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  1. 1. T: +44 (0) 1872 262622 F: +44 (0) 1872 265326 Award Winning E: CFD Advisors W: S P E C I A L R E P O R TThe Secret Truth about Lloyds, RBS and Barclays Andrew Gibson, Head of Research 14th May 2012 discount of only 4%. And RBS was lagging behind with50% Off Sale – while stocks last a 17% discount. So the discounts can evaporate quicklyHere we go again. After a strong start to the year, when the economic outlook improves.Europe is threatening to spoil the party. Shares of the Today’s steep discounts are certainly not specific to theUK’s leading banks are under pressure once again. UK banks either. The shares of many European banksBut the fact is the UK banks are in much better shape are trading at even bigger discounts. According tothan they were a few years ago. Balance sheets have Bloomberg, overall Italian and Spanish banks arebeen shrunk, bad debts are falling and capital ratios are trading at a 60% discount to book value and Frenchlooking a lot healthier. banks an astonishing 70% discount.Yet right now, valuations remain at depressed levels. The discounts ultimately reflect that the stock marketThe UK banks are trading at around half their book believes the book valuations are wrong and thatvalues – it’s a 50% off sale! mammoth losses are set to be reported in the future.The table below shows a quick comparison between This is understandable to some extent. It’s not prettyRBS, Lloyds and Barclays. out there. Europe seems to be sliding back into Measure Whats it tell us? Which way is best? RBS Lloyds Barclays Core tier 1 capital Ability to absorb shocks Higher the better 10.8% 11.0% 11.0% Net tangible asset value Value of underlying assets Higher the better 48.8p 58.6p 391p per share Approx discount to book How cheap a share is relative to Higher the better 55% 50% 51% value the net assetsBook value is simply the value of a bank’s assets minus recession, which could trigger further losses fromits liabilities. Basically it’s the amount of money that property loans or corporate failures. And there is thewhat would be theoretically left over if all assets were serious risk of a sovereign default across severalsold and all debts paid off. European countries (banks are big holders of government bonds, so would face big losses).All three banks are trading at hefty discounts to But unless a bank is forced to raise additional capital,their book value. it’s hard to see how these discounts can be justified.These discounts are not a permanent feature by any Sure, some European banks may well need to recapitalise soon. Don’t forget the EBA (Europeanmeans. For example, back in March 2010 investors werefull of optimism. Stock markets around in the world had Banking Authority) has set tough new capital rules – allbeen in ‘rally mode’ for around a year - the FTSE 100 European banks must have core Tier 1 capital ratios of 9% or more by 30 June this year. Time is running out.went from 3,500 to 5,700 over that period.At that time, Barclays was actually trading at a 4% While 37 banks failed the EBA’s stress test last time around, the UK banks sailed through. Not a single UKpremium to its book value. Lloyds was trading at aGalvan Research and Trading is authorised and regulated by the Financial Services Authority no. 401179 1
  2. 2. T: +44 (0) 1872 262622 F: +44 (0) 1872 265326 Award Winning E: CFD Advisors W: S P E C I A L R E P O R Tbank was required to raise a penny of additional capital. While many banks have already scaled back theirYou can see from the table above that RBS, Lloyds and reliance on short-term and ratings-sensitive funding, itBarclays all have decent headroom above the 9% doesn’t take much in this market to spark a run onthreshold. deposits. Institutions regularly move billions between different banks with the click of a button. Any sniff ofAnd it’s not just capital ratio’s (solvency) that have been trouble and a bank could face serious knock-on effects.actively improved in the UK. The funding gaps (liquidity)have now been largely tackled. A funding gap happens The fact is a bank’s credit rating affects both their costwhen a bank loans out more than it holds in customer and access to funding. Downgrades could mean a bankdeposits. needs to post greater collateral in the repo or derivatives markets, squeezing liquidity. Some sourcesUp until recently, the UK banks were reliant on short- of funding may even be cut-off. For example, moneyterm loans from the UK government to bridge their market funds could be unable to hold short-term debtfunding gaps. Worst of all was Lloyds. It was in a truly that does not hold the highest rating from the agency.shocking position, but has managed to make a fair bitof progress. For investors with physical shares, they mayInterestingly when you look back at many of the broker choose to hedge their positions.research notes over the last few years, a commonargument for a bearish view was because the funding Hedging is where an investor who holds shares takesgaps of the UK banks would be too big to overcome. out