Alliance Trust: Current UK banking sector

Commenting on the current UK banking sector, Tim Gibbens, Global Financials Analyst at Alliance Trust, said: "The banking sector has been through a turbulent time and investors will be keeping a close eye on banks' interim management statements to determine how the credit crunch and the recent government bail-out package have affected them. Statements issued so far have revealed a marked deterioration in credit quality, especially on the corporate banking side, with commercial property being a particular problem area. Banks' participation in the government's plan has led to a need to raise fresh capital, through the issuance of ordinary and preference shares, to repair their tier one capital ratios.

A condition of the government's bail-out package has been that the banks must pay back the preference shares before they can resume paying dividends to their ordinary shareholders. As a result, existing shareholders in the affected banks have seen their shareholdings heavily diluted. Although Barclays was distinct in choosing to tap various Middle East investors to raise fresh funds, instead of via a government underwritten capital issue, it too did so on punitive terms for existing shareholders.

While the recent raft of global initiatives by governments and central banks has undoubtedly helped to unfreeze money markets, banks are still reluctant to lend to each other. A further condition of the government's scheme was that the banks lend money to those areas most in difficulty, that is overextended mortgage customers and small and medium-sized businesses. The bold 1.5 percentage point reduction in U.K. base rate was aimed at both helping with this process of resuscitating money markets and also dealing with the sharp macroeconomic slowdown and resultant deterioration in banks' credit quality.

In time, these combined measures will lead to banks recovering their appeal as investments. Recent co-ordinated interest rate cuts by central banks around the world will also help deal with the serious deflationary effects of the credit crunch.

However, until the banks are able to break free from the government's influence and are able to resume paying dividends to ordinary shareholders, the banks are not particularly attractive investments. This outlook may change once there is more transparency about what shape the recapitalised banks' business models will take in terms of risk taking and how stringent any regulatory clampdown will be. With greater clarity, they could again look attractive as long term investments.

However, another consequence of recent events is that we will see a return to traditional banking at its most basic, with banks focusing on their core function of lending out deposits. Many of the higher risk, more opaque revenue streams will cease to exist in their current form. Therefore, while tomorrow's banks will be more stable, transparent institutions, the potential upside for shareholders will be capped by lower returns because of lower risk businesses being supported by larger capital bases."