Alliance Trust: UK banking sector

Commenting on the current UK banking sector, Tim Gibbens, Global Financials Analyst at Alliance Trust, said: "The key point to take away from the failure of Lehmans is that the Fed is not prepared to prop up every institution which has taken on too much risk or been too highly geared and then run into difficulties. However, where there has been the threat of systemic risk, such as in the case of the bail out of AIG and the GSEs, and the engineered takeover of Bear Stearns by JP Morgan Chase, the Fed has taken action. It is also possible that they had some influence in Bank of America's decision to take over Merrill Lynch. In this environment, it is increasingly becoming a case of survival of the fittest; the market is placing a premium on those institutions with relatively strong capital positions and secure deposit franchises whilst penalising those excessively exposed to rising wholesale funding costs and the risk of further asset writedowns or credit quality deterioration. In this environment, further consolidation can be expected, whether occurring naturally or being induced by the authorities, given the importance of banks to the global economy.

"The fact the share prices of companies with suspect business models has been so hard hit has made it harder for them to raise capital, leading to even tighter liquidity conditions on heightened fears of systemic risk. Also causing problems is a general reluctance to undertake deals given the sheer uncertainty over what lies on any target's balance sheet. This means central banks are having to step in to the money markets to provide liquidity to ward off systemic risk.

"While the Bank of England, like the Fed and ECB, has also taken various measures to increase liquidity in the markets, further interest rate cuts could be slow in coming as long as inflation remains at elevated levels. Besides, it is debatable how effective such rate cuts actually are as they fail to deal with the underlying problem, namely the banks' basic reluctance or inability to extend credit.

"Although the crisis is showing no signs of ending soon and conditions will remain volatile, valuations among the U.K. banks are attractive when looked at on a long term basis. Most banks are trading on single digit P/E multiples and at or near book value. Returns on equity are expected to be lower going forward because of continued deleveraging although this fall in returns is arguably already discounted in valuations. Although banks' dividend yields are at historic highs, in some cases, this may simply reflect market expectations of future dividend cuts.

"When conditions eventually do stabilise, banking stocks are likely to experience a sharp bounce but it may be short-lived. Tough fundamentals such as a mature U.K. economy, intense competition and still stretched capital positions will soon reassert themselves."