High street bank returns poised to fall

UK bank shares are likely to resemble those of low-growth utility companies if reforms proposed by the Independent Commission on Banking are implemented – but will still offer the prospect of rising dividends, analysts say.

New measures to ringfence bank’s high-street operations from their investment banking arms will be “game changing” and reduce total returns for shareholders, according to KPMG. “In many respects we are seeing a return to a more simple 1940/50s style of retail banking where it is perceived as more of a basic utility with low return on equity for shareholders,” said Jon Pain, co-head of the firm’s regulatory centre. “The really tough question is: can they generate earnings from the activities and services in the ringfenced bank that will provide a decent return?”

Barclays and Royal Bank of Scotland (RBS) – the banks with “the biggest and most diversified operations” – will see their costs and profitability affected most, points out Adrian Lowcock of financial advisers Bestinvest. Richard Hunter, head of equities at Hargreaves Lansdown Stockbrokers, forecasts that the returns they can achieve in future will fall from double to single-digits.

However, even with limited growth potential, most analysts believe banks will still appeal to income investors. “Post-Lehmans, it was inevitable that banks would revert to a utility status,” says Brian Dennehy of advice firm Dennehy Weller & Co. “But utility earnings should be predictable and that will eventually make them a dividend play – otherwise they would have little attraction at any level for shareholders.”

These yields have the potential to rise in spite of falling profits, notes Nicolas Ziegelasch, global equity analyst at broker Killik & Co. “We could see profitability fall and banks pay out more of their earnings, because their dividend pay-out ratios could go up.” He prefers Lloyds to RBS and Barclays, which it suggests avoiding “because of the uncertainty.” Hunter takes the opposite view, though. He says Lloyds is only a “strong hold”, as it is as a play on UK economic recovery, and still has to sell branches. But he believes RBS is “edging nearer a cautious buy”, while HSBC, Standard Chartered and Barclays are buys.