U.K. Banks Credit Outlook 2024: Earnings Stay Solid As Margins Ease (2024)

This report does not constitute a rating action.

S&P Global Ratings expects U.K. banks' credit fundamentals will remain robust in 2024. Earnings should stay healthy, albeit lower than the buoyant 2023 level due to near-term margin pressures and an uptick in credit loss charges. Rising yields on banks' structural hedges will be increasingly visible from the second half of 2024, offsetting the impact of probable interest rate cuts.

We think banks' capital, funding, and liquidity metrics will continue to support our ratings. Nevertheless, competition for deposits and refinancing of central bank borrowing could pose challenges. Even though the U.K.'s economy has proven more resilient than we expected at the start of last year, GDP growth, consumption, and investment remain weak, constraining demand for loans.

U.K. banks have started the year with generally benign credit conditions, due to prudent underwriting, low unemployment, falling inflation, and solid growth of wages and corporate earnings. Nonetheless, we see more downside than upside to our base-case credit loss projections, and upcoming elections in the U.K. and elsewhere could bring added volatility.

U.K. Banks' Creditworthiness Remains Steady

The outlooks on all our U.K. bank ratings are currently stable and we see stable trends for economic and industry risk under our U.K. Banking Industry Country Risk Assessment (see table 1). We raised the ratings on Barclays and NatWest in the second quarter of 2023 due to these banks' improved business stability, strengthened earnings, and robust credit quality. Further positive rating actions are unlikely this year amid muted economic growth, although a possibility in the medium term, particularly if lower-rated banks enhance their resilience and performance. The main threats to ratings would likely stem from economic risks that trigger a material deterioration of asset quality.

Table 1

Economic Conditions Are A Mixed Blessing For The Banking Sector

The U.K. economy faces another weak year (see table 2). Although most of the G7 nations face a slowdown through 2025, the U.K.'s growth numbers are set to be among the lowest (see "U.K. Economic Outlook 2024: More Stagflation Ahead," published Nov. 27, 2023, on RatingsDirect).

Table 2

Headline inflation has slowed markedly due to lower energy prices and tighter monetary policy, but remains higher than in the eurozone and U.S. Nevertheless, robust wage growth may contribute to stubborn core inflation. The Bank of England (BoE) will likely start cutting interest rates in the second half of this year and maintain a steady pace of quantitative tightening. The next U.K. election will take place no later than January 2025, and important elections are also scheduled this year in the U.S., EU, and elsewhere. Domestic political parties' electoral positioning is likely to begin in earnest following the government's March 2024 budget statement (see "Bulletin: Autumn Statement 2023: Spending Budgetary Windfall On Tax Cuts Won't Help Rebuild The U.K.'s Diminished Fiscal Headroom," published on Nov. 23, 2023).

We project that unemployment will stay below 5%, which should support banks' retail asset quality. The labor market has softened but remains relatively tight. Robust earnings growth underpins corporates' overall debt-servicing capacity. However, certain sectors and borrowers face cash-flow and refinancing pressures, including the commercial real estate (CRE) market and leveraged corporates that depend on weak consumer spending.

The U.K. housing market will likely remain subdued this year.This is despite a slight recovery of house prices in recent months as mortgage rates eased (see chart 1). The interest rate on most U.K. residential mortgages is fixed for a relatively short period, typically two to five years. Therefore, about 55% of mortgage loans have already been repriced since the BoE's first rate hike in late 2021. The resulting increase in debt-servicing costs has dampened house prices, home buying, and consumer spending.

Banks' solid balance sheets provide a sizable cushion to absorb unexpected economic and financial shocks.A downside economic scenario is a second wave of inflation leading to recession and higher-for-longer interest rates, which would increase banks' credit loss charges and bring negligible net interest margin upside. Such a situation could stem from ongoing global conflicts and geopolitical tensions. The results of the BoE's last stress test indicate that U.K. banks would be able to cope with a deep recession, albeit with significant hits to earnings and capital (see "Latest BoE Stress Test Signals U.K. Banks' Resilience To A Severe Downturn," published July 12, 2023).

Earnings Will Remain Elevated But Lose A Little Altitude

We project that rated U.K. banks' pretax earnings will be slightly lower in 2024 but remain healthy. We think the margin compression that started at midyear 2023 will continue in the first half of this year, wage growth will push up costs, and credit loss charges will rise but stay close to the historical average (see table 3). Foreseeable exceptional items reflected in our 2024 projection for the sector include HSBC's estimated $5.5 billion gain on the sale of its Canadian subsidiary and, less materially, litigation and severance provisions.

