Bad debt hasn't gone away - and it could be about to bite

Barclays and HSBC paying price for chasing volumes. Bank of England warns of vulnerabilities

Dark clouds were circling ominously over Britain's banks at the beginning of the recent batch of trading statements.

Several analysts produced scary sounding reports, warning that the rising tide of insolvencies that is sweeping Britain would hit the banks hard.

And after Barclays and HSBC had both said there was no end in sight to the surge in consumer bad debt, it looked like a nasty storm was about break.

But then everything seemed to get brighter. Both Royal Bank of Scotland and LloydsTSB painted a rather different picture, of stable and even falling losses from bad loans.

And yesterday HBOS, last of the big five to issue its festive pre-results trading statement, signed off the reporting season with a flourish. The bank said the charge it has to take to cover bad loans would be lower than the £1.9bn expected by the City, while earnings will beat the consensus forecast of £5.35bn.

Its trading statement was so good that James Eden, banking analyst at house broker Dresdner Kleinwort Wasserstein, described it as "everything we wanted for Christmas - and more". "Even if you blindfolded HBOS's management and tied their arms and legs together, they would still find a way to beat expectations - whether you are a customer or a shareholder, HBOS always gives you extra," he said.

So why the difference in tone between the likes of Barclays and HSBC and the rest?

After all, the big five all operate in an environment where personal insolvencies have been hitting new records every quarter while companies like Debt Free Direct flood the airwaves with ads promoting Individual Voluntary Arrangements. This easier form of bankruptcy lets people emerge debt-free in five years but requires banks to write off substantial chunks of their loans.

Neil Shah, director of research at Edison, the independent research house, said: "Barclays and HSBC have been chasing volumes and now they are paying the price."

He notes that former building societies such as HBOS "tend to have better credit controls" than their rivals. LloydsTSB, for its part, took a bearish view of the credit cycle rather earlier than its peers and acted to tighten its lending criteria accordingly while Royal Bank, under Sir Fred Goodwin, rarely gets it wrong.

Barclays and HSBC have also dabbled in the "sub prime" market. Individuals in this, admittedly rather insulting, category are those with poor credit ratings - people who may have county court judgements against them, or be financially constrained. It is these people who get hit first when hard times appear on the horizon and they have had to absorb a number of knocks in recent months. Utility bills have increased sharply and tax rises imposed both by councils and the Chancellor Gordon Brown have further eaten into their income and weakened their ability to pay back loans.

While there may be tax credits available for some, it takes a postgraduate degree to fill the forms in, much less understand them. HSBC has a big sub prime business in the US and the company has therefore suffered "a double whammy" with rising bad debt on both sides of the pond.

But is the cautious optimism of the likes of LloydsTSB, Royal Bank and HBOS justified going forward? Have bad debt levels stabilised for those that have lent money cautiously?

Opinion is divided. Mr Eden takes an optimistic view. In a recent note he said: "For years we have argued that consumers have too little debt, not too much." He believes the concerns about Britain's consumer debt levels are vastly overstated.

He has a point, although his view is based on DKW's rosy assessment of the economic situation. Bad debt levels at some of Britain's banks might be rising (he describes Barclaycard as an embarrassment) but by historic standards they remain low.

Supporting his case is the fact that the growth consumer lending is slowing down markedly. Some people, at least, are beginning to pay off their loans while higher interest rates are pushing up savings balances. HBOS's head of economics, Shane O'Riordain, was positively purring yesterday at the prospect for the other side of the bank's business next year saying: "We think 2007 will be the year of saving. Next year balances of secure liquid savings will go above £1 trillion in the UK. We have a 16 per cent market share in savings so we are very excited about this business."

Others, though, are less sanguine about Britain's debt mountain. Prior to the recent trading statements, Goldman Sachs correctly predicted solid trading statements from the likes of HBOS, LloydsTSB, Alliance & Leicester and Bradford & Bingley. But, warning of a 40 per cent rise in personal bankruptcies to come, the broker has urged its clients to sell the lot, predicting a "tough" retail banking environment over the next 18 months.

Morgan Stanley too takes a gloomy view of the prospects for Britain's retail banks. Its analyst, Mark Phin, says: "Rising unsecured impairment charges are nothing new, but neither is the topic going away, we think. All of the factors which caused the current issues - high consumer debt levels, budgetary pressures, greater awareness of debt relief - are unlikely to be resolved in the short term."

And even if you accept Mr Eden's arguments about consumer debt, that is only half the story. Corporate defaults have been running at all time lows over the past few years and the recent batch of trading statements suggested that the picture remains rosy. Royal Bank said: "The corporate credit environment remains favourable."

LloydsTSB went further: "Corporate and small business asset quality has remained strong with no signs of deterioration in the overall quality of our lending. The quality of new business remains good."

But the good times can not last forever. The ratings agency Standard & Poor's has already said the exceptionally benign conditions are likely to end and warned that credit quality is on the slide. Mr Shah agrees. He says: "We think that the credit cycle is turning, as the economy starts to slow. We don't think it has come to an end on the consumer side of things either."

The Bank of England deputy governor John Gieve yesterday said that, while the UK financial system remains stable, vulnerabilities have edged up. Mr Gieve, who is responsible for financial stability, said that in the search for better returns, financial companies may not be as vigilant as they should be. He warned: "A number of vulnerabilities have edged up a little as [debt funded] leveraged buy-out (LBO) activity and commercial property lending have grown and as the number of personal insolvencies has increased."

LBOs happen when companies use a substantial amount of borrowing to finance purchases of other companies. Mr Gieve's concerns about them echo those of the Financial Services Authority, which has sounded the alarm at the fall in credit quality and said the major failure of a private equity deal is now "all but inevitable". That would leave the banks who financed the deal to pick up the tab. So don't get too attached to those bank shares. The bad debt bear has not gone away. In fact, if the pessimists have it right, he's only just waking from a long hibernation.