It isn't all bad news for banks, and brave investors may find value there

The sector is finally beginning to rally, says Kate Hughes, though there are still problems ahead

Barely a week has gone by this year without a banking disaster story. With just one exception, the latest reports from the UK banks have shown significant declines in profits. Desperate measures have been taken to get the cash flowing again. Assets are being sold off and three UK banks have called upon investors for £17bn of new capital.

Over the last few weeks, however, the banking sector has started to rally, despite ongoing concerns over liquidity, capital and the state of the economy. So can it get worse, or have we hit bottom? Is now the time to dive back into banking and pick up a few bargain prices, or is more bad news in the pipeline?

Optimistic view

At first glance, the latest results from the banking sector have been catastrophic. Royal Bank of Scotland (RBS) recently announced pre-tax losses of £691m for the first six months of 2008 alone, after being hit by credit-crunch write-downs of £5.9bn. The losses were not, however, the billions of pounds that analysts had predicted, and the bank's share price actually rose in value at the news.

"Recent weeks have certainly seen a mixed bag of results for banks," says Nick Raynor, an investment adviser at The Share Centre. "Although RBS's losses were huge, they were not as bad as expected, and the company has gone some way to sure up its debts.

"Shareholders who backed the banks' rights issues are likely to be smiling the most, as they are currently showing a near-20 per cent profit. And investors in RBS, Lloyds TSB and Barclays should be encouraged by their decision to not cut dividends."

A calmer future may be on the cards as the results season winds down. "Rights issues have caused a lot of technical activity, driving the prices down," says James Lowen, senior fund manager for JO Hambro. "Now this has finished, the effect has unwound, and that should help clam the volatility we have seen recently."

And of course, there's nothing like a crisis to encourage organisations to do some work behind the scenes. "We have passed the period of write-downs, and most of the capital problems, because of the work the banks have done to raise money," adds Lowen. "This all means that the improved trends we've seen in the last few weeks should continue."

Many argue that the effects of an economic downturn have already been taken into account in the banks' share prices. Being burnt by the US sub-prime crisis, and the slowdown in the UK, means that many banks have dramatically reduced their exposure to risky business, like high loan-to-value mortgages.

"Being able to cherry-pick risk will filter through to performance and profits," says Henk Potts of Barclays Wealth. "Profitability of the banks will be key over the next two or three years. It is all about looking through the negative market sentiment and getting back to fundamentals."

Pessimistic view

It is difficult to call the end of the problems in the banking sector, Potts admits. Write-downs are difficult to forecast, and there is no doubt that, despite preventative measures for the future, the banks' problems have been exacerbated by the fall in the housing market and the slowing economy.

"Investing in the banks is still a high-risk option," says Richard Robinson of investment manager Ashburton. "Sentiment could easily turn again, inflation could rise, and there remains a lack of transparency in the sector. You could argue that this is cheap time to buy into the banks, but it's like someone trying to sell you a car very cheaply that they won't let you see."

If you feel that there are bargains to be had, go for an investment with clear diversification, the experts advise. When investing directly, stay away from niche operators, warns Potts, such as those only dealing in buy-to-let mortgages, for example. "We favour banks with Asian exposure, like HSBC and Standard Chartered, which reported a 31 per cent jump in profits in the first half," he adds.

"There is a lot to dispute about the recent talk that better-than-expected results from the banks mark a turning point for the sector," says Darius McDermott of Chelsea Financial Services. "We would only recommend that investors take the plunge should the banks begin to show some momentum, not relatively minor share-price bounces. In this environment, investors should avoid being blinded by false dawns."

For those brave enough, he suggests the Henderson UK Equity Income fund and Psigma Income fund. Around 11-13 per cent of their holdings are in banks – most significantly, RBS and HSBC.

Another way to get exposure to the financial sector is to consider specialist funds such as the Jupiter Financial Opportunities fund and New Star Financial Opportunities fund. These funds have avoided the UK banks, but invested in other financial stocks across the globe.

Unless you're a sophisticated investor, it's worth getting financial advice before taking the plunge. To find an independent financial adviser in your area, visit www.unbiased.co.uk.