Investment Column: Low-risk HSBC offers shares to bank on

Give a cursory read to the banking sector's recent set of interims and you could be forgiven for thinking that the salad days were back. Bumper profits across the board, smiling executives and even the prospect of the return of dividend payments at some point in the future. The trouble is, all this bonhomie could easily be a mirage.

The most striking feature of the results was the marked fall in loan impairments enjoyed by every one of the big four UK-listed banks. Most believe these impairments peaked last year and will continue to fall, although worries linger about the exposure of Barclays to Spain and Lloyds to Ireland.

Nonetheless, in a sobering assessment of the sector's prospects, Standard & Poor's (S&P) gave warning last week that significant risks remain. The optimism could prove to be misplaced, particularly if the economy turns south.

The Coalition's austerity plans could easily cause this, and certainly will add to the unemployment queues. If interest rates begin to rise sharply (as some fear), people out of work are likely to struggle to meet mortgage repayments. All of a sudden the improvements in loan losses could move into reverse.

What's more, S&P warns that if a combination of the above does send the economy into a tailspin, there's precious little that the banks can do about it. Many of the improvements we have seen have not been down to the banks' management teams. Rather, the Government's economic stimulus, unexpectedly robust economic performance from Britain in the first half of the year and relatively low unemployment have brought about improvements.

Add to this a regulatory environment which is all but impossible to predict. A threat from the Coalition to break up the banks could easily result in HSBC and Barclays scurrying overseas and could bring instability back to the Royal Bank of Scotland (RBS).

On the upside, at least banks' financial strength and cost bases have been improved. And the GDP figures on Friday showed that the economy positively roared ahead in the second quarter (the 1.2 per cent growth was the fastest for nine years). So we're OK in the short term.

In considering the banks, it's perhaps best to split them into two groups: the state-aided Lloyds and RBS in one, and those that avoided going cap in hand to the taxpayer – HSBC and Barclays – in the other.

HSBC is in positively rude health. Its exposure to the world's fastest-growing economies is the object of envy from almost every other bank you care to mention. It continued paying dividends throughout the credit crunch, and, crucially, its funding position is about as solid as it can get. Even the debacle of its US subprime business has been largely dealt with.

HSBC is by no means cheap, at 12.71 times the consensus forecasts for 2010 and earnings falling to 9.76 times in 2011 – although its yield (3.65 per cent rising to 4.11 per cent) is streets ahead of any rivals and under no visible threat.

So HSBC is our tip in the sector because it offers less risk than any of its rivals and, while you won't get rich from buying the shares, it should continue to perform well. Barclays is a more difficult case. The bank has oodles of management talent, and its investment bank, Barclays Capital, is a money-making machine, although it may not put up quite the stellar numbers in the next couple of years as it has recently. However, it is firmly in the sights of banking reformers. It could be argued that Sir John Vickers' Independent Commission on Banking, which will look at breaking up the banks, is aimed squarely at Barclays.

At 9.63 times this year's forecast earnings, falling to 7.29 times with a prospective yield of 2.45 per cent rising to 3.31 per cent, it is cheaper than HSBC. Its funding position is not quite as robust but it is stronger than its part-nationalised rivals and, notwithstanding the Spanish worries, it has less exposure to the UK property market. The regulatory issue hangs over it like a storm cloud, however.

We've backed Barclays on the way up and it has rewarded us handsomely. But given the regulatory uncertainty, investors can expect a wild ride in the coming months. On valuation grounds, the shares are not overly expensive but we fear it may be wise to take profits now and get back in on any signs of weakness down the line.

Lloyds is a conundrum. A (nearly) pure-play retail bank, it could turn into a money-making machine with a fair wind behind it. On the other hand, how do you grow your business when you already have market shares in several categories of product that should already worry the competition authorities? Then there is its huge exposure to the mortgage market.

Lloyds has recovered more quickly than anyone expected and is ahead of schedule in its integration of HBoS. But its future prospects are hugely dependent on the UK economy and there isn't really a fall-back. It is also worryingly reliant on Government funding. Lloyds looks in much better shape than it was. It sits on 9.56 times next year's earnings but can't pay a dividend until 2012. We'd just about hold for now, but be ready to jump for the exit if the economy turns down.

RBS has also shown signs of life. Its chief executive Stephen Hester is somewhat gaffe-prone, but appears to be having some success with his turnaround programme. All the same, his trouble is that the brand is toxic while the investment bank is second tier at best, has lost many of its top people, and may have to be divested .

The shares look more or less fully valued at their current level at around 13 times next year's earnings, by which time the bank should look more stable. They are likely to be highly volatile and we'd steer clear for now. They remain shares for short-term traders and gamblers. Longer-term investors might be best to sit back and see how things develop.