an opposite (short) position in the same sharesAnd that even if by some miracle external funding was using a CFD. Investors do this to lock-in gains or tofound to replace the government funding, it would be protect themselves from falls in the share price, withoutso expensive that it would kill profits. So far these fears having to sell their existing shares. It can also be a wayhave proved unfounded. of reducing portfolio volatility during a fluctuating market.Fear of the unknown For those looking to profit from the relative movementsSo what’s the main issue facing the UK banks today? of two banks, they could take advantage of a ‘pairsFear of the unknown. There’s a lot of balls still up in the trading’ strategy. The aim of pairs trading is to matchair with the banks. Earnings visibility is poor. Balance two closely related shares (that have historically movedsheets still aren’t trusted. Regulators continue to together).introduce tougher rules. Most of the time these shares move up and down at theAnd now the credit rating agencies are set to fuel the same time, but by using a pairs trade, an investor couldfire. Moodys recently warned that 114 European banks take advantage of periods of divergence – one doingare on downgrade review. better than the other. When these divergences occur a trader takes a longNine of these banks are headquartered in Britain, position in the underperformer and a short position inwith Barclays and HSBC said to be among the the overachiever. If the pair reverts to normal, thebanks that might be downgraded by two notches. positions are then closed and an overall profit is made. Pairs trading with CFDs is pretty straightforward as it’sThe reviews will begin in mid-May and be completed by easy to go long or short.the end of June. It’s going to be a critical period for the We’ll now take a specific look at RBS, Lloyds andUK banks. There’s bound to be winners and losers. Barclays.Galvan Research and Trading is authorised and regulated by the Financial Services Authority no. 401179 2
  3. 3. T: +44 (0) 1872 262622 F: +44 (0) 1872 265326 Award Winning E: CFD Advisors W: S P E C I A L R E P O R TRBSRBS continues to make good progress, but despite this, Another outstanding issue is the sale of the insuranceit’s still a complex beast. business. RBS is being forced to offload it as part of its punishment from the European regulators. Although theWhile RBS reported a headline loss of £1.4 billion, this insurance business did nothing wrong, ‘bad banks’ likewas not a true number as it included some misleading RBS were basically told they had to shrink. Selling theaccounting adjustments. The underlying operating profit insurance business was part of the deal. Getting a goodwas actually £1.2 billion, which was a good result. price for it will be critical.Bad debts, once the biggest number in RBS’s results, A final key thing investors want to understand is howshrunk by another 20%. And a key milestone has been profitable the slimmed down investment bank will be.reached: RBS has now repaid all its loans from the UK RBS has slashed and burned many parts of itsgovernment. investment bank in the last few years. Right now it’s hard to know what’s actually left, how much money itThe big talk lately has been about a possible exit can make and how volatile its earnings will be.strategy for the government. The proposed 10 for 1 share consolidation is aimedRumours are that the government could sell up to a at bringing some ‘respectability’ back to the sharethird of its stake to the Abu Dhabi sovereign wealth, although sources close to the situation say anysale would not happen until the end of 2013. If RBS’s shares are trading at around 22p at the time,RBS needs to become cleaner and simpler before it can then they would be re-valued at 220p, but shareholdersbe “marketable” to big international investors. would be left with 10% of the shares they had beforehand.For a start, investors would like to see the dividendresumed. RBS had been banned by Brussels from Fund managers would like a more solid looking sharepaying dividends for three years. But that ban expired price, rather than a dangerous looking penny April this year. RBS recently announced it will begin Many private investors don’t see it that way andto pay dividends again on preference shares, but has confuse a low share price with a cheap company.not said when it will resume paying on ordinary shares. Either way, it’s an artificial move and won’t have anyI think with the European debt crisis hanging over the lasting affect. If may actually put off short-term traderssector, RBS, along with most other banks, will want to who like the volatility a low share price tends to bring.keep hold of all the spare capital they’ve got. A dividend Overall, credit must be given to Stephen Hester foris a luxury they can do without for now. getting things back on track. RBS is leaner and meanerRBS is also keen to withdraw itself from the Asset today than many thought possible a few years back. ButProtection Scheme, which it was forced into when RBS still faces plenty of challenges ahead.things got really bad during the financial crisis. If you Long-term the shares look cheap, short-term they’reremember, the government agreed to act as a backstop only for the nimble.for all of RBS’s really toxic assets. But it will need to paythe UK government a few billion to free itself of this‘insurance contract’.Galvan Research and Trading is authorised and regulated by the Financial Services Authority no. 401179 3
