Will those high-rise bank profits come tumbling down?

Thanks to soaring house prices and a strong economy, the lenders have kept getting richer, writes Ben Schneiders. But now the outlook is bleaker as consumer debts turn sour

While the start of the reporting season this week will reveal how the banks have fared over the past six months, much interest will focus on the future as consumers - who are still borrowing at a rate of £1m every seven minutes - start to struggle under their debts.

This week Northern Rock and Lloyds TSB release results, followed by HSBC, Alliance & Leicester, HBOS, Royal Bank of Scotland, Barclays, Standard Chartered and Bradford & Bingley in the following weeks. Complicating the results will be the introduction of international financial reporting standards that could reduce the sector's reported earnings by 6 per cent, according to a recent report by Goldman Sachs.

But it is the banking sector's sensitivity to the flagging UK economy that will gain most of the attention. In recent months, HBOS, Barclays and HSBC have warned that the number of people defaulting on debt repayments has risen, in some cases sharply. Across the industry, missed payments as a proportion of consumer debt are up from 3.75 to 4.9 per cent, according to figures from Barclays.

"UK consumers are hugely indebted [and uncomfortable with it]. They seem to have spotted that house prices are the most overvalued they have ever been," says James Hamilton, a banking analyst at WestLB Equity Markets.

This is an important point. A report from Credit Suisse First Boston reveals that since the turn of the decade, UK consumer debt has increased by more than 75 per cent, or £460bn. Emboldened by a strong economy and the rising value of their homes, people have spent an extra £10,000 each. But now there are signs that consumers have overextended themselves. Government figures show that cases of personal bankruptcy rose 30 per cent to 37,900 in the year to March.

"There have been margin pressures for some time in UK mortgages and savings, but this is the first year for several that some concerns have been raised about emerging credit risk," says Russell Collins, a partner in the UK financial services practice of accountants Deloitte.

For banks, most of the pressure is on unsecured loans, which have little or no underlying collateral. Between 1995 and 2004, this type of debt accounted for around 93 per cent of total individual write-offs, according to CSFB.

"The key question is that, as the economy weakens, are you going to see the problems with sub-prime [higher-risk] lending spread into more prime lending?" asks Mr Hamilton at WestLB.

CSFB says Northern Rock, Alliance & Leicester, Egg, Lloyds TSB and Bradford & Bingley are among those banks that have grown their loan books aggressively over the past two years. It has warned investors to be "wary" of them as a result.

Yet not everyone thinks the outlook is this bleak. Goldman Sachs expects that underlying earnings in the sector - once the effects of the changes in reporting standards are stripped out - will increase by 10 per cent in 2005 and 9 per cent in 2006.

And others assert that concerns about provisions for bad debts have been overstated. "Put it this way, I don't expect any UK bank to talk about provisions in a way that jeopardises their future earnings growth in a material way," says James Leal, banking analyst at Teather & Greenwood.

He does believe there could be some minor increases in provisions but adds: "This has to be put into the context of a hugely profitable sector."

Mr Leal also points out that, in spite of the fears about consumer confidence, lending levels are growing, so the demand is still out there. In fact, consumer debt is growing at around 10 per cent year-on-year.

In this respect, another source of optimism is a possible cut in interest rates by the Bank of England. Some in the market believe that this could stimulate further consumer borrowing and spending. Most economists are pencilling in a quarter-point reduction for as soon as next month, taking the cost of borrowing down to 4.5 per cent.

It is arguable, though, whether this would be a positive development for the banking sector. "We have had something of a credit bubble in this country, and a cut in rates would probably encourage people who are out of their depth to borrow more," says David Smith, chief economist at stockbroker Williams de Broë. "I would be worried about long-term credit quality - that you actually want to encourage the alcoholic to have another drink."

How the sector fares will hinge largely on what happens to the UK economy, with most analysts and economists not expecting a repeat of the last recession.

"We have argued for a long time that this cycle differs from the early 1990s one, especially with regard to affordability, unemployment and the interest rate cycle," Goldman Sachs has noted in a recent report.

The bank argues that provisions, on average, would have to treble before they started to eat into the industry's dividend payments, and that would require a big economic downturn, which most see as unlikely.

Additionally, many of the banks have overseas interests, including HSBC, Barclays, Royal Bank of Scotland and Standard Chartered. This would lessen the impact of a UK slowdown, though foreign exposure has pitfalls of its own.

Mr Smith at Williams de Broë expects UK economic growth to be 2.25 per cent to 2.5 per cent this year. "In the short term I do see a rebound in growth; in the longer term I expect to see a period of German-style growth [ie slow], and that is because the tax burden is heading up," he says.

Mr Smith's long-term growth prediction for the UK is between 1.5 per cent and 1.75 per cent - far lower than the rate over the past decade. He reckons that most of the danger in the current cycle is posed by the heavily geared buy-to-let investors who have moved into the property market in the past few years. "You have people who are speculating to a degree that isn't wise, considering their asset base."

One bank that would be particularly affected by any problems in the buy-to-let sector is Bradford & Bingley. "If you see a flat property market, it's only going to be a matter of time before they [property investors] realise that the net yield on residential property does not cover the mortgage cost," says Mr Hamilton at WestLB. "In that situation I think buy-to-let investors will dump them on the market."

He believes that this could cause an 8 to 10 per cent decline in house prices. "Ultimately, the first product they start to default on is the credit card. Then it's unsecured loans, and then mortgages."

This view is backed by CSFB, which says that, so far, homeowners have presented relatively few problems for the banks. Those with the biggest market shares in UK mortgages are HBOS, with 22 per cent, Abbey (now part of Spanish bank Banco Santander Central Hispano) with 10 per cent and Lloyds TSB, which has 9 per cent.

However, with most forecasters predicting a more subdued property market, and with consumers reining in spending, the banks will have to look at other areas to improve profits, analysts say. "Banks have top-line growth problems," says Mr Hamilton. "Alliance & Leicester is likely to produce pretty close to zero revenue growth."

Others expect an increased focus on cost cutting. "We will see a major focus on the cost base as banks try to align it with the revenue base, which is an issue in the retail business," says Mr Collins at Deloitte.

"One challenge is the requirement to increase service in branches while improving cost efficiency ... Innovative action such as offshoring, meanwhile, is quite a sensitive subject politically."

At the moment, the relocation of banking services has largely been a case of call centres being shifted to Asia. But other areas could follow, such as back office functions or accounting.

Another strategy is to continue to branch out from retail banking. "Banks have more sources of revenue, and hence revenue growth, than lending to consumers," says Mr Leal. "Investment banking, life assurance and insurance are all examples of how banks have diversified in recent years."

However, not all diversifications have worked. Abbey, most notably, was hit hard by its failed foray into investment banking.

The other option for banks would be to expand their savings businesses. A report by WestLB says that the long-term outlook for this area is strong: "We see this growth being driven by three related factors: demographics, the economy and the property market." The decline in the number of people aged between 20 and 40, the report notes, and the increase in people aged 40 to 65 - a key savings group - should persuade banks to expand that part of their business. Weaker or stable house prices will force people to save more too, WestLB says, as consumers would feel less secure about using the value of their property to underpin spending.

The upcoming results season will give a snapshot on how the banking sector, one of the market's biggest, is currently faring. Yet the real issue for investors is not what is happening today but what tomorrow will bring, as the long consumer boom and the easy profits that the banks have enjoyed start to tail off.

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