Banking on assets

As the future of beleaguered bank Northern Rock remains in the balance confidence in the wider banking sector continues to be low.

According to Ralph Brook Fox, UK Fund manager at Resolution Asset Management, the main reason for the nervousness stems from uncertainty over the values of subprime related securities such as mortgage backed securities and CDOs, and the quantities of such securities that banks hold.

“Earnings streams from capital market areas are likely to fall significantly, while retail earnings will be affected by a slowing mortgage market, likely higher arrears, and potentially tighter spreads for those reliant on wholesale funding,” he says.

“Retail funding is also becoming more expensive as there is intense competition for retail deposits given the lock-down in the wholesale markets.”

Despite the high-profile nature of Northern Rock’s fall, Brook Fox stresses that the bank has not been the cause of the problems in the sector.

“The US housing market and subprime is the cause, and all wholesale funded banks, as well as other institutions such as Paragon, are feeling the heat,” he says. “The Rock was simply the first to pop.”

Chou Chong, head of pan-European equities at Aberdeen Asset Managers, agrees with Brook Fox that the sector is in poor shape, adding that the only UK-focused lender he invests in is Lloyds TSB.

“It boasts the benefits of a prudent management team and a very secure funding base, which has proved especially beneficial over the last few months,” he says.

“In contrast to the domestic banks we view the internationally diversified names such as Royal Bank of Scotland, Standard Chartered and HSBC as offering better potential for long-term growth, primarily through their exposure to less developed markets where demand for banking products could well continue to increase at a rapid pace.”

That said, Chong points out that even these banks face challenges in that they all have some level of exposure to the problems of the credit crunch.

“It may be that if share prices continue to be weak some interesting long-term investment opportunities will be thrown up but at this moment of uncertainty, and with an outlook of deteriorating trading conditions, we're choosing to remain cautious with our investors' money,” he adds.

Brook Fox remains equally cautious, pointing out that it would be “a high-risk game to increase exposure to the banking sector at this point, given continued lockdown in the credit markets and spill-over into the real economy”. Brook Fox adds that estimates vary widely in terms of how long this situation will last.

“Very tough credit conditions will persist into the year-end as banks protect their own liquidity positions,” he says. “But we will not get much clarity on the banks’ balance sheets until results in February and March. A more gloomy scenario is that the root cause is the US housing market, which is relevant for the pricing of many of these securities. Pricing will remain volatile until we know the true extent of the defaults, and this could take 18 to 24 months.”

1 December 2007