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British banks ready for Brexit but face profitability squeeze, says S&P Ratings

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British banks ready for Brexit but face profitability squeeze, says S&P Ratings

British banks can cope with uncertainties surrounding Brexit, but tough competition in the mortgage market, weakening loan demand and slowing growth prospects could squeeze profitability, according to S&P Global Ratings.

In its report, "Limbo State Lingers for U.K. Banks," Ratings said its base-case economic forecast assumed that the U.K. will not leave the European Union without a deal. U.K. bank ratings would remain broadly stable under this scenario, it said.

However, on Aug. 28, the day the report was published, the U.K. government said it would suspend Parliament shortly after MPs returned in September. This would reduce the time MPs have to try to pass legislation to prevent a no-deal Brexit on Oct. 31, when the country is due to quit the EU. Prime Minister Boris Johnson has said the country will leave the EU on that date with or without a deal.

Ratings said in its report that a no-deal scenario that resulted in severe macroeconomic weakness could lead to rising personal and corporate U.K. insolvencies and weaker collateral values. This would eventually affect bank asset quality, undermining earnings and possibly capitalization, too.

"In that kind of no-deal scenario, we see outlook revisions as more likely than downgrades in the near term and, in our view, these factors would be relatively greater for smaller lenders, given their business focus on U.K. retail banking or property-related lending," said S&P Global Ratings.

The rating agency said recent half-year results showed the big U.K. banks were in a good position with robust asset quality metrics, stable capital, and healthy liquidity and funding. It said that capital distributions have increased as banks look to prioritize investor returns during a broadly benign period. Barclays PLC and Lloyds Banking Group PLC have announced dividend increases, with Lloyds and HSBC Holdings PLC executing buybacks, while Royal Bank of Scotland Group PLC has announced its second large special dividend.

Pressure on margins

However, Ratings said narrowing net interest margins have led banks to report lower operating revenue growth, and despite banks reporting stable earnings in the first half, lower profitability could result from pressured margins and slowing loan demand.

U.K. banks with more limited international diversification have tended to experience larger revenue declines and could face particular disruption in a no-deal scenario due to their focus on the U.K. market. Santander UK Group Holdings PLC and RBS both posted pronounced falls in operating revenues of around 8% in the first half of 2019 compared with a year earlier.

Banks' corporate clients have delayed investment decisions, resulting in higher deposits and moderating loan growth as business and consumer confidence reached five-year lows, the agency said.

S&P Global Ratings said banks’ management would counter pressure on margins by focusing aggressively on cost control rather than increasing risk appetite. It said relentless competition in the U.K. mortgage market has squeezed net interest margin for many quarters, and the agency said this could intensify as additional headwinds emerged.

It also said "exceptionally low and inverting yield curves" — indicating that investors expect slower inflation and tepid economic growth in future had increased the pace of erosion on lenders' net interest margins. Ratings also said banks with insufficient margins risked being left behind in the crucial field of technological development.