BREWIN DOLPHIN 
By
Banks - What's underlying the underlying?
Unpredictable, Unintelligible, Unsustainable, Incomprehensible: All words that could be used to describe some elements of the banking sector's third quarter results.
There is no doubt that few could have predicted exactly what has happened in the third quarter with a weight of new information: ECB comments, Bank of England policies, Government disposals, Rights issues etc and the results certainly showed a considerable amount of variations. When banks release results, analysts have to consume a vast amount of information to try and comprehend the environment in which the company is operating. It is often the case that investors can be 'pleased' with the results despite losses, or relieved when figures seem to be worsening and this is due to analyst's 'cleaning' the results to try and find what underlies the underlying results: is the core business making money? Rather than try and explain the benefits of these techniques, we believe it is as important to understand the factors which are impacting the results. Within the third quarter results, we would argue that there are six acronyms which impacted banks in different ways; namely:
1. FICC stands for Fixed Income, Currencies and Commodities where banks provide a variety of trading, risk management, sales, structuring, financing, market analysis and strategy services across the globe. For big banks, FICC revenues are dominated by trading government and corporate bonds and the currencies of the world's main economies. The third quarter results for all investment banks were dominated by the decline in trading income as revenues in their bread and butter business of bond and interest rate trading continued to decline after the prospect of a tapering of the Federal Reserve's bond buying programme and low volatility hurt activity levels. Investment banks' fixed income business traditionally accounts for more than half of their income but it has been under pressure this year as revenues fell and higher regulatory capital charges - as well as stricter trading rules - compressed margins. Also, European banks were hit harder in the quarter as rates trading failed to repeat last year's feverish levels spurred by Mario Draghi, the European Central Bank's president, who said he would do "whatever it takes" to save the euro.
2. FINMA is the Swiss regulator and has certainly been active recently. It announced in the quarter that it, as well as the FCA in the UK and the US Department of Justice, was looking into possible manipulation of the $5.3 trillion daily global foreign exchange market. This was rumoured to be the case and both UBS and Deutsche Bank announced that they were co-operating with investigations. FINMA, however, surprised the market by ordering UBS to hold more capital for litigation risk. Management of UBS stated that this was a temporary 50% add-on to its risk related RWA in relation to 'known or unknown litigation, compliance and other operation risk matters'. This is expected to result in additional operational risk-related RWA of approximately CHF 28bn on both a fully applied and phase-in basis which will reduce UBS' fully applied Basel III Core Tier One ratio by 130 basis points. Management stated there is no transparency from FINMA as to how they came up with the new buffer need and there was no indication as to what items and business lines this refers to.
This was a concerning, if not unprecedented, move by the regulator and is another case of the regulator moving the capital goal posts. The news came as a surprise and UBS shares traded down 7%. It seems that as soon as investors start to think of increased dividend payments, the regulators will require more capital to be kept on the balance sheet. Don't expect a quick return to dividend payments!
3. An increase in provisions for PPI hurt Lloyds share price on its results day despite it reporting 'underlying' earnings which were in line with expectations. The announcement that a further provision is being taken for PPI (£750m) which takes the total to near £8bn impacted net earnings figure. Management commented that 'PPI complaint volumes have continued to decline, albeit at a slower than expected rate, while response rates to proactive mailing were higher than forecast'. This means that the capital position is not as a high as we were hoping or expecting. The Core Tier One ratio fell 10 basis points quarter-on-quarter to 9.5% due to PPI, pension volatility and share issuance. It is worth noting that if we include the disposals that were made post the quarter end, this figure is nearer 9.9%.
It appears that the scariest thing this Halloween may just be PPI which continues to haunt Lloyds and we were surprised by this further provision. What was bad news for Lloyds actually turned out to be good news for Barclays which announced no further PPI provisions; Barclays already provisioned £1.35bn in the second quarter. As at 30 September 2013, utilisation of the provisions for PPI redress resulted in a reduction in the provision by £387m to £1,263m, while utilisation of the provision for interest rate hedging products redress resulted in a decrease in the provision by £56m to £1,293m.
