Don’t despair of the big banks just yet

The interests in the big banks are still high, even though the value of their shares drop. Let us clarify why it is so.

Disputes connected with the leading banks are still on after the accident of Deutsche Bank that made the shares around Europe drop dramatically. So now we are asking a question: is investing in the leading banks still a reliable and profitable option?

What was the trouble at Deutsche Bank?
The bank’s shares have fallen by more than 45% after its representatives announced they need to pay a huge fine to the US. The penalty had to be about $14 billion, and Deutsche Bank had to pay because of their misleading sells of mortgage-backed securities while nearing to the financial crisis. The news made the shares drop by millions of dollars, but after some negotiation with the regulators the penalty became $5 billion, and the share value started to rise again.

Investors were spooked by fears that the business could not withstand a $14 billion fine. For Germany, Deutsche Bank is considered to be too big to fail and Angela Merkel, the chancellor, refused to say whether the state would pick up the bill should the bank need a bailout.

“The investment-banking industry is cyclical, so the bank needs a strong capital base to see it through the down times. That’s the issue Deutsche Bank has — not enough capital,” says Ian Tabberer, a fund manager at Henderson Global Investors.

What about other banks?
Some banks are still experiencing a hangover from the financial crisis. The Deutsche Bank fine reflects the heavy-handed stance that regulators have taken since 2008. A litany of fines for mis-selling products, breaching sanctions, manipulating currency markets, and the Libor scandal have cost 20 of the world’s biggest banks more than $235 billion (£186 billion), according to Reuters.

The possibility of future fines has put some investors off. “But you can just invest in the banks that won’t be fined,” Mr Tabberer says. Many have not been involved in the activities that have led to penalties and city analysts say the worst of the fines are over. Banks are also hampered by the fact that interest rates are heading downwards in Europe — banks tend to make more money during periods of rising rates. Quantative easing is keeping bond yields low, which trims another revenue stream. Some of Europe’s banks are also grappling with high levels of bad debt, particularly in Italy and Spain.

Why are funds still investing?
Not all the world’s banks have these problems. Many are highly capitalised, have avoided bad debt and are enjoying pockets of growth. In an industry as old as banking, business models can vary wildly, from staid to much more speculative.

Deutsche Bank expects a fine of £5bn for mis-selling mortgage securities

Stephen Message, the manager of the Old Mutual UK Equity Income fund, has invested in Lloyds, 9 per cent of which is still owned by the government, and HSBC. Both are relatively cheap because shares are trading at about book value. In an environment where assets such as bonds, property and high-quality shares seem expensive, he says, bank shares stand out as reasonable value.

Although based in Britain, HSBC’s business is more tied to the positive path of interest rates in the US. “The way it is funded is as a very conservative bank. It has a surplus of equity with deposits on its balance sheet that aren’t really earning anything, but as rates normalise in the US that should change,” Mr Message explains. “The reason I like Lloyds and HSBC is because there is still meaningful scope for these businesses to improve on metrics and returns.”

Scope to improve
Turnaround potential is important to fund managers — a business doesn’t need to be perfect. Once markets get wind of an improvement through a strong results announcement, the share price rises and others invest too. Standard Chartered is one bank on this path, says Mr Tabberer. “We like what the chief executive is doing in sorting out the bad-loans issue. There’s sufficient self-help that the company’s shares look cheap.”

A high level of capitalisation is crucial for any bank to be worth investing in. Mr Tabberer tends to avoid investment banks, although Goldman Sachs is the exception. “It is very careful with its capital; other banks are not so careful,” he says.

Decent dividends
Pre-crisis, banks provided a quarter of all dividends in the UK market, according to figures from Old Mutual Global Investors. As banks continue to recover profitability, there are hopes that they will once again pay out large dividends — HSBC and Standard Chartered report profits in dollars, so should have higher earnings as sterling continues to fall. “There is no reason why, once Lloyds has got rid of its legacy issues, it shouldn’t be returning a significant proportion of its profits as dividends,” says Mr Message.

HSBC’s shares yield about 7 per cent, significantly above the market average. “Whenever you see a company yielding 7 per cent, the market has concerns over the sustainability of the dividend. But given that the bank is so strong, it will be able to pay this,” says Mr Message. Lloyds is yielding 5 per cent.

Growth potential
Banks focusing on customer service, wealthy clients or the under-served poor are the ones that fund managers like the most. Handelsbanken, the Scandinavian giant, has grown to 200 branches in the UK and prides itself on offering an old-fashioned banking experience. It doesn’t advertise rates on savings or loans; instead the bank manager gives each customer a deal after meeting them. “It blows the high-street banks out of the water with service,” says James Thomson, manager of the Rathbone Global Opportunities fund.

Mr Thomson also invests in First Republic Bank, based in the US, which calls itself the “Ritz-Carlton of banking” and has a concentration of branches in the wealthy west-coast cities.

Indonesia’s Bank Rakyat is another bank that fund managers rave about. It provides micro-loans of $5 upwards through a network of branches in a country where traditional banks don’t have a big presence. Bank Rakyat’s return on assets is 3 per cent, compared with the global average of 0.8 per cent. “Consumer outcome is sensational. People are so grateful they’re finally able to get the money that it generates very high levels of loyalty,” says Mick Dillon, of the Brown Advisory Global Leaders fund.