several banks could still be undervalued. 

Breaking the chains: The go-ahead to resume dividends is a sign the banks now have sufficiently strong balance sheets to withstand any potential shocks from bad loans

‘Even after the recent rally, bank shares look cheap by historic standards,’ says Job Curtis, manager of investment trust The City of London which has increased its dividend payouts for 54 consecutive years. But he warns that banks still represent ‘high risk’ investments. 

Values are so depressed that for every 60p of UK bank shares an investor buys, they are in effect receiving £1 of assets in return, research for The Mail on Sunday shows. The UK’s listed banks are trading at an average of 62 per cent of their ‘book value’, according to analysis conducted by financial planner Bowmore Wealth Group. This means banks are currently valued at significantly less than the value of all their assets. Charles Incledon, a director at Bowmore, says: ‘The UK stock market is still relatively undervalued, and banks offer a clear illustration of this.’ 

So why are bank share prices still so low? 

According to Callum Abbot, comanager of investment trust JPMorgan Claverhouse, banks are currently being valued in the same way as they were during the 2008 financial crisis. 

This is despite the fact that 12 years ago the banks were the trigger for the crisis during which several needed help from the taxpayer to stay afloat. ‘This time, rather than the enemy, banks are part of the solution,’ says Abbot. 

He adds: ‘They are working with the Government and regulators to try to help the economy through the current pressures. That’s a much better place to be in from a banking point of view and means they are likely to be viewed more positively by the regulator.’ 

Banks also have bigger cash buffers than in 2008. After the financial crisis, the regulators put in place stricter rules on the amount of cash banks must hold and regularly ‘stress test’ their financial strength in different scenarios. 

As a result, banks have £200billion of additional capital compared with the last financial crisis. The regulator believes banks could withstand economic scenarios considerably more catastrophic than those likely to pan out in the wake of coronavirus. So, if banks look undervalued, are financially resilient and back in favour with the regulator, shouldn’t investors rush in? 

Not necessarily. Richard Marwood is a senior manager on investment fund Royal London UK Equity Income. He believes banks are still battling several strong headwinds. 

Marwood argues that investing in British banks is a gamble on the future health of the UK economy. After all, banks are exposed to all areas of the economy. So, if unemployment rises, more homeowners could struggle to make mortgage payments, potentially leaving banks with bad debts. 

Similarly, if increasing numbers of businesses fail, business loans could sour –again leaving banks with losses. In a nutshell, if the UK economy makes a strong recovery, banks are top of the list to benefit. But if the recovery is muted and difficult, banks could struggle. 

Marwood’s view is that the economy is not yet out of the woods. He says: ‘We’ve heard a few people suggest recently that we haven’t yet seen the full economic impact of Covid and I have sympathy with that view.’ He adds: ‘After all, the furlough scheme will have masked the true impact on unemployment. We have not seen all the bad debts crystallise, thanks to Government support and loans. And the ban on home evictions and repossessions and the stamp duty holiday will have hidden the impact on the housing market.’ 

He also reckons a ‘bad’ Brexit would not be good for the banks because it could deliver a shock to the UK economy. Susannah Streeter, senior analyst at wealth manager Hargreaves Lansdown agrees. She says that ‘failure to agree a Brexit deal is likely to put pressure on Lloyds, NatWest and Barclays amid fears the recovery will take longer and bad debt provisions may have to increase’. But she adds that if a last-minute deal is clinched, it is likely to ‘further power the recovery witnessed over the past month’. 

A bad Brexit would also increase the likelihood of sustained low or even negative interest rates which would curb bank profits. That’s because banks make money on the spread between the interest rate they pay depositors and the separate one they charge borrowers. Banks are unable to cut rates to depositors much further without charging them to hold cash – a move that would not go down well with customers. Instead, the spread would likely shrink, and with it profitability.

So where are these dividends, then?

Dividend payments could restart early next year. But they are likely to be modest, at least at first. The regulator has cautioned that payments must be made ‘within an appropriately prudent framework’. So they must not affect a bank’s ability or willingness to support households and businesses – and payments cannot be higher than 25 per cent of a bank’s cumulative profits over the past two years. 

The City of London’s Job Curtis says most analysts are predicting annual dividends for the banks equivalent to around 2.5 per cent at first. But these may increase in 2022. 

Which banks are the best placed? 

Curtis likes Barclays and Lloyds, although the trust’s holdings in these two banks are considerably smaller than at the start of the year. He likes Barclays because it is ‘so cheap, a good-quality bank and has an investment banking arm which has enjoyed good profitability’. 

He rates Lloyds because it has ‘strong profitability’ – although he cautions that it would be particularly exposed if rising numbers of households struggle to keep up with mortgage payments. JPMorgan’s Abbot thinks insurers represent a wiser investment than banks. ‘They are showing better returns, better growth and are already paying dividends,’ he says. Legal & General and Prudential are both among JPMorgan Claverhouse’s top ten holdings. 

Royal London’s Marwood likes Paragon Bank and Close Brothers because they are ‘smaller, more focused and easier to manage’.

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