British banking has become a stagnant backwater – and it’s painfully obvious why

Should we be relieved or scared? More than a decade after the fallout from the financial crisis started to settle, during which time the UK’s lenders have broadly kept their heads down and their noses clean, the banking sector is dangerously close to becoming interesting again.

Deals are suddenly back in vogue and “consolidation” is the word on everyone’s lips. Nationwide Building Society is paying £2.9bn to buy Virgin Money – thereby increasing in size by about a third. Coventry, the second biggest building society in the country, is planning to buy the Co-op from its hedge fund owners for £780m.

Tesco recently sold the bulk of its banking business to Barclays and J Sainsbury has said it’s open to offers for its financial services division. Meanwhile, the Government is hatching plans to sell its remaining stake in NatWest through a “Tell Sid”-style retail offer to the general public.

Excuse me while I stifle a yawn.

A bit of M&A action will no doubt make a welcome change for those advisers whose thumbs must have become over-muscled from so much twiddling. But anyone tempted to suggest these deals indicate animal spirits are returning to the City is barking up the wrong tree.

In reality, this all, like the recent something-and-nothing strategy overhaul from Barclays, amounts to so much displacement activity. It highlights the extent to which the industry is bogged down, devoid of fresh thinking and stymied by negative investor perceptions of the UK economy.

The defining characteristic of UK banks is that they are massively undervalued compared to their international peers, a fact that Andrew Bailey pointed out in a speech in February and which he described as “puzzling”.

The Governor’s intervention came soon after Jeremy Hunt had called bank chiefs into No 11 for a chat about why their share prices were doing so badly.

Oh, to have been a fly on the wall at that meeting. If the bankers were being honest, their list of reasons would surely have included the Governor of the Bank of England and the Chancellor of the Exchequer. To understand why, we need a little context.

The share prices of UK banks fell off a cliff in April 2007 and have basically just bumped along the seafloor ever since. This is sometimes blamed on enduring memories of the financial crisis and regulatory demands to hold more capital. But both these factors are just as true of international banks as they are of British ones.

The bulk of bank regulations are set globally. Watchdogs around the world are currently in the process of implementing the last leg of the post-financial crisis capital reforms known as Basel 3.1.

Sure, it’s taken a while, but the new regime can broadly be considered a success given the ease with which most big banks navigated the economic turbulence of the last four years.

Never the less, something is amiss in the UK. As Bailey pointed out in his February speech, the average price to tangible book ratio for the major UK banks in the two years before Northern Rock imploded in 2007 was 3.4. That figure is now 0.7. In other words, the market believes UK lenders are worth less than the sum of their parts.

Barclays actually trades at a 50pc discount to the book value of its assets. This is one of the worst valuations of a large bank in the Western world. NatWest, Lloyds and HSBC are faring a little better but not much.

Normally such deep discounts would suggest investors are worried there are nasties lurking on balance sheets. That’s not the case here.

“The paradox is starkly apparent – a period when banks were valued by markets at more than 300pc of tangible book value ended in disaster,” said Bailey. “Today’s greater stability looks the better place to be, but not for market valuations. That leaves us with the puzzle.”

Yeah, I’m not sure it’s that much of a head-scratcher.

When all is said and done, investors who take a stake in a bank are really placing a bet on the economy or economies in which those lenders operate.

Shareholders in UK banks have been hit with additional levies on top of normal corporate taxation since 2011 and the Bank of England’s decision to ban lenders from paying dividends during the pandemic.

Add to that the political chaos of recent years – culminating in Liz Truss’s cluster-Budget – together with the lack of any credible plan to stimulate strong economic growth since, and it becomes clear that the main issue with UK banks is not the “banks” bit but rather the “UK” part.

Of course, HSBC, which generates two-thirds of its profits in Asia, is a partial exception, although exposure to China is clearly a mixed blessing at the moment. Many analysts believe that the latest Barclays rejig will result in the bank becoming even more focused on the UK. Yay!

And the real problem with their low valuations is that it isn’t much of a problem. Many bargain-basement UK companies are currently being snapped up by foreign buyers, but there’s no way regulators will allow that to happen to banks. Nor will they let the big four acquire each other, as this would reduce competition yet further.

Meanwhile, the sheer volume of post-crisis rules, although necessary, has made the regulatory moat around the bigger firms even wider and deeper.

Despite being the largest challenger bank in the UK, Virgin Money’s cost of equity was in the low teens, while its return on equity struggled to escape single digits, meaning it was burning through shareholder value. No wonder its owners are tapping out.

The UK banking industry has come to resemble a stagnant pond. Now and then a sprat will swallow a minnow; flashy fintechs might create a bit of a buzz. But the ecosystem is low on the oxygen of real competition. UK banks are safer now. However, they are medium-sized fish sluggishly drifting through a shrinking backwater.