What new Bank of England report means for Lloyds and others

UK banks are becoming investable again, but they remain very much under the scrutiny of regulators. Despite the Bank of England's bi-annual Financial Stability Report reducing the overall warning level on the sector from "elevated" to "standard", it did warn about "pockets of risk".

Two areas of interest are the reinstatement of the countercyclical buffer (CCyB) and concerns among members of the Financial Policy Committee (FPC) – the central bank's risk monitor - around consumer credit growth.

It's been decided that the CCyB will rise to 0.5% from June 2018 and to 1% the following November. Increasing the buffer means banks must keep more capital available to cope with any shock and keep lending. Every 0.5% raise adds around £5.7 billion to banks' capital requirements.

While the initial increase was widely expected, the second was not. However, the FPC has said before that the appropriate buffer in a "standard risk" environment would be 1%.

Elsewhere, the report argues that consumer credit has grown much faster than household incomes in recent years, while a loosening of underwriting standards is also a concern.

As a result, the BoE will bring forward its stress test assessment of stressed losses on consumer credit lending by two months to September. It will then decide whether any additional resilience is required.

The impact on UK banks

Broker UBS says the decision to re-impose the CCyB "does not make sense" given the Brexit-related slowdown forecast by its economists. Analyst Jason Napier points out that banks are not short of the extra £5.7 billion initially required: "The banks already have this in surplus."

Similarly, Barclays sees no negative impact, "with banks operating well above regulatory capital requirements and no change in stance on consumer credit".

The Bank of England has previously indicated a core equity tier 1 (CET1) ratio – a measure of financial strength - of 11% is appropriate for banks, although most of the big players currently sit above their own internal targets of 13%.

Consumer credit "clearly remains an area of focus for the FPC", but Barclays analyst Rohith Chandra-Rajan notes that major banks funded only a quarter of consumer credit growth in the year to April.

While there was not a lot new on consumer credit, a forthcoming report from industry supervisor the Prudential Regulation Authority is expected to confirm underwriting standards have eased since 2011.

Chandra-Rajan thinks the FPC could impose limits on lending by looking at 0% balance transfer credit cards and car dealership finance. This will impact on Barclays' two favoured banks, but the risks are manageable.

Two favoured banks

The outlook for the ever-popular Lloyds Banking Group is improving, and it's won plenty of new backers in recent months. It's top of the list at broker Barclays.

It rates Lloyds shares as ‘overweight' with price target of 77p. Coincidentally, our technical analyst Alistair Strang mentioned the same figure this morning, writing "Lloyds has ticked all the boxes for 77p on the current cycle".

The government's recent exit from Lloyds shareholder list is a clear positive for the lender, while profitability remains strong, with consistent underlying return on tangible equity (RoTE) of 13% supported by rising net interest margin and a relatively shallow credit cycle.

Sustain that RoTE and Lloyds should generate sufficient capital to return around a quarter of its market cap to shareholders over the next three years, says Barclays.

"At 8.6 times underlying 2017 earnings, 1.2 times tangible book value and a 7-9% dividend yield, we continue to see the shares as attractive."

And Chandra-Rajan believes Virgin Money, at a shade below 270p, is depressed by concerns on consumer credit and Brexit. However, with superior growth and returns being delivered, consensus earnings are "too conservative".

It's a straightforward business – a retail loan and deposit franchise – and has no legacy issues. Low market share in mortgages and credit cards, and a scalable operating platform, facilitate continued loan growth. Combined with solid profitability, this should also drive strong tangible book growth.

"The current [forecast] 7.4 times 2017 earnings multiple and 0.9 times tangible book valuation undervalue our expectations that Virgin can deliver a three-year compound annual growth rate of 17% for earnings and 12% tangible book value growth, with RoTE rising from 12.6% in 2016 to 14.6% in 2019."

A price target of 380p implies over 40% upside, while an uber-bullish upside case of 777p is achievable through mid-to-high teens RoTE, with fast growth and a low risk profile resulting in fast tangible book growth and a lower cost of equity.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.