Our base-case earnings projection compares well against the historical trend (see chart 2). In a downside economic scenario, where credit charges significantly exceed our expectations and revenue is squeezed, the sector should remain moderately profitable and generate sufficient capital to maintain regulatory ratios at about the targeted levels.

Most of our U.K. bank ratings are on large incumbents. These groups have significantly benefited from monetary tightening due to their large balances of relatively rate-insensitive floating rate and non-interest-bearing deposits. In contrast, some newer entrants generally face higher funding costs and a struggle to deepen and monetize customer relationships, resulting in structurally lower profitability. Alongside institution-specific factors, we think these traits contributed to Metro Bank Holdings PLC's (not rated) recent capital increase (see "Metro Bank's Rescue Deal Has No Direct Consequence For Rated U.K. Banks," published Oct. 9, 2023).

Rising Structural Hedge Yields Mitigate The Impact Of Rate Cuts

Although U.K. banks achieved strong year-on-year growth of net interest income in 2023, margins have been declining since June due to deposit migration and low spreads on new mortgage lending. We think these trends will persist in the first part of this year and then ease. Structural hedge yields continue to widen and should offset most of the drag on margins from the BoE's eventual rate cuts. As a result, we think net interest margins will show greater stability from the second half of this year.

There was a steady flow of deposits toward fixed-term products last year to lock in higher rates (see chart 3). This trend continues but is slowing because term interest rates have fallen, and the most rate-sensitive balances have already migrated. We think banks such as NatWest and Virgin Money face less incremental pressure on deposit margins than peers because they frontloaded repricing and migration last year. Competition for mortgage loans will remain intense as lenders fight for the modest amount of new business. Nevertheless, the pressure on mortgage spreads mostly arises from the run-off of higher-margin loans originated during the pandemic, and this process is well advanced.

Some European banks increased balance-sheet hedging last year in the expectation that rates had peaked. However, U.K. banks have taken a more mechanistic hedging approach, particularly in domestic currency, which is expensive when policy rates are rising; for example, Barclays reported a £6.0 billion net cost in the first nine months of 2023. That said, structural hedges are more of a risk management tool than a profit center, and they reduce interest rate sensitivity by deferring income to periods when monetary policy loosens. The hedges' rising gross yield will therefore underpin banks' margins as the BoE cuts rates (see chart 4). Banks are gradually tapering the notional size of their structural hedges in response to deposit migration. This will curb revenue, but that impact will be significantly outweighed by the yield increase.

Low credit demand and tight underwriting mean that asset growth will provide minimal support to banks' net interest income this year (see chart 5). Small and midsize enterprises (SMEs) continue to repay government-guaranteed loans extended in 2020, and other borrowers also show greater propensity to pay down debt. Large corporates' demand for credit might benefit from the government's recent introduction of permanent tax expensing for investment in plant and machinery. But this does not appear to be a game changer in the near term for lending or debt capital market volumes.

With robust capital and liquidity, and few organic balance-sheet growth opportunities, banks are likely to be attracted to reasonably priced bolt-on acquisitions. We note that Coventry Building Society (not rated) has entered into an exclusivity agreement in relation to a possible offer for The Co-operative Bank Holdings Ltd. (not rated), and media reports indicate that part or all of Tesco Personal Finance PLC (not rated) may be for sale. A large incumbent bank appears the most likely suitor for the Tesco business.

Loan Arrears And Credit Loss Charges Are Likely To Go Up

Credit quality was generally benign last year, except for HSBC's and Standard Chartered's elevated charges on cross-border exposures to CRE developers in mainland China. Due to higher debt-servicing costs, we think aggregate credit loss charges will rise moderately this year but stay close to rated banks' 30 basis point average before the pandemic (see chart 6). We think banks' solid underwriting and focus on collateralized lending offset risks from a severe stagflation scenario. Credit losses would nevertheless increase materially in those circ*mstances, particularly in higher-risk segments of corporate loan and unsecured consumer credit portfolios.