4. We all know about the growth potential of the BRIC economies but not all exposure is necessarily good exposure. Standard Chartered has had a tough year to date with the shares down nearly 4% compared to the FTSE 100 Bank index which is up over 10%. The third quarter results showed that trading was resilient, underpinned by continued strong client activity despite a volatile market environment. Management stated that the quarter started well but slowed as usual in August; yet the difficult market conditions that arose in August also had an impact in September. Management stated that the depreciation of a number of emerging market currencies, including the Indian Rupee and Indonesian Rupiah mean that, at current rates, there would be a full year impact of $200m on income and around $70m on profits. The impact of possible tapering of US bonds has caused much lower growth for many of Standard Chartered's end markets and the volatility of currencies has impacted its performance. It may not be hugely exposed to Brazil and Russia but India and China are important factors in its growth trajectory. The results showed that Singapore and Korea are perhaps just as important.
5. The Prudential Regulatory Authority (PRA) has certainly made itself known since the split of the Financial Services Authority (FSA). Over the year it has taken steps to shore up the balance sheets of UK companies, specifically targeting a 3% leverage ratio. Barclays' third quarter results were the first opportunity for analysts to assess the balance sheet post the rights issue and see what measures have been taken by management to deleverage. Overall the message was positive and should remove some investor concerns about reaching the targets that the PRA set it to achieve by June 2014. It does bring up a valid point though: what will be the next target and when is enough actually enough? The PRA wants to be leading the regulatory market and wants UK banks to be at the forefront of capital discipline.
6. It would have been hard for investors NOT to notice the size of the JP Morgan fine ($13bn) which was made during the quarter and although many of the calculations remain unknown, investors know the main damages concerned the Federal Housing Finance Agency (FHFA). These fines surround the misrepresentation the quality of the mortgages it sold to Fannie Mae and Freddie Mac, two government-backed mortgage companies. Bank of America said that it had nearly doubled the legal cost of the issue to nearer $5bn. Litigation is in the spotlight on the other side of the pond and we have no doubt that the focus will swiftly move East. At least nine banks are under investigation, including Royal Bank of Scotland. Below shows the potential litigation settlements for three UK listed banks based on our estimates; namely: Royal Bank of Scotland $2.82bn, Barclays $580m and HSBC $450m. Any potential fine is a large headwind at a time when management is trying to increase capital headroom and reduce volatility.
Unpredictable, Unintelligible, Unsustainable, Incomprehensible: All words that could be used to describe some elements of the banking sector's third quarter results.
There is no doubt that few could have predicted exactly what has happened in the third quarter with a weight of new information: ECB comments, Bank of England policies, Government disposals, Rights issues etc and the results certainly showed a considerable amount of variations. When banks release results, analysts have to consume a vast amount of information to try and comprehend the environment in which the company is operating. It is often the case that investors can be 'pleased' with the results despite losses, or relieved when figures seem to be worsening and this is due to analyst's 'cleaning' the results to try and find what underlies the underlying results: is the core business making money? Rather than try and explain the benefits of these techniques, we believe it is as important to understand the factors which are impacting the results. Within the third quarter results, we would argue that there are six acronyms which impacted banks in different ways; namely:
- FICC (Fixed Income, Currencies and Commodities);
- FINMA (The Swiss Financial Market Supervisory Authority);
- PPI (Payment Protection Insurance);
- BRIC (Brazil, Russia, India and China);
- PRA (Prudential Regulatory Authority);
- FHFA (Federal Housing Finance Agency)
1. FICC stands for Fixed Income, Currencies and Commodities where banks provide a variety of trading, risk management, sales, structuring, financing, market analysis and strategy services across the globe. For big banks, FICC revenues are dominated by trading government and corporate bonds and the currencies of the world's main economies. The third quarter results for all investment banks were dominated by the decline in trading income as revenues in their bread and butter business of bond and interest rate trading continued to decline after the prospect of a tapering of the Federal Reserve's bond buying programme and low volatility hurt activity levels. Investment banks' fixed income business traditionally accounts for more than half of their income but it has been under pressure this year as revenues fell and higher regulatory capital charges - as well as stricter trading rules - compressed margins. Also, European banks were hit harder in the quarter as rates trading failed to repeat last year's feverish levels spurred by Mario Draghi, the European Central Bank's president, who said he would do "whatever it takes" to save the euro.
