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Fitch Ratings says in a new report that although major UK bank earnings have recovered this year, evolving regulation of capital and liquidity will weigh on earnings over the long term. Capital management policies will also be heavily influenced by the final requirements and timing of the new regulation and the response of international peers. Other banking reforms could also have implications for ratings.

H110 represented a marked recovery for the major UK banks’ earnings. The continuation of positive trends, such as lower loan impairment charges and stable to modestly widening net interest margins, could help close the earnings gap that opened up amongst the four major UK banking groups during the recent crisis.

Better performance, combined with improvements in risk profiles and funding structures, could also help close the gap between the Individual Ratings of Lloyds Banking Group plc (’C') and The Royal Bank of Scotland Group plc (’C/D’), both of which have ‘AA-’/Stable Long-term Issuer Default Ratings (IDR) and Barclays plc (’B’ and ‘AA-’/Stable) and HSBC Holdings plc (’B’ and ‘AA’/Stable).

There are indications that asset quality has stabilised at major UK banks, although charges are likely to remain high, given the muted economic recovery.

Although the major UK banks remain vulnerable to a double-dip recession, this is not Fitch’s expectation and the positive trends in the areas of margins and impairment charges should continue in 2010 and into 2011.

Even so, earnings will remain weaker relative to pre-crisis levels, at least until economic recovery takes a more definitive path. Given the more stringent capital and liquidity requirements being phased in, earnings may never recover fully. Lower trading volumes in Q310 are likely to confirm the volatility of investment banking as an earnings source.

Fitch notes that banking reforms could exert downward pressure on certain ratings. Direct structural reforms, such as the introduction of “living wills” to complement the UK’s bank resolution law and subsidiarisation (whereby banks would be split into legally separate subsidiaries), could reduce the implicit state support for systemically important banks and thus represent a potential threat to Support Rating Floors and to Issuer Default Ratings and debt ratings that are currently dependent on it (eg, Lloyds and RBS).