Rising mortgage loan arrears reflect a step up in debt-servicing costs as borrowers refinance at higher interest rates. This trend is likely to continue this year (see chart 7), but low unemployment, rising real wages, and falling mortgage interest rates imply that a severe deterioration remains unlikely. Household debt is concentrated among high-income households, and borrowers refinancing their mortgage loans were originally stress tested at interest rates well above those for current new business. Limited demand for concessions (such as a switch to interest-only payments for six months) under the government's mortgage charter indicates that most households have sufficient financial flexibility to cope with higher debt-servicing costs. Furthermore, banks' limited exposure to mortgages with high loan-to-value ratios contains the potential impact of a house price correction.

We expect U.K. credit card arrears will increase moderately this year from a low starting point.U.S. consumer credit balances and delinquencies have recovered to pre-pandemic levels, but remain subdued in the U.K.

Domestic corporates have manageable debt-service ratios in aggregate.However, there is pressure on leveraged borrowers in sectors most exposed to weak consumer spending and higher input costs. Banks' significant risk-transfer securitizations partly mitigate single-name and portfolio credit risks in those areas.

Banks have kept a lid on their CRE exposures since the global financial crisis and none appears to show concentration in this sector (see chart 8). Domestic CRE loans have good collateral cover and there have been few defaults of large tenants. Nevertheless, as in other countries, CRE prices in the U.K. have fallen (by nearly 20% from the midyear-2022 peak). The decline comes as the office and retail property segments undergo structural shifts and there is limited demand for buildings in non-prime locations or with poor energy efficiency. CRE sponsors have been generally supportive but tend to take an asset-specific approach, and elevated refinancing risks will likely crystallize losses on low-quality properties. The last BoE stress test modelled a painful but affordable 7.5% five-year stressed loss rate on domestic CRE exposures.

Banks appear prudently provisioned.This is partly due to low triggers for exposures to move to stage 2 (which require lifetime credit loss provisions) from stage 1 (requiring 12-month provisions) (see chart 9). Banks also maintain sizable management adjustments related to inflationary pressures. The vast majority of stage 2 loans are fully performing but their modeled probability of default has increased. Benign credit conditions have kept stage 3 balances broadly flat, and banks could begin to release part of their management adjustments if this position persists in 2024.

Banks Are Targeting Cost Savings To Compensate For Lower Margins

For example, Barclays has disclosed in its latest quarterly earnings that it is likely to book material charges in its year-end 2023 results, in respect of cost actions, to underpin shareholder returns. We expect these measures will focus on reducing headcount and structural costs rather than on a deeper restructuring of the bank.

We think that, likewise, peers will seek opportunities to streamline their cost bases to alleviate the impact of wage inflation and realize efficiencies from recent technology investments. All in all, we think banks' cost-to-income ratios will edge up this year due to tempering revenue and moderately higher operating expenses (see chart 10).

Funding Plans Reflect Increased Deposit Migration And Wholesale Issuance

We see shrinking deposit balances and increased deposit migration as an earnings issue more than a funding concern. Relative to income, excess savings accumulated during the pandemic have largely dissipated, but nominal deposit balances and banks' loan-to-deposit ratios remain robust. Nevertheless, the effects of deposit migration, quantitative tightening, and refinancing of the BoE's Term Funding Scheme for SMEs (TFSME) require careful management by banks' treasury functions.

TFSME outstanding stood at £153.4 billion on the latest reporting date and mature over the next several years. Relative to their balance-sheet size, smaller lenders have more material refinancing needs than larger banks. We think the sector will repay TFSME mainly through increased wholesale funding (in particular, covered bonds) and by reducing the amount of excess liquid assets, but there may also be an increase in deposit competition and pricing.

Rated U.K. banks' funding and liquidity metrics are solid and they navigated relatively smoothly through last year's bank collapses in the U.S. and Switzerland. Any recalibration of the liquidity coverage ratio is likely to be a medium-term process led by the Basel Committee, and may include a greater focus on banks' access to contingent central bank liquidity. For this purpose, U.K. banks have for many years routinely placed large amounts of collateral at the BoE. The BoE's next resolvability assessment, due in June 2024, will doubtless consider lessons learned from recent bank collapses when assessing potential funding sources and needs following a resolution action.

Banks hold manageable amounts of bonds valued at amortized cost because their structural hedges in pound sterling mostly use swaps and their liquid assets in sterling are mostly central bank reserves. In addition, gilts in the banking book are largely hedged. The situation differs in other currencies, and HSBC, like its U.S. peers, crystallized mark-to-market losses on government bonds in the second half of last year as it chose to accelerate reinvestment into higher-yielding securities. The BoE has committed to maintaining ample bank reserves as quantitative tightening progresses and shown no indication of joining the European Central Bank in reviewing the interest rate paid on these balances.