  4. 4. T: +44 (0) 1872 262622 F: +44 (0) 1872 265326 Award Winning E: CFD Advisors W: S P E C I A L R E P O R TLloydsIt used to be called “the world’s most boring bank”. While Lloyds’ capital position looks solid enough, weHow Lloyds longs for the good old days. don’t believe it can afford to be dishing out dividends just yet.Unlike RBS and Barclays, Lloyds is pretty much a pureretail bank. Furthermore, most of its business comes “The balance sheet is the most important thing at thisfrom the UK whereas RBS and Barclays have substantial stage,” said Mr Horta-Osório predicting a “long andforeign operations. difficult” recovery. It doesn’t sound like a man ready to loosen the purse strings but it hasn’t stopped rumoursWhile this makes Lloyds a lot easier to understand, it that the dividend will be back before the end of thisdoesn’t mean its problems are any easier to fix. There’s year.not a lot it can do about the weak UK economy. Thefact is customers are borrowing less, not more. As a One thing that could bring some relief to the shares isresult, growth is very hard come by. the sale of Lloyds 632 ‘excess’ branches, known as Project Verde. This saga has been dragging on for farOn the cost front, Lloyds is also facing an uphill too long. The Co-Op and NBNK have been battling it outstruggle. but must also get approval from the FSA, who are imposing strict criteria that must be met.The mega-merger with HBOS was meant to bring vast A recent wildcard has been rumours that Lloyds maycost savings. They have delivered these to an extent, sell Scottish Widows, its life assurance, pensions andbut Lloyds is still facing shrinking profit margins. Why? investments business. Its certainly a prized asset, butOne of the reasons is that it’s hard for any UK retail Lloyds is not in need of the money and it would onlybank to make much money when interest rates are at make their strategy even narrower.record lows (they prefer a higher rate environment). While 2012 and 2013 are unlikely to be vintage yearsBut the main reason is that Lloyds is in the process of for Lloyds, looking further out its well positioned toreplacing cheap state funding with more expensive benefit from a recovery in the UK economy.commercial funding.Because of rising funding costs, Lloyds’ net interest Lloyds has leading positions in current accounts,margin fell below 2% in the final quarter of last year for savings, mortgages and personal loans as well asthe first time since 2009. What’s more, management strong positions in business banking, insuranceexpects it to fall further in 2012. and fund management.Like RBS, Lloyds recently reported a big headline loss - While we have short-term reservations, over the longer£2.8 billion. But when all the one-offs and accounting term, we think Lloyds has plenty of recovery potential.adjustments are stripped out, the core bank actually The bank has a good track record of delivering costmade a profit of £2.7 billion. savings and paying out juicy dividends. For those withThe management issues also seem to be behind them. patience, I think Lloyds will emerge as a serious cashAfter a health-scare, CEO António Horta-Osório says he cow when economic conditions improve.feels fully recovered and is now “sleeping like a baby”.The one thing that would really get shareholdersbuzzing would be a reinstatement of the dividend.Galvan Research and Trading is authorised and regulated by the Financial Services Authority no. 401179 4
  5. 5. T: +44 (0) 1872 262622 F: +44 (0) 1872 265326 Award Winning E: CFD Advisors W: S P E C I A L R E P O R TBarclaysIs Barclays hard done by? Its shares are at a similar rivals. But business levels have failed to bounce to both RBS and Lloyds yet it has no state Diamond needs to get out the axe and cut costs.ownership, has not incurred anything like the level ofbad debts and pays a decent dividend. The question is The European crisis has yet to cause any majorwhy? issues for Barclays, but has the potential to do so.One issue is trust. Barclays have always taken a more While RBS and Lloyds have been massacred inbullish view on things. Confidence can be good in times Ireland, Barclays Achilles heel is Spain.of growth but the flipside is that some investors accuseBarclays of being slow to recognise losses when times Most of the headline numbers you see refer only toare tough. exposure to sovereign debt. But that doesn’t include the exposure to private sector debt (eg mortgages).Aggressive accounting combined with a huge and Barclays is the largest foreign bank in Spain with acomplex balance sheet means it’s hard for million customers and a network of 550 