Now that the banking sector has got over the events of 2007/8, the survivors are being encouraged to retain earnings so as to build up their capital ratios even further as protection against the next recession (whenever that may be).

This is nothing more than the time-honoured concept of putting a bit by during the good times so as to have savings to draw on cometh a rainy day, but the concept here is being forced on the banks by the Basel III rules and their Bank of England regulator because the banks were not sensible enough to do it for themselves during the 2003-07 period of economic expansion.  The Basel III rules require banks to hold a minimum of 7% of their RWA (Risk-Weighted Assets) in Core Tier 1 capital by 2019, and banks which are Too Big To Fail (TBTF) will need to have approx 10% Core Tier 1 capital.

The Bank of England is also mandating banks to hold a higher percentage of their assets in cash & government bonds as a liquidity reserve.  LLOY now has a Liquid Asset Portfolio of £155 bln, RBS also has £155 bln and BARC has £154 bln.  These are big numbers, especially in the context of £175 bln Government borrowing this year (last year the Government borrowed £178 bln and the BoE helped it out by buying £200 bln of Gilts).  With 10-year Gilts yielding 3.71% and Base Rates stuck at 0.5%, banks will undoubtedly be tempted to buy even more gilts and get deeper into the carry trade, especially as corporate & household demand for loans is still weak (because the credit crunch frightened them into deciding to reduce their borrowings and this process is still not yet complete).  The Government is borrowing heavily at the moment and banks effectively have no choice other than to lend to the Government (who are not going to go bust) - the banks’ only choice is how far out along the yield curve they decide to invest.  So there will still be buyers for Gilts, especially because Government bonds are excluded from RWA (so a bank can lower its RWA by buying Gilts with the money received from maturing corporate loans).

The way Basel III is working in practise is that dividend payout ratios are being kept low whilst banks are making money and the retained profits are serving to increase Core Tier 1 capital.  e.g. Barclays’ 2010 EPS were 30.4 pence but the BARC 2010 dividend was 5.5 pence; similarly HSBC 2010 EPS were 73 cents with a 36 cent dividend.  The EU has prevented LLOY and RBS from paying out any dividends until 1 Feb 2012, so any profit they make in 2011 will increase Core Tier 1 capital. Poor old RBS have yet to post a profit for any six-month period since 2008 and when they do eventually make some money their dividends will be effectively capped (until they redeem their B shares) at 1.4 pence per share by the formula which sets the B-share preference dividend at 7% (of the B-shares 50 pence nominal value) or 2.5 times the ordinary dividend (whichever is the greater). 

LLOY were particularly effective at reducing their RWA in 2010 (RWA fell 18% to £406 bln) which raised its Core Tier 1 ratio from 8.4% to 10.2%.  HSBC’s healthy-looking 10.5% Core Tier 1 ratio (boosted by retained earnings from 9.5% last year) is set to fall to 7.5% under the Basel III rules.  The implication is HSBC are set to spend the next 3 years retaining earnings so as to boost their Core Tier 1 capital; they also cannot afford to expand lending aggressively as this will increase RWA and therefore lower their Core Tier 1 ratio.  Hence HSBC’s 78% Loan-to-Deposit ratio (LTD) will not be rising back up towards 100% – HSBC trumpet their low LTD ratio as a virtue but the reality is they are capital-constrained from increasing their customer loans significantly. 

How should banks then be valued?  It pays to bear in mind that bank shares typically trade between 50% and 300% of their NAV over the cycle.  BARC (346p NAV) are primarily an investment bank these days with a healthy & rising Core Tier 1 ratio of 10.8%.  RBS (51p NAV) have a Core Tier 1 ratio of 10.7% but it is falling because of the way the Asset Protection Scheme works and their shares are effectively capped by the 50 pence conversion price of the £25.5 bln B shares (which the UK Government own).  LLOY (68p NAV) were knocked back by Ireland in 2010 but they too have a healthy & rising Core Tier 1 ratio of 10.2%.  Only HSBC ($7.94 NAV) trade at a premium to their Net Asset Value; their Core Tier 1 ratio of 10.5% will need to be boosted as it is negatively impacted by the Basel III rules.  In general banks are still trading at the lower end of their valuation range with RBS the clear runt of the litter.