Will Lloyds fall behind NatWest in this downturn?
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Will Lloyds fall behind NatWest in this downturn?

As a long recession looms for the UK, past successes may be a sign of future problems.

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In the UK’s last economic crisis, 15 years ago, taxpayers spent tens of billions of pounds bailing out the then newly formed Lloyds Banking Group, as well as Royal Bank of Scotland – or NatWest, as it is now known.

The memory of those events lingers in financial markets and in society. Lloyds’ problems, however, proved easier to resolve than those of RBS, even if Lloyds’ restructuring was an extremely stressful process as well.

By the mid 2010s, Lloyds was free from government ownership and one of the most profitable banks in Europe.

Alison Rose, NatWest

Are NatWest's and Lloyds' relative fortunes about to turn?

NatWest has been through an epic restructuring over the past decade and a half: going from, at one point, the world’s biggest bank, to now little more than a UK retail and commercial bank. Its balance sheet has shrunk by two thirds, while its corporate and investment bank is a shadow of its former self.

Even today, NatWest’s restructuring is not completely finished, as chief executive Alison Rose tries to extricate the bank from the Republic of Ireland by winding down Ulster Bank.

But with the UK now facing its most serious economic challenge since 2008, there is hope that NatWest could do better this time.

While sell-side analysts are more bullish on banks in general than the buy side, it is notable that the former think Lloyds will be less profitable than NatWest in 2023, even if Lloyds is still slightly more profitable in 2022.

Higher rises

There has certainly been an impressive change in the sell-side consensus outlook for profitability at NatWest.

Since the mid 2010s, Lloyds has tended to earn comfortably above a cost of equity usually modelled at 10%. NatWest (or RBS, as it was until 2020) has typically fallen well short of 10%.

In 2022, however, NatWest has seen higher rises in future consensus earnings than any other big European bank, according to Citi.

Third-quarter results showed that – when in doubt – investors still tend to penalise NatWest more than its domestic rival

In early 2022, NatWest’s management was still signalling a return on equity of barely more than 10% in 2023 and 2024. Now, thanks to higher interest rates, they are expecting return on equity in the mid-teens, and many analysts (including those at Citi) are expecting more than 17%.

If Lloyds did less well than NatWest over the next few years, however, it would not just be because NatWest’s restructuring is almost over. Rather, it would be primarily because Lloyds is less exposed to the benefits – and more exposed to the downsides – of higher interest rates.

That is arguably partly because NatWest’s restructuring took longer.

As Lloyds moved on from the previous crisis more swiftly, it was able to focus better on improving its returns, including in its trading book, and building up in areas such as unsecured lending and car loans, as Bank of America analyst Alastair Ryan notes.

Indeed, under former chief executive António Horta-Osório, Lloyds spent £1.9 billion buying credit card company MBNA in 2017, for example.

Charlie Nunn, Lloyds Banking Group

In 2021, Horta-Osório handed over to the less charismatic CEO Charlie Nunn. Yet Lloyds’ unsecured book remains much bigger than NatWest’s small business loan book: about £40 billion versus less than £10 billion, according to Ryan.

Larger unsecured lending served Lloyds well during a period of relatively good economic growth and low rates. And it could prove good again if low rates return and the recession proves short-lived. Today, however, much higher rates and a cost-of-living crisis will inevitably lead to a higher cost of credit in areas such as credit cards.

Small business lending is another risky area, and NatWest has a higher share of this than Lloyds. Lloyds, too, has appeared more conservative on provisions for credit losses than NatWest in 2022.

Small business benefits

But the legacy of the government’s Covid-era Bounce Back Loan programme is one factor in NatWest’s favour. This will provide banks with some protection from the riskiest small business borrowers, as some of this borrowing is now state guaranteed.

At a time of higher rates, NatWest’s bigger market share than Lloyds in small business customers – partly thanks to the quiet demise of its SME carve out, Williams & Glyn – is also of greater benefit than credit cards in terms of the cheap deposit base it brings.

Yet investors are still wary.

At NatWest, there is still the stigma of government ownership, even if this fell slightly below a majority early in 2022. There is also no government share-sale overhang at Lloyds, whereas at NatWest there is the real risk that the government may dump a big chunk of shares on the market at any time.

Partly because of the stigma of state ownership and the memory of past problems, a lack of clarity on the trajectory of NatWest’s cost base went down particularly badly in its third-quarter results. The stock was down 9% in a day.

Compared with 15 years ago, Lloyds and NatWest are now very different animals in terms of the size and focus of their businesses, and their risk appetite in areas such as commercial real estate. NatWest’s restructuring has been even more severe.

Third-quarter results, however, showed that – when in doubt – investors still tend to penalise NatWest more than its domestic rival.

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