White Knuckle Investments: How to Trade UK Banks

Investors need a strong stomach to invest in UK bank stocks. In recent years they have displayed considerable levels of volatility that cannot be wholly explained by the fundamentals of the individual banks. In fact, bank stocks are now arguably the most effective barometer available to measure risk appetite.

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Investors are constantly weighing relatively weak short-term earnings potential against longer-term averages, with their constantly-changing assessments driving stock price moves. Those taking a long-term view that banks will return to something like their former profitability will have a bumpy ride, probably lasting several years.

Conversely, taking a short-term view to exploit market volatility is a very high-risk game. Although such a strategy can deliver considerable returns, the current unpredictability of bank stocks means luck is required as much as skill.

A bank’s return on equity versus its price to tangible book ratio is one important measure of how well a bank is doing. If it is generating revenue equal to its cost of capital, then it should be trading at around one times its price to book.

Banks themselves have typically set a target of 12-15 percent return on equity by 2014, but for now most are trading at a discount to tangible net asset value.

With banks looking at a two-year time horizon or longer, stocks are especially sensitive to the uncertainty created by the ever-changing regulatory picture.

These investor concerns are not irrational. Regulatory changes currently being discussed and implemented are likely to have dramatic implications for banks’ profitability in coming years. The potential separation of investment banking and retail banking in the UK, and the way that “systemically important” financial institutions get defined will both be especially significant.

“Most of these questions have not yet been resolved but the impact of most of them looks set to be negative,” said Jane Coffey, head of equities at Royal London Asset Management. “There will probably be some realism in the end, the measures will probably be phased in or dropped if they are judged to be too harmful, but it has made investors extremely nervous about the sector. It does not seem to be the best place to make money at the moment.”

Banks with high exposures to UK mortgages, for example Lloyds , are paradoxically being assisted by the weak economy, with interest rates being held well below long-term trend levels, thereby keeping mortgages cheap.

Any sign of sustained recovery is likely to see interest rates rise, spelling potential difficulty for real estate and banks with large mortgage businesses.

Institutions that are less active in UK mortgages have less exposure to interest rate risk, and will benefit from a gently rising interest rate environment, which will boost interest margins.

However, other banks such as Standard Chartered or HSBC , which have a relatively small real estate exposure proportionately to the size of their overall balance sheet, have different exposures investors should be aware of—for example via their business in emerging markets.

And naturally, banks have varying degrees of exposure to Greece, Italy and other European nations that are suffering from the ongoing European debt crisis.

"We prefer specialist banks such as Investec and Close Brothers to the mainstream banks, as they operate in niche lending areas and benefit from higher margins on their current loans,” said Coffey. “In many instances the specialist areas they operate in have been vacated by the mainstream banks, which have focussed on their core product areas", which has further enhanced their prospects.