28 Feb 2011 | Economy

The Financial Crisis - Back to Basics 

The financial crisis has changed the face of banking, writes Jennifer Hill.

Hard as it may be to believe, it’s been almost four years since cracks started to appear in the Western world’s banking system. New Century Financial, an American sub-prime mortgage specialist, filed for Chapter 11 bankruptcy protection in April 2007, and it was not long before the collapse of the sub-prime market was felt around the world.

In September 2007, Northern Rock, the British mortgage bank which relied on money markets (as opposed to savers’ deposits) to fund its lending, was forced to ask for emergency financial support from the Bank of England, leading ultimately to the government stepping in to guarantee savers’ money.

RESCUE PACKAGES

Banks started to unveil colossal losses on their loan books, and in January 2008 global stock markets suffered their biggest falls since September 2001. Soon after, the US government was forced to rescue mortgage lenders Fannie Mae and Freddie Mac, whose lending accounted for nearly half of the outstanding mortgages in the US.

The British government allowed (or possibly even invited) Lloyds TSB to acquire mortgage lender HBOS in a £12bn deal, creating Lloyds Banking Group, a banking giant with one-third of the UK’s savings and mortgage market. Days later, Bradford & Bingley, the mortgage lender, was nationalised. Its savings operations and branches were later sold to Spain’s Banco Santander.

In October 2008, the UK government announced plans to pump £37bn of taxpayers’ money into the Royal Bank of Scotland (RBS), Lloyds TSB and HBOS in one of Britain’s biggest nationalisations ever. A day later, the US government unveiled a $250bn (£143bn) plan to buy stakes in a string of banks, while Icelandic, German and Irish authorities also stepped in to bail out their banks. Others though, were left to go to the wall, most notably Lehman Brothers, the US investment bank. The crisis has shattered the image of British banking stalwarts among private investors – these were once regarded as a safe bet for incomeseekers relying on the shares to maintain capital values while paying a good level of dividend.

STICKY TIMES

Gerald Smith, manager of the Monks Investment Trust PLC, had been wary of banks for some time. Tom Coutts, an investment manager in the European team recalls an ongoing investment debate at Baillie Gifford in late 2006 and early 2007. “The discussion was about whether UK banks were actually good businesses or were just riding a wave of leverage and a property price bubble, which meant their returns were illusory. Gerald was convinced it would all come to a sticky end, and he’s been proved correct.”

Consequently, Monks had very little exposure to banks – and that remains the case today. At the height of the financial crisis, in November 2007, it had 3 per cent in the sector, a figure that now stands at 1.9 per cent. The trust, which invests internationally, holds only US-listed CapitalSource and Brazil’s Itaú Unibanco.

The picture is similar across Baillie Gifford’s other investment trusts. “We were largely unenthusiastic about the (banking) sector three or four years ago, and with some exceptions largely remain so today,” said Tom. “Our scepticism has persisted.”

STOCK-PICKING OPPORTUNITIES

Fund managers have, however, found what appear to be good opportunities – largely overseas banks in countries where take-up of financial products is low and regulators enforce high capital requirements.

“We’re bottom-up investors – stock-pickers – so we look at the case for individual banks,” said Tom. “In general, though, we’re steering away from heavily-indebted Western banks that have had a long run of growth and where gearing (borrowing) levels are very high, and looking towards those in countries where there’s low penetration of financial products and quite rapid economic growth. These are good long-term growth opportunities. That was the case four years ago, and we’ve become more convinced in our view that this is one of the better ways to invest in banks.”

Like Scottish Mortgage, EWIT currently holds Banco Santander of Spain and Turkey’s Garanti Bankasi. It also owns shares in Indian mortgage bank HDFC and Brazil’s Itaú Unibanco. Scottish Mortgage also holds ANZ Bank of Australia, HDFC, South Africa’s Standard Bank and China Merchants Bank. And SAINTS holds Itaú and Standard Bank, as well as Singapore’s DBS Group, Svenska Handelsbanken, of Sweden, and New York Community Bancorp of the US. However, British holdings are few, and selected for their significant exposure to emerging markets.

NEW PLAYERS

Scottish Mortgage and Monks have also bought into NBNK Investments, the banking venture of Lloyd’s of London chairman, Lord Peter Levene that raised £50m in a stock market listing in August. NBNK is one of a clutch of new banks that have sprung up to take market share from Britain’s ‘Big Four’, HSBC, Barclays, Lloyds Banking Group and the Royal Bank of Scotland Group.

Other new entrants looking to break into UK retail banking include Metro Bank and Aldermore, while Virgin Money and Tesco Bank are poised for expansion. Metro, which launched in July 2010 (the first consumer bank to enter the market since the Co-operative Bank in 1872) is trying to win market share by staying open for longer hours, seven days a week and by providing superior customer service.

Appetite for new banks is strong. A YouGov survey for Deloitte in November 2010 revealed that almost one-third of consumers wished there were more high street banks to choose from. However, with a fifth more concerned about the safety of the banks than they were a year ago, newcomers will have to position themselves carefully.

Neil Tomlinson, head of retail banking consulting at Deloitte, said: “There is great potential for new entrants but they will have to get their service offering spot-on to take business away from the established players.”

TRADITIONAL VALUES

While some people might be attracted to the flexibility of banking with Tesco, which offers customers the chance to bank while picking up groceries in open-all-hours supermarkets, Tom believes that banks with traditional or family values will fare best. Santander, for example, is chaired by Emilio Botín, the fourth generation of a Cantabrian banking family. His daughter, Ana Patricia Botín, became head of its UK operation in December last year.

“It’s essentially a family business,” said Tom. “The family only owns a few per cent of the shares, but that accounts for the vast majority of their wealth. They’re interested in handing it down from generation to generation, which means they manage the business in a very long-term way.”

His top stock pick, though, is Svenska Handelsbanken. The Swedish bank, founded in 1871, has more than 700 branches worldwide, of which over 80 are in the UK. “It’s like an old-fashioned community bank, with Captain Mainwaring-style bank managers who know their customers. People in the branches are responsible for lending money out and getting it back, rather than it all being done through some centralised system,” Tom said.

Tom believes the bank could double or treble in the UK over the next five years. “In my view, it’s the best bank in Europe and its model is proving very popular here.” In the aftermath of a crisis that brought the UK’s banking system to its knees; that is hardly surprising.

Figures on portfolio holdings correct as of 31 December 2010

Please remember that ongoing stock market conditions and currency exchange rates will affect the value of investments and any income from them. Investors may not get back the amount invested.

Investing in emerging markets is only suitable for those investors prepared to accept a higher level of risk. This is because these markets could go down or up more than the main international markets.

Jennifer Hill
is an award-winning British journalist and started her own media consultancy, mediahill in January 2010. She is the former deputy Money editor of The Sunday Times and personal finance editor of The Scotsman.

Jennifer also writes a regular Trust Online column, Capital Hill, which you can read here.