Highlight | Banking Sector

Big bonuses are in the spotlight again, euro debt remains a constant worry and banking regulations are set to tighten. And yet, there may still be hope for banks.

In late 2008 and early 2009 the UK banking sector was an unhappy place. The sub-prime mortgage crisis that had hit the US had made its way to British shores and some high street names were suddenly faced with government bailout or collapse. Banks have been among the most prominent of scapegoats of the resulting recession, and have incurred the wrath of politicians, sections of the media, and the public alike.

In 2010, however, the economy emerged from recession and the banking sector found something like stability again. The FTSE^® 100 had a solid year, adding 9% overall and rebounding from a mid-year slump below 5000 to break through 6000 for the first time since mid-2008 in the week before Christmas. As we make our way in 2011, banks seem to have established a good platform for further growth.

Many analysts have already predicted that 2011 will be a strong year for the FTSE^®, with a possible rise to and beyond 7000. Will banks be leading this charge, or might they be among the few bad apples in the basket? We look into a few factors which may affect the sector this year:

Ongoing European sovereign debt

Exposure to euro debt has been a constant concern for banks recently. Already there has been bailout action in Greece and Ireland, but the consequences could be catastrophic if certain other European nations are allowed to fail – in particular Spain, where UK banks have amplified exposure. Despite a recent upswing in sentiment, driven by successful bond auctions in Spain and Portugal, lingering uncertainty may dampen growth in the banking sector over the next year.

Tighter regulations expected

With the Basel III accord anticipated sometime this year, banks will have to set aside extra capital to protect against potential future losses. The likelihood is that this will hit profits, and therefore growth, but the extent of any damage caused will ultimately depend on just how severe the regulations are, and to what extent the action is priced into the market.

Low interest rates and rising inflation

In the UK, net interest income represents the largest revenue contributor for commercial and retail banking. It follows that the lower the bank rate, the smaller the net interest margins are likely to be for interest-generating products. Obviously this hurts profitability for banks, but it is nothing new – they have been operating with a 0.5% bank rate for nearly two years. But with inflation on the rise, the repo rate could be due for a hike sooner rather than later. Whether rising inflation hurts the economy, and equities in general, remains to be seen.

Conclusion

With UK banks priced relatively low at the moment, and equities generally expected to perform well, the domestic banking sector may appear to be primed for an uptrend. However, taking the above factors into consideration, investors will need to pay close attention to ensure gains do not turn swiftly into losses.

Take a position

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Updated: 26/01/11

The above comments do not constitute investment advice and IG Markets accepts no responsibility for any use that may be made of them.