Banks' profits soar as interest rates rise

Lloyds will pay out its first dividend since the financial crisis struck. Richard Northedge reports

Rising UK interest rates will cause profits at Britain's high-street banks to soar this year, particularly boosting Lloyds and Royal Bank of Scotland, which will report greatly improved results for 2010 this week.

The improvement is expected to allow Lloyds to pay a dividend for the current year – its first payment to shareholders since the financial crisis struck. The results could encourage UKFI, the government agency holding the state's £50bn of shares in Lloyds and Royal Bank of Scotland, to start selling its holdings this year.

The City believes RBS will show a return to profit of around £1.7bn when it announces its figures on Thursday, compared with 2009's £2.6bn pre-tax loss. Lloyds is expected to almost double its profits from £1bn to £1.9bn.

But those figures will soar in future years as interest rates rise because banks will not pass on the increase to the savers who provide much of their capital. Credit Suisse is forecasting profits exceeding £8bn for Lloyds next year, with RBS making £5.75bn.

The governor of the Bank of England, Mervyn King, admitted for the first time last week that he expects to raise rates this year from their 0.5 per cent record low.

Jonathan Pierce, a banking analyst at Credit Suisse, said: "We would expect a 1.5 per cent rate rise – the level priced into the money market between now and December 2012 – to boost domestic bank revenue by £1.5bn. "The deposit base is so large that even a 50 basis point [0.5 per cent] increase in spread on a 1.5 per cent base rate rise would add £2.5bn to UK domestic bank revenues."

Profits on personal current accounts are offsetting banks' losses on commercial lending. Barclays admitted last week that retail banking profits rose by 39 per cent in 2010 to account for £989m of its £6.07bn pre-tax profit. Its Barclaycard subsidiary added another £791m, higher than in previous years.

Barclays' net interest margin on its UK retail business rose to 1.45 per cent – well above the 1.15 per cent earned by its Western European retail operation. Barclaycard's margin rose to 9.77 per cent.

Arturo de Frias, a banking analyst at Evolution Securities, said a key lesson learnt from Barclays' results was that UK retail banking is performing better than expected. But when the Bank of England raises its rates, the clearing banks' net interest margins are expected to rise much higher.

Leigh Goodwin, a Citigroup analyst, says the expected rate increase could add £400m to RBS's annual profit. "Some 66 per cent of RBS's £420bn of consumer deposits are in the UK and over half of those are no-rate or low-rate current accounts and deposits," he says.

He is expecting two quarter-point base rate increases this year and two more in the first half of 2012. "We estimate that each rise will lift RBS's net interest margin by around six basis points and add £400m to operating profits." The bank's retail and commercial margin had already risen to 3.23 per cent by last September.

Stephen Hester, the chief executive of RBS, will report that the bank shrank its asset base further during 2010 but is on course to meet lending commitments which were agreed as part of Project Merlin. Mr Hester, who will receive a £2.04m bonus for the year – paid in shares he cannot cash for three years – will also say his core, Tier-1 capital ratio now exceeds 10 per cent.

Lloyds' figures will be the last from Eric Daniels, the outgoing chief executive whose £1.45m bonus will be deferred until 2013. They will show the net interest margin now exceeds 2 per cent but that second-half profits were hit by provisions against Irish lending.

He is unlikely to comment on future strategy or dividend policy, which his successor, Antonio Horta Osorio, will announce after he joins from Santander in March. Mr Osorio is also expected to outline plans for the sale of 600 Lloyds branches. Lloyds' improvement means it will be able to pay shareholders part of this year's profits.

Lloyds last paid a dividend in 2008 and is barred from further payments until next January under the terms of the state capital injection, but that allows a dividend for 2011. Evolution Securities believes the bank could pay 2p a share and double that the following year.

Mr Goodwin at Citigroup thinks RBS could follow with a 1.4p payment next year, saying: "RBS will be one of the major beneficiaries of interest rate increases in the UK".

At Credit Suisse, however, Mr Pierce says: "We do not expect Lloyds to pay any material dividend or effect any capital repurchase for at least two years." He adds that there is little chance of an RBS payment until at least 2013.

Soaring bank profits will be considered by the Independent Banking Commission when looking at the feasibility of forcing Lloyds to divest part of its business. With its Halifax arm, Lloyds has 30 per cent of UK current accounts compared with RBS's 16 per cent and market shares of about 14 per cent each at Barclays and HSBC, which reports its profits on Monday week.

The Office of Fair Trading dropped an inquiry into the fairness of unarranged overdraft terms 14 months ago, after a court challenge, but has investigated current accounts and recently warned: "Unless further action appears appropriate sooner, the OFT expects to consider a further review of the market in around 2012." A progress report is due next month.