By Erin Davis
The Bank of England recently warned that it anticipates little improvement in U.K. banks' limited ability to generate capital. Consequently, it suggested that banks should seek outside sources of capital, including equity, in order to meet increasing regulatory requirements. We reviewed the capital cushions of Barclays (BCS), HSBC (HBC), Lloyds Banking Group (LYG), Royal Bank of Scotland (RBS) and Standard Chartered across a number of capital measures. We find that Lloyds and Barclays are the least well-capitalized U.K. banks. We further find that their subpar near-term profitability means that neither bank is likely to meet our capital expectations by year-end 2013, although both could do so by 2015 in our base-case scenarios. On the other hand, we find that HSBC, Standard Chartered, and RBS are all fairly well capitalized and unlikely to need outside equity capital to meet regulatory requirements. HSBC and Standard Chartered are trading near our fair value estimate and offer little upside to investors, but we think that shares of RBS, priced at a 25% discount to our fair value estimate and a 35% discount to tangible book value, may be attractive to long-term investors.
Bank of England Urges U.K. Banks to Raise Additional Capital
The minutes of the Bank of England's Interim Financial Policy Committee meeting in mid-September revealed that the committee thinks U.K. banks' limited ability to generate capital means that they should seek outside capital (for example, sell mandatory convertible bonds or new shares through rights offerings).
In response, we're taking an in-depth look at U.K. bank capital levels. All of the U.K. banks we cover assert that they have enough capital and will meet the Basel III requirements organically. While we agree that U.K. banks meet current capital standards, we argue that regulators and markets often force banks to meet higher standards and more aggressive schedules in times of uncertainty. We note that Credit Suisse said that it had sufficient capital - just before it raised capital in July after its regulators publicly stated that the bank needs to expand its loss-absorbing capital.
Tangible Common Equity Ratios Show That Some Capital Levels Are Thin
We consider the ratio of a bank's tangible common equity (the best, most loss-absorbing kind of equity) to its tangible assets (after netting derivatives to make the number comparable to U.S. accounting) to be one of the best measures of a bank's capital. Other measures, such as Basel capital requirements, rely on complex calculations that can obscure a firm's true leverage. Barclays and Lloyds neither meet the 5%-6% level that we consider to be the minimum necessary to be well capitalized nor have been able to build significant capital since 2010. In contrast, HSBC, RBS and Standard Chartered all meet our well-capitalized threshold, and RBS - the most troubled of the three - has been able to build its capital levels materially as it deleveraged.
Moreover, we estimate that it will take until approximately 2015 for Barclays and Lloyds to meet a 6% tangible common equity target with organically generated capital. In the gradually improving economic environment projected in our base case, Barclays will only generate enough earnings to get 37% of the way to a 6% TCE ratio by the end of 2013, and Lloyds will only earn enough to get 30% there.
While all U.K. banks currently report core Tier 1 ratios near or above 11% and exceed current regulatory requirements, neither Lloyds nor Barclays has a fully loaded, pro forma Basel III ratio near 9%, the anticipated requirement for these systemically important institutions. Basel III regulations will put downward pressure on banks' regulatory capital levels, through more stringent standards for what can be counted as capital (thereby reducing the numerator) and by increasing the risk weighting on various types of assets (thereby increasing the denominator). Although banks' specific capital shortfalls remain unknowable to the market, as they depend on undisclosed granular balance sheet details and banks' proprietary risk models, we view the 6% TCE target as a reasonable proxy for banks' capital needs. Basel III requirements will not be fully phased in until 2019, but regulators and markets are increasingly demanding that banks prove they can meet these requirements by year-end 2013.
Subpar Returns on Equity Mean That Capital Generation Will Remain Weak
Barclays and Lloyds do not yet meet Basel III capital requirements, so they are at least partially dependent on their ability to internally generate capital in order to meet the standards. However, capital generation at U.K. banks, apart from HSBC and Standard Chartered, has been weak since 2007. Both Lloyds and RBS posted losses in 2011, and we do not expect that economic conditions will allow U.K. banks to generate significant capital in the near term. We project that RBS and Lloyds will generate returns on equity near 5% in 2013, while Barclays' returns will be modestly higher at 7.6%. With the U.K. economy likely to contract in 2012 and grow only modestly, at best, in 2013, we see it as increasingly unlikely that Barclays, Lloyds or RBS will earn its cost of capital in the medium term. We think HSBC and Standard Chartered are much more likely to do so because of their geographic diversification - both have significant exposure to fast-growing markets, and Standard Chartered has relatively little exposure to either the United Kingdom or Europe.
RBS Looks the Most Attractive of the U.K. Banks
We see Royal Bank of Scotland as particularly attractive at today's prices. Its Irish exposure creates downside risk, but we think the bank's sturdy base means it is unlikely to dilute shareholders through a capital raise, despite the high likelihood that asset quality in Ireland will remain low. Moreover, we think that the risk that the bank will report long-term subpar earnings is fully incorporated (indeed, overly so) into the bank's market price near half of tangible book value. For investors wishing to stay away from Ireland, we're also intrigued by Barclays, which is trading at a similar discount to our fair value estimate. While Barclays' capital base is thinner, we think its higher earnings power, which is not hindered by the large non-core portfolio that RBS struggles with, will allow Barclays to meet Basel III requirements if given time to do so by regulators and investors.
We see Lloyds as the least attractive. While the market is pricing it at a premium to both Barclays and RBS, we think it is the most likely of the three to raise capital because of its thin capital and low earnings power. We urge investors to look elsewhere for bargains or wait for a more attractive entry point.
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