Authored by Bill Blain via MorningPorridge.com,

“Tuppence wisely invested in the bank…”

As UK bank reporting season kicks off, the dull, boring, predictable UK banks should look good. But the reality is they are dinosaurs – their failure to digitise and evolve leaves them vulnerable to tech-savy FinTechs and Challenger filling their niche. If the future of modern finance is a Tech hypersonic missile… British Banks are still building steam trains. 

Today see’s the start of the UK bank reporting season. Yawn….

I wrote a piece for the Evening Standard y’day – Another set of numbers to disguise the rot. (I’ve reused some of it this morning – lazy, eh?) Exactly as I predicted in that note, Barclays came in strong this morning with a decent lift from its investment banking businesses. Lloyds and HSBC will also produce acceptable numbers and limited losses on post pandemic recovery.  The sector outlook looks positive, the regulator will allow them to increase dividends, and there is higher income potential from rising interest rates.

But… would you buy the UK banks?

They face substantial market and ongoing pandemic risk. The cost of economic reality falls heavy across them all. This morning the headlines are about Medical groups screaming out for a renewal of lockdown measures to protect the NHS – a move that will 100% nail-on recession and cause multiple small businesses to give up. The threat of recession in the UK is pronounced – exacerbated by global supply chain crisis and risks of policy mistakes. The worst outcome for banks would be stagflation resulting in exploding loan impairments.

Lloyds is the most vulnerable to the UK economy – hence it’s underperformed the others. Even without renewed Covid measures, potential policy mistakes by the Bank of England in raising interest rates too early, or by government by raising taxes and austerity spending, will hit business and consumer sentiment hardest, causing the stock prices to crumble back towards its low back in Sept 2020 when it hit £24.72. It’s got the largest mortgage exposure – but no one really expects a significant housing sell-off. (When no-one expects it – is when to worry!)

If you believe the UK’s economic potential is under-stated, then Lloyds has the best upside stock potential among the big three. If the economy recovers strongly, Lloyds goes up. If it stumbles, then so will Lloyds!

Barclays is a more difficult call. It’s a broader, more diversified name. It retains an element of “whoosh” from its markets businesses – which have delivered excellent returns from its capital markets businesses fuelled by low rates, but it also runs a higher-than-average reputational risk for generating embarrassing headlines. But, when the global economy normalises, higher interest rates will impact the fee income of all the investment banks, thus impacting Barclays to a greater extent than Lloyds. Barclay’s international business gives it some hedge against a UK economic slide.

HSBC is the most complex call. The UK banking operation is a rounding error compared to the Bank’s Hong Kong business. The bank is pivoting towards Asia, orbiting China and other high-growth Far East economies where it seeks to attract rising middle-class wealth. It’s underperformed due to a distaste among global investors for its China business, but also the perception it’s just too big a bank to manage effectively.

If its China strategy was to pay off, it will be a long-term winner. But that’s no means certain – Premier Xi’s crackdown on Chinese Tech threatens to morph into a China first policy, and the space for a strong foreign bank in China’s banking system looks questionable, even as the developing crisis in real-estate could pull it lower.

Ok – so good for UK banks…

Whatever the respective bank numbers show this week, the banks will remain core holdings for many investors. Generally, big banks are perceived to be “relatively” safe. Regulation has reduced their market risk profiles, and strengthened capital bases since the post-Lehman unpleasantness in 2008 which saw RBS rescued by government.

Conventional investment wisdom says the more “dull, boring and predictable” a bank is, the more valuable it will be perceived in terms of stable predictable dividends, sound risk management, and for not surprising investors. Strong banks are perceived to be less vulnerable to competition with deep moats around their business.

Since 2008 that’s changed – in ways the incumbent banks have completely missed. The costs of entry have tumbled as banking has evolved into a completely different service. New, more nimble Fin-Techs like Revolut, digital challenger banks such as Starling, and cheaper foreign competitors, including the Yanks, are not only eating their lunch, but dinner as well.

The old established UK banks don’t seem to have a clue it’s happening. These incumbent banks look like dinosaurs wondering what that bright shiny light getting bigger in the sky might be. Despite proudly boasting of hundreds years of history, they are constrained by old tech ledger systems and never built centralised data-lakes from their information on individuals or the financial behaviours of crowds to improve and develop their services and income streams.

The future of banking is going to be about Tech and how effectively banks compete in a marketplace of online digital facilities and services. Banks that you use tech smartly will see their costs tumble, freeing up resources to do more, better! (When I ran a major bank’s FIG (Financial Institutions Group) about 100 years ago – the best banks were those with lowest cost-to-income ratio!)

There is an excellent article outlining FinTechs and Challengers from Chris Skinner this morning: Europe’s Challenger Banks are Challenging (and worth more than the old names). Let me pluck a bite from his piece: “Revolut is the most valuable UK tech start-up in history and the eighth biggest private company in the world, worth an estimated US$33 billion, according to CB Insights. Revolut has more than 16 million customers worldwide and sees over 150 million transactions per month.”

The new generation of nimbler Fin Techs and Challengers can innovate product offerings with sophisticated new systems and software. In contrast, UK bank IT departments are engaged in digital archaeology.  I understand only 17% of Senior Tech positions are held by women. Within the banks, I’m told its still a boys club, where the best paid IT jobs are for ancient bearded D&D playing coders brought into to patch 50 year-old archaic systems. Legacy systems leave the big banks with impossible catch up costs.

It’s probably unfair to say the big UK banks don’t know what’s happening – their management can’t be that unaware? Surely not…. But…. Maybe..

Although the banks brag how well diversified they are with over 37% of UK board members female – how much have they really changed? Hiring on the basis of diversity is a fad. At the risk of lighting the blue-touch paper and this comment exploding in my face, I would hazard to suggest the appointment of senior ladies who’ve worked their way up the existing financial system simply risks confirmation-bias on how things are conventionally done in banking.

They might do better hiring outside movers and shakers – rather than listening to themselves.

The bottom line is its not just their failure to innovate tech that’s a crisis. Over the years the UK banks have become increasingly sclerotic – slow to shift and adapt. The middle to senior levels of banking are hamstrung by bureaucracy, a satisficing culture, stifled innovation, a compliance fearful mindset, and senior management fixated on impressing the regulators first and foremost.

If the future of modern finance is a Tech hypersonic missile… British Banks are still building steam trains.