Stable Capitalization And Shareholder Distributions Will Likely Continue

We expect rated banks' capital, leverage, and additional loss-absorbing capacity metrics will remain relatively stable (see table 4). Earnings should comfortably cover banks' incremental capital needs from asset growth, internal rating migration, and model updates under the Capital Requirements Directive IV. Therefore, we assume for our projections that much of the excess earnings will continue to be returned to shareholders through ordinary dividends, supplemented by share buybacks and special dividends.

Table 4

The U.K. Basel 3.1 package will be phased in from July 2025 to January 2030, and the BoE projects it will raise the banking sector's Tier 1 capital requirements by about 3% at the end of that period. This is lower than the estimates for EU and U.S. banks, partly because U.K. banks have sizable Pillar 2 add-ons that the BoE intends to cut to avoid double-counting. With these modestly higher Basel 3.1 capital requirements on the horizon, banks may issue a little more hybrid capital than usual this year.

Regulatory Initiatives That Could Influence U.K. Banks In 2024

Regulatory change is ever present and, alongside those already mentioned, domestic initiatives we are monitoring include the following:

Ring fencing.

• Alongside technical changes to ring-fencing rules, the government has proposed options for more fundamental reforms to align the regime with the resolution framework. An independent panel previously recommended disapplying ring-fencing requirements to resolvable banks, though industry feedback suggested that this would be difficult to operationalize. The government intends to announce its policy response in the first half of this year.

Supervision of smaller banks.

• The regulator is establishing a "strong and simple" regulatory regime for smaller banks and, separately, evaluating options to ensure continuity of access to deposits held by nonsystemic banks in the event of liquidation.

Fraud.

• A new mandatory reimbursem*nt scheme for authorized push-payment scams is due to be implemented in October 2024, which will likely raise banks' costs.

Consumer duty rules.

• The consumer duty regime was applied last year to open-book (currently marketed) products, and closed book products follow in July 2024. This regime puts the onus on firms to deliver good outcomes to customers. Elsewhere in conduct regulation, buy-now-pay-later products are due to be brought within the regulatory perimeter.

Operational resilience.

• Non-financial risks, including cyber security and system availability, are a key aspect of banks' credit profiles. The banking sector has until March 2025 to satisfy regulators that it can remain within impact tolerances for each business service. A December 2023 consultation proposed new requirements for third-party providers of banks' critical infrastructure, such as cloud services.

Stress testing.

• In addition to its annual solvency stress test, the BoE runs biennial systemwide exploratory scenarios. In the wake of the market volatility that followed the U.K.'s mini budget in September 2022, the BoE is currently assessing the potential impact of more severe market instability. The results will be published later this year.

Related Research

• Banking Industry Country Risk Assessment: United Kingdom, Nov. 28, 2023
• U.K. Economic Outlook 2024: More Stagflation Ahead, Nov. 27, 2023
• Bulletin: Autumn Statement 2023: Spending Budgetary Windfall On Tax Cuts Won't Help Rebuild The U.K.'s Diminished Fiscal Headroom, Nov. 23, 2023
• Bulletin: U.K. Bank Earnings Lose Their Fizz In The Third Quarter, Oct. 30, 2023
• United Kingdom 'AA/A-1+' Ratings Affirmed; Outlook Stable, Oct. 20, 2023
• Metro Bank's Rescue Deal Has No Direct Consequence For Rated U.K. Banks, Oct. 9, 2023
• As Their Funding Evolves, U.K. Banks Have Flexibility, Sep. 14, 2023
• U.K. Banks Enjoy Another Strong Half Year As Margins Peak, Aug. 24, 2023
• Latest BoE Stress Test Signals U.K. Banks' Resilience To A Severe Downturn, July 12, 2023
• Comparative Statistics: U.K. Banks Compete Strongly As Rates Climb, June 16, 2023
• U.K. Bank Credit Losses Will Rise Modestly To £5.2 Billion In 2023 As Marginal Borrowers Feel The Strain, Apr. 26, 2023
• Interest Income Fuels Bumper U.K. Bank Profits As Rates Near Their Peak, Mar. 10, 2023