UK banks’ risky sweet spot has further to run

Lloyds Banking Group on July 30 pledged to boost shareholder returns, measured by return on tangible equity, to around 20% by 2030. The UK bank is expecting to grow income from lending by around 5%, in terms of a compound annual growth rate, and fees and other revenue in the “high single digit” range. Lloyds said it would make a return on tangible equity of 16% in 2026, and 18% in 2028. Lloyds shares rose 1.3% as of 1009 GMT, to 112.9 pence per share. That steady growth, along with £2 billion of cost cuts, should underpin a plausible 20% return on tangible equity target by 2030. That would support a valuation, in time, of around 2 times tangible book value, assuming a cost of equity around 10%, suggesting Lloyds' current 1.7 multiple is not a stretch. But the target also sends a mixed message to lawmakers. Prime Minister Andy Burnham is looking for ways to boost income in order to cut the cost of living for angry voters. One obvious lever is to hike bank levies. With Lloyds, NatWest and even Barclays now comfortably exceeding their cost of capital, a little bank raid may be hard to resist. UK banks' purple patch may have further to run. Lloyds Banking Group LLOY.L on Thursday said it planned to hike its return on tangible equity from above 16% this year to around 20% by 2030, buoyed by growth and cost cuts. That rests on a bold but plausible combination of lending and fee growth. The danger is that Prime Minister Andy Burnham interprets a healthy sector as fair game for further taxes. Whereas banking peers in countries like Spain benefited as higher rates pushed up lending margins, groups like Lloyds, Barclays BARC.L and NatWest NWG.L typically use swaps to smooth out interest rate moves, spreading income gains over a longer period. Those hedges have added £5 billion in income growth since 2021 for Lloyds. But with that tailwind set to slow over time, banks are under pressure to find other sources of growth. There’s only so much scope to crank up lending. Mortgages margins are thin, and Lloyds' deposits roughly match its loans so CEO Charlie Nunn would have to pay up for the required funding. Still, he expects the rate of loan growth to rise more than nominal GDP, and net interest income to increase by around 5% a year through 2030. It helps that UK borrowers, battered by years of high interest rates and uncertain politics, are hardly over-geared: corporate debt, for example, has fallen by over 20 percentage points of GDP since 2020. The lagged effect of the rate-smoothing "structural hedge", meanwhile, will still grow net income by an extra £2 billion. But that leaves plenty of heavy lifting for other kinds of revenue. Lloyds expects income from fees, payments, and private investments to rise in the high single digit range. That comes from somewhat new areas, like renting property, or technology innovations like tokenised payments, as well as insurance like motor and home protection. Lloyds has some basis to assume it can succeed: "other operating income" has grown by a similar 8% rate since 2021. And while the bank's home insurance market share has grown by 4% since 2021, 20 million of its customers don’t use Lloyds for their protection. International benchmarks are also encouraging: Intesa Sanpaolo ISP.MI, for example, has fees nearly matching interest income. If Nunn hits his targets, other income would only be around half, per Breakingviews calculations.

UK banks’ risky sweet spot has further to run

Context news

Valuation and political risk

Lloyds sees more room to lift returns

Growth, fees and costs would need to do the heavy lifting

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