I Pick Lloyds To Outperform Among The British Banks (NYSE:LYG)

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The economic question

Or perhaps an economic truth that we all need to know – or even relearn. Banks live off their margins (minus losses from defaults, of course). The margin is the difference between the price they borrow at and the price they lend out at. Yes, I know this is simple, but it does need to be restated.

For a bank, their cost is the price they pay to depositors – the interest they pay out on deposits. Please note that we can leave that Modern Monetary Theory stuff entirely alone here. Yes, OK, banks simply invent money when they make loans and… yawn. It’s still true that by the end of that working day they must fund that loan they’ve just made. That means gaining deposits to do so.

So, they collect interest on loans they’ve made, pay out interest on deposits they have. The gap between these two is the gross income to the bank, out of which they pay expenses and the remainder at the end is the net profit. Simple, simplistic, explanation but one that’s good enough for us here.

The economic point that needs to be made after this is that low interest rates compress this margin. There have been experiments, this past decade, with negative interest rates but depositors really, really, don’t like them, so banks have pretty much decided not to try them. But loan rates have of course collapsed – that has constricted margins.

So, as interest rates rise, we’d expect to see those banking gross margins widen again. This should feed through direct to the bottom line of those banks.

There’s also a significant part of bank funding which they never do pay interest on – the float. Our own current accounts might go from quite pleasing really the day our paycheck arrives in it to miserable a week later once we’ve paid the rent and the bills. But for the bank as a whole, with millions of accounts, that’s a predictable chunk of cash and a large one which can be lent out. So, they do. That’s the float, upon which they gain market interest without having to pay out interest for it. So there’s decent leverage to this margin business as well.

British banking

I’m limiting myself here to the four big commercial and retail banks in the UK. They’re all slightly different and those differences will lead to this margin expansion having slightly different effects.

Barclays (NYSE: BCS) [LON: BARC] has a substantial investment banking operation. Rising interest rates might be a cause for greater profit there and might not be – depends upon how they trade the circumstances. But there’s nothing inherent in rising interest rates benefitting an investment bank. That substantial portion of the business which is capital markets means that the influence of this margin decompression will be less here than elsewhere in the sector.

HSBC (NYSE: HSBC) [LON: HSBA] has very substantial non-sterling business activities. Sure, as global rates rise there will be the same effect, but it’s not really quite true that global rates do rise in lockstep. I’m really talking about the effects of sterling interest rate rises here – not what might be happening in China or Hong Kong – so again, we can put HSBC to one side as not being one of the greater beneficiaries of this process.

NatWest (NYSE: NWG) [LON: NWG] has a different problem. Yes, the business is largely sterling, yes it’s commercial and retail, rather than investment, banking oriented. So, we can imagine it benefitting from this process of interest rate rises. Except, well, the government still owns near 53% of it. My take on this is that any significant rise in the NWG share price is going to be met with a wave of government selling. After all, they’ve been whittling away at that stake all along.

Perhaps more to the point that’s likely the market view as well. We’re not, therefore, going to see any substantial rise in that NatWest share price until the government stake is either fully sold down or, perhaps, declared to be locked away by some change in politics.

Lloyds Bank (NYSE: LYG) [LON: LLOY] thus becomes the choice to outperform as this effect seeps through the system. Lloyds’ business is hugely sterling based, it’s, as I’ve said before, hugely retail based. The business is, thus, almost entirely exposed to this effect.

Interest rates

There is, in my mind, absolutely no doubt now that UK interest rates are going to rise. Yes, of course, we’ve just had the announcement of the rise in base rate but that’s not all. The Bank of England is going to completely sell down the commercial bonds part of the QE balance sheet. It’s also going to stop reinvesting the maturing part of the gilts QE book. Market interest rates – spreads being the other name for the same thing – are going to rise rather more than the announced base rate is.

Proper, consistent and sustained interest rate rises in sterling are coming in volume.

My view

It simply is true that banks have been hard hit by the compression in margins in this decade just past. As interest rates rise again, that squeeze will decompress. Retail banks are looking attractive again for the first time in a decade.

The investor view

There is of course the aspect that the sector as a whole is to become more attractive as margins and thus profits increase. We’d all expect dividend payments to get rather better as well. But within this sector I expect Lloyds Bank to outperform.

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