branches. It’sinvestors to believe that what you see is what you not an enviable position given that Spain is effectively inget. a depression. Overreliance on investment banking, exposure toAnother issue is strategy. Since the late 1990s, Barclays Europe, and regulatory risks mean Barclays ishas gradually built up its investment banking unit from vulnerable to credit downgrades. Moody’s have alreadya niche player in bonds to a global player that can highlighted Barclays as a bank at risk.compete with the biggest names on Wall Street. Thepurchase of Lehman’s Brother’s (US operations) has In the next few years Barclays must brace itself forcemented Barclays in the world’s top tier. a regulatory overhaul.The result is that the bulk of Barclays’ profits now comefrom trading debt, commodities and currencies. Implementing the Independent Commission onEarnings from these areas tend to be fairly volatile at Banking’s recommendations for ring-fencing investmentthe best of times and big losses can come out of banking operations could be painful. It will also create anowhere. lot of uncertainty, which won’t go down well with investors.The recent $2 billion trading loss announced at JPMorgan is yet another example of this. It is more But a healthy pickup in the performance of the UKsammunition for regulators looking to turn the screws on retail banking division and Barclaycard demonstratesinvestment banks, particularly those such as Barclays that there’s more to Barclays than just BarCap. And itsthat are housed together with a retail bank. majority stake in Absa - the largest consumer bank in South Africa – continues to deliver strong growth.The CEO Bob Diamond says he is fully aware thatBarclays must reduce its reliance on its investment In summary, Barclays looks in better shape than RBSbank, known as BarCap. But that’s hard to believe and Lloyds. Its problems are more perceived thanbecause it’s ‘his baby’ – he’s spent the last 20 years of proven. And because it’s not had to radicallyhis life building it up. restructure, it remains largely intact. Meaning if the economy bounces back, Barclays would be off to theBarCap has also been criticised for its heavy cost base. races. But regulators look set to enforce restructuring,In the depths of the financial crisis it went on a massive unless lobbying efforts can dilute their efforts. Its goingrecruitment drive and paid top money to lure staff from to be a cloudy couple of years ahead but the shares look cheap.Galvan Research and Trading is authorised and regulated by the Financial Services Authority no. 401179 5
  6. 6. T: +44 (0) 1872 262622 F: +44 (0) 1872 265326 Award Winning E: CFD Advisors W: S P E C I A L R E P O R TAbout GalvanGalvan Research and Trading is a specialist advisory CFD broker.We’ve been going since 2004, helping private investors make the most of CFDs. Galvan specialisesin CFDs as we firmly believe they are the most innovative and versatile product available toinvestors today.Our aim is to provide investors of all sizes with professional advice and an approachable service.That’s why each client at Galvan is looked after by their own personal trader.Your trader is someone you can build a relationship with, seek advice from and exchange ideaswith. We tell you specifically what we’re recommending, where to take profits and how to manageyour exposure. You can receive as much or as little advice as you need, and you are under noobligation to trade.Our team of in-house analysts are always on the look-out for opportunities. As a client of Galvan’syou are also given full access to our popular Research Centre at no extra cost. We produce a rangeof reports from short-term trading calls to more in-depth special situations. We are committed toutilising our extensive knowledge, experience and contacts for your benefit.If you would like to find out more about our CFD advisory service or have any questions please callus on 01872 26 26 22.Galvan Research and Trading Registered Office: CMA House, Newham Road, Truro, Cornwall, TR1 2SU 6Risk Warning: Information provided by us in respect of our products and services is for general information onlyand is not to be relied upon by users in making (or not making) specific investment decisions. Whilst we try toensure that the content of our products and services are accurate and up to date we cannot guarantee thecurrency and accuracy of this information. Investors should be aware that the value of their investments mayfall as well as rise. Leveraged products such as CFDs can result in losses that exceed your initial deposit. Marketprices can move rapidly. Tax laws may be subject to change. Past performance is not a reliable indicator offuture results. CFD trading may not be suitable for all investors and you should therefore ensure you fully Winner: Best Equity Derivativesunderstand the potential risks involved. Never risk more than you can afford to lose and seek independent Advisor, Best CFD Advisoradvice where necessary. Galvan Research and Trading is authorised and regulated by the Financial ServicesAuthority no. 401179