Lloyds Bank shares could see interest rate bonanza

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It’s fair to say that a lot has changed for Lloyds Bank shares since the mid-1990s. In 1997, the group had an after-tax return on equity (RoE) of 40%. In its latest half-year result, the lender was praised by City for raising its annual RoE forecast from 10% to 13%.

The outlook for Lloyds Bank shares has changed

Analyzing what has changed and what has not changed is instructive. Lloyds needed less than £6bn of equity to generate an after-tax profit of £2.35bn in 1997.

At that time, when the Spice Girls topped the charts and Pete Sampras won Wimbledon, equity was just under 4% of total assets of £158billion.

Equity now stands at £50bn and the bank’s total assets have soared to £886bn. But profits have not kept pace with the growth of the bank’s balance sheet. If they had, then Lloyds would be reporting the highest profits of any company in the FTSE 100 index.

Dividend growth was also a disappointment. The total payout of £0.9bn on Lloyds Bank shares in 2021 was exactly the same as the payout in 1997.

The good news is that favorable winds are blowing in the banking sector.

Inflation and rising interest rates

Lloyds doesn’t have a funding problem – it has £478bn in deposits, up £70bn from a few years ago.

As restaurants were closed and travel was difficult during the pandemic, consumers had few spending options and the savings ended up piling up in bank accounts.

As the bank only offers its loyal savers 0.2% interest on savings, the bank’s annualized interest charges amount to just £500 million on these almost a half a trillion pounds of customer deposits.

The bank can take those deposits and lend the money overnight to the Bank of England earning 1.75% risk-free or buy UK government bonds, which currently yield over 3%. Simply put, Lloyds is not passing on the benefits of rising interest rates to savers and if this continues it will enjoy windfall profits.

Windfall profits are expected to be a net positive for Lloyds Bank shares, although the past two decades have shown that bad bank behavior and poor public relations have been bad news for shareholder returns, while high management continued to leverage bonuses very well.

Will falling property prices affect earnings?

The biggest risk to the company’s outlook is the prospect of an economic slowdown and falling house prices, which will lead to increased write-downs for bad debts.

The cheap mortgage deals and stamp duty holidays that boosted the UK property market during the pandemic have come to an end. Two-year fixed mortgage rates have tripled in the space of 12 months.

This tightening of credit conditions is already having an effect on the market. The most recent figures from the Bank of England show that mortgage approvals, a leading indicator of the housing market, were down 14% year-on-year.

Lloyds’ mortgage portfolio is £310bn and has an average loan to value (LTV) ratio of 40%. Unlike before the financial crisis, Lloyds only has 3% of mortgage balances on an LTV above 80%, as regulators discouraged high LTV lending.

In other words, house prices could drop 20%, and only 3% of the bank’s mortgage borrowers would end up in negative equity. This means that a fall in property prices similar to that observed during the 2008 crisis is not, in itself, sufficient to cause a problem for the bank.

The unknowable risk for Lloyds Bank shares

Instead, the unknowable risk is unemployment. The Bank of England predicts five consecutive quarters of recession, with unemployment, a lagging indicator, starting to rise in the middle of next year.

For context, in the three years following the financial crisis, Lloyds took an £8.9 billion impairment charge in retail banking alone, including £4.2 billion in 2009. vast majority of these impairments came from bad uncollectible debts, such as credit cards, rather than the mortgage book.

Industry data shows credit card borrowing is growing at 13% annually, the highest annual rate since October 2005 (+13.7%) could be a harbinger of trouble ahead.

In response, Lloyds says borrowing on credit is not driven by the cost of living crisis.

Instead, the wealthiest households are spending on non-essential goods like travel, which are up 300% year-on-year and are now back to pre-Covid levels. Analysts’ consensus forecast for the bank shows current expectations for losses well below those suffered as a result of the financial crisis: £1.2bn write-down for the group’s bad debts next year, rising to £1.4 billion in the 2024 financial year.

If these predictions turn out to be correct, then the bank is trading on a price-to-earnings ratio of less than seven times 2023 and 2024 earnings. The expected dividend yield is close to 6%.

Gaining an advantage from rising interest rates means Lloyds Bank shares could outperform the broader market as most stocks are hurt by rising interest rate expectations.

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