2. FINMA is the Swiss regulator and has certainly been active recently. It announced in the quarter that it, as well as the FCA in the UK and the US Department of Justice, was looking into possible manipulation of the $5.3 trillion daily global foreign exchange market. This was rumoured to be the case and both UBS and Deutsche Bank announced that they were co-operating with investigations. FINMA, however, surprised the market by ordering UBS to hold more capital for litigation risk. Management of UBS stated that this was a temporary 50% add-on to its risk related RWA in relation to 'known or unknown litigation, compliance and other operation risk matters'. This is expected to result in additional operational risk-related RWA of approximately CHF 28bn on both a fully applied and phase-in basis which will reduce UBS' fully applied Basel III Core Tier One ratio by 130 basis points. Management stated there is no transparency from FINMA as to how they came up with the new buffer need and there was no indication as to what items and business lines this refers to.
This was a concerning, if not unprecedented, move by the regulator and is another case of the regulator moving the capital goal posts. The news came as a surprise and UBS shares traded down 7%. It seems that as soon as investors start to think of increased dividend payments, the regulators will require more capital to be kept on the balance sheet. Don't expect a quick return to dividend payments!
3. An increase in provisions for PPI hurt Lloyds share price on its results day despite it reporting 'underlying' earnings which were in line with expectations. The announcement that a further provision is being taken for PPI (£750m) which takes the total to near £8bn impacted net earnings figure. Management commented that 'PPI complaint volumes have continued to decline, albeit at a slower than expected rate, while response rates to proactive mailing were higher than forecast'. This means that the capital position is not as a high as we were hoping or expecting. The Core Tier One ratio fell 10 basis points quarter-on-quarter to 9.5% due to PPI, pension volatility and share issuance. It is worth noting that if we include the disposals that were made post the quarter end, this figure is nearer 9.9%.
It appears that the scariest thing this Halloween may just be PPI which continues to haunt Lloyds and we were surprised by this further provision. What was bad news for Lloyds actually turned out to be good news for Barclays which announced no further PPI provisions; Barclays already provisioned £1.35bn in the second quarter. As at 30 September 2013, utilisation of the provisions for PPI redress resulted in a reduction in the provision by £387m to £1,263m, while utilisation of the provision for interest rate hedging products redress resulted in a decrease in the provision by £56m to £1,293m.
4. We all know about the growth potential of the BRIC economies but not all exposure is necessarily good exposure. Standard Chartered has had a tough year to date with the shares down nearly 4% compared to the FTSE 100 Bank index which is up over 10%. The third quarter results showed that trading was resilient, underpinned by continued strong client activity despite a volatile market environment. Management stated that the quarter started well but slowed as usual in August; yet the difficult market conditions that arose in August also had an impact in September. Management stated that the depreciation of a number of emerging market currencies, including the Indian Rupee and Indonesian Rupiah mean that, at current rates, there would be a full year impact of $200m on income and around $70m on profits. The impact of possible tapering of US bonds has caused much lower growth for many of Standard Chartered's end markets and the volatility of currencies has impacted its performance. It may not be hugely exposed to Brazil and Russia but India and China are important factors in its growth trajectory. The results showed that Singapore and Korea are perhaps just as important.
5. The Prudential Regulatory Authority (PRA) has certainly made itself known since the split of the Financial Services Authority (FSA). Over the year it has taken steps to shore up the balance sheets of UK companies, specifically targeting a 3% leverage ratio. Barclays' third quarter results were the first opportunity for analysts to assess the balance sheet post the rights issue and see what measures have been taken by management to deleverage. Overall the message was positive and should remove some investor concerns about reaching the targets that the PRA set it to achieve by June 2014. It does bring up a valid point though: what will be the next target and when is enough actually enough? The PRA wants to be leading the regulatory market and wants UK banks to be at the forefront of capital discipline.
6. It would have been hard for investors NOT to notice the size of the JP Morgan fine ($13bn) which was made during the quarter and although many of the calculations remain unknown, investors know the main damages concerned the Federal Housing Finance Agency (FHFA). These fines surround the misrepresentation the quality of the mortgages it sold to Fannie Mae and Freddie Mac, two government-backed mortgage companies. Bank of America said that it had nearly doubled the legal cost of the issue to nearer $5bn. Litigation is in the spotlight on the other side of the pond and we have no doubt that the focus will swiftly move East. At least nine banks are under investigation, including Royal Bank of Scotland. Below shows the potential litigation settlements for three UK listed banks based on our estimates; namely: Royal Bank of Scotland $2.82bn, Barclays $580m and HSBC $450m. Any potential fine is a large headwind at a time when management is trying to increase capital headroom and reduce volatility.
Ed Salvesen
Deputy Head of Equity Research
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