UK banks, base rate, bad debts and borrowing … what does it all mean?
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UK banks, base rate, bad debts and borrowing … what does it all mean?

- After a sustained period of quantitative easing, and with more deposits than loans, UK high street banks have huge liquidity

- If the unemployment picture turns negative, we are likely to see rising bad debt, despite increased levels of savings

- We think the additional earnings from charging higher rates on loans relative to deposits will outweigh the drag from rising bad debts

The UK is facing numerous headwinds: soaring energy bills, falling house prices, high and persistent inflation, rising interest rates, country-wide strikes across multiple sectors and weaker economic performance than the eurozone. It’s natural as an analyst team that, in the midst of such turmoil, our thoughts turn to how the high street banking sector might fare.

 

Base rate effects


When the Bank of England (BoE) raises the base interest rate, high street banks quickly increase the interest rate at which loans are offered. With the base rate having risen from 0.25% at the start of 2022 to 4% as of 15 March 20231, a household rolling its two-year fixed mortgage this year will find that the interest rate on the loan will likely have moved from somewhere less than 2% to more than 4%.

 

Calculating how much a bank pays out as interest to depositors, however, is less straightforward. This is much more dependent on competition and consumer behaviour. Currently, UK banks are awash with liquidity. The BoE has been pumping money into the system through quantitative easing2 and for the first time in decades there are now more deposits in the UK than loans3. Moreover, unlike SVB and Credit Suisse, the UK high street banks have a high proportion of stable household deposits. Since the banks have sufficient deposits, they aren’t competing for them as keenly as they have in the past, which they would do by offering higher rates of return. When a UK bank increases the cost of borrowing by 1% it will generally only increase the return it pays on deposits by less than 0.5%4. It holds on to the remaining 0.5% as increased revenues.

 

The effects of bad debts


However, as the cost-of-living crisis continues to bite, bad debts are sure to rise among consumers. UK households in aggregate built up savings buffers throughout the Covid crisis when they were unable to go out and spend money how they normally might5. In addition, year ahead wage growth averaged at a high pace of 5.7% in February6. Our research suggests that while this is a hard time for UK households, most have enough wiggle room in their budgets to make them stretch – provided the breadwinners in the family remain employed. Once unemployment kicks in, however, it becomes much more difficult to pay the bills. Unemployment is therefore the primary input into banks’ forward-looking assessments of credit losses.

 

We examined what the impact might be of these two opposing forces – improving earnings and rising bad debt – on bank profits and capital. Our data science team took our analyst models and aggregated them up to the system level. We predicted how much net interest income could grow as rates rise and how much the bad debt charge (cost of risk) could increase as unemployment rises. We were then able to calculate what sector level profitability (ROE: return on equity) and capitalisation (Core Tier 1) would be at each interest rate and unemployment rate (Figures 1 and 2 respectively).

Figure 1: UK banks’ sector level profitability (%)

Figure 2: UK banks‘ capitalisation

Source: UK bank company reports and Bloomberg. As at 15 March 2023 the market is pricing base rates to peak at 4.25% and unemployment to remain below 5%.

As can be seen in Figure 1, the UK is in a sweet spot of low unemployment and higher rates. Higher interest rates have pushed return on equity (ROE) to around 10%, indicated by the green zone. Even if unemployment rises and ROE tips into the orange zones we expect the sector to remain profitable. Therefore, we expect capital (Figure 2) to remain above 13%, which is considered healthy.


Our conclusion from this analysis is that the tailwind from rising interest rates is so powerful for the UK banking sector that it would need a significant move towards higher unemployment to dent profitability, and capital would remain at healthy levels. We are comfortable with the UK banking sector as a whole and given the fundamentals are happy to take exposure to some of the smaller, risker UK banks to benefit from fundamental improvement as earnings grow.

19 April 2023
Paul Smillie
Paul Smillie
Senior Credit Analyst
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UK banks, base rate, bad debts and borrowing … what does it all mean?

1 https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate

2 https://www.bankofengland.co.uk/monetary-policy/quantitative-easing

3 Bank of England, March 2023

4 UK bank company reports, 2023

5 The Guardian, Covid savings: Britain built up second highest level on record in early 2021, 30 June 2021

6 FT.com, UK businesses expect inflation and costs to ease but wages to stay high, 2 March 2023

Important information

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). For marketing purposes.

This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk.  Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.


In the UK:
Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A., registered with the Registre de Commerce et des Sociétés (Luxembourg), No. B 110242 and/or Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

In Switzerland: Issued by Threadneedle Portfolio Services AG, an unregulated Swiss firm or Columbia Threadneedle Management (Swiss) GmbH, acting as representative office of Columbia Threadneedle Management Limited, authorised and regulated by the Swiss Financial Market Supervisory Authority (FINMA).

In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA).  For Distributors: This document is intended to provide distributors with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

 

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Important information

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). For marketing purposes.

This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk.  Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.


In the UK:
Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A., registered with the Registre de Commerce et des Sociétés (Luxembourg), No. B 110242 and/or Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

In Switzerland: Issued by Threadneedle Portfolio Services AG, an unregulated Swiss firm or Columbia Threadneedle Management (Swiss) GmbH, acting as representative office of Columbia Threadneedle Management Limited, authorised and regulated by the Swiss Financial Market Supervisory Authority (FINMA).

In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA).  For Distributors: This document is intended to provide distributors with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

 

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