- Ample, stable deposit funding and prudent liquidity management have made rated U.K. banks resilient to banking system, economic, and geopolitical volatility.
- As systemwide deposits fall from their highs, the capacity to compete selectively for deposits, low asset encumbrance, and mature wholesale franchises give U.K. banks funding flexibility.
- Extensive balance-sheet hedging will allow most banks to deal with declining rates, preserving earnings over the next couple of years.
U.K. banks' funding and liquidity profiles are proving to be a credit strength, enabling the banks to plot a course through 18 months of volatility. The glut of pandemic-era deposits led to a stable platform of cost effective, granular funding, and accessible central bank liquidity has provided further ballast to liquidity profiles.
However, the banking system looks set to embark on a long process of normalization. Deposits are beginning to cool as central bank tightening begins, credit growth slows, and depositors start to draw down their excess liquidity. Pandemic era central bank funding to U.K. banks, or the Term Funding Scheme with additional incentives for small and midsize enterprises (TFSME), while not essential to rated banks' funding stability, will begin maturing in 2025, leaving banks with a hole to fill. Some have started paying down these liabilities with excess liquidity, lowering regulatory liquidity coverage ratios (LCRs) from multiyear highs in the process, all while banks look to reinvigorate secured term funding channels that haven't gotten much use in recent years.
We expect rated U.K. banks to cope with these changes, with our ratings on them reflecting this. Liquid asset portfolios are high and concentrated in central bank deposits; asset encumbrance (even accounting for TFSME) is contained; and banks' resilient earnings outlook gives them the financial flexibility to absorb changes in their balance sheets. These strengths will continue supporting the generally high and stable ratings on the country's banks even as the system embarks on the long road back to normality.
After Years Of Growth, Systemwide Deposits Are Cooling Off
Deposit balances in the U.K. financial system now sit 21% higher than at Dec. 31, 2019, with households and corporates (excluding financial corporations) accumulating over £532 billion of fresh balances on top of the 2019 position. The U.K.'s rated banks have been major beneficiaries, adding on £400 billion of deposits through to second-quarter 2023 by our measures (although this measure includes international deposit accumulation).
This deposit accumulation has shifted the balance sheet dynamics of rated banks meaningfully. S&P Global Ratings-adjusted loan-to-deposit ratios now sit below 80% on average--a number that itself masks some more dramatic changes. For example, Nationwide's net loan-to-deposit ratio moved to 95% at April 2023 from 109% in 2019. This is a significant shift in balance-sheet mix, with the rise in deposits reducing the society's reliance on wholesale funding and improving its income sensitivity to rate rises (assuming it can compete effectively to retain these deposits). While Nationwide is the most extreme example, the trend is visible throughout the sector, with loan to deposits for 2022 lower than 2019 across the board.
Evidence of deposit outflows is growing, however. First-half data from the Bank of England has seen an average monthly net reduction in the system's money supply of about £3.5 billion--a combination of seasonal tax payments, selective deleveraging from companies and households, and quantitative tightening. While seasonal factors like tax won't repeat in 2023 given that this is an annual phenomenon, demand for credit from consumers and corporates is subdued, with some electing to run down excess liquidity by repaying loan balances, and quantitative tightening is well underway. Combined, this has seen money supply contract in first-half 2023 after a sustained slowdown through late 2022.
Although the contraction represented less than 1% of deposit supply from the system, it signals that we have likely seen the peak in balances and the start of a slow tapering in systemwide deposits. Indeed, the majority of U.K. banks saw their nontransaction deposit balances fall in first-half 2023, reinforcing this to some extent. As deposit growth tapers gradually, banks will need to prepare themselves for more normalized deposits.
Rated U.K. Banks Sit On Excess Liquidity
As rated banks' deposits have surged, so have their liquidity positions. The average LCR for the sector rose 6% from December 2019-December 2022, leaving major rated banks with a liquidity surplus of more than £500 billion above the 100% LCR level, underpinned by a collective high-quality liquid asset portfolio above £1.4 trillion.
At first-quarter 2023, this portfolio was significantly concentrated in central bank deposits, with the remainder of the portfolio composed of bonds accounted at fair value through other comprehensive income, bonds held at amortized cost, and highly liquid reverse repo market exposures. U.K. banks did record a regulatory capital hit of £8 billion for 2022 from the Fair Value through Other Comprehensive Income portions of their book, representing about 2.5% of total tier 1 capital. This is relatively low overall, and the distance to crystallizing these losses is significant.
So as deposits begin to move around and even out of the U.K. banking system, this surplus liquidity leaves the largest rated banks able to meet the associated liquidity needs. Of importance, we believe that most U.K. banks will compete to retain their elevated deposit bases, meaning that net liquidity outflows will generally be affordable for the sector's leaders even as a rising cost of deposits begins to eat into their net interest margins. To this end, where idiosyncratic outflows occurred in first-half 2023--for instance, at NatWest, which saw a net liquidity outflow from tax payments of £8 billion in the first quarter--they were met. Even in an acutely stressful scenario, we estimate that it would take, on average, an outflow of about 30% of retail deposits for the sector's LCR to hit 100%, or an average outflow of about 80% of wholesale deposits (excluding outliers where the implied ratio is greater than 100%) for the same result. While these implied stresses naturally have their limitations (for example a 30% run on the retail portion of a bank's deposit base would have widespread implications across its business), they imply that U.K. banks have some room to manoeuvre as liabilities in the banking system begin their gradual normalization.
|Liquidity coverage reverse stress test|
|Liquidity coverage ratio components as per bank pillar 3 disclosure|
|Retail deposits and deposits from small business customers||Unsecured wholesale funding|
|As of June 2023 (H1 2023)||LCR %||Liquidity buffer above 100% LCR||Effective outflow rate in LCR calculation||Outflow rate at which LCR = 100%||Effective outflow rate in LCR calculation||Outflow rate at which LCR = 100%||LCR impact following repayment of TFSMEs from high-quality liquid assets|
|Barclays PLC||157||£116 billion||8.8||52.5||51.6||97.3||146.2|
|HSBC Group Holdings||132||$154 billion||10.5||28.4||45.1||64.2||129.4|
|Standard Chartered PLC||156||$64 billion||10.3||53.4||44.5||68.5||156.1|
|Lloyds Banking Group PLC||143||£43 billion||6.9||19.0||48.7||90.0||112.8|
|Nationwide Building Society||183||£25 billion||6.4||19.8||92.0||363.9||126.2|
|Natwest Group PLC||145||£52 billion||7.8||27.7||46.2||77.0||134.6|
|Santander UK Group Holdings PLC||167||£20 billion||6.2||19.7||53.9||130.5||97.8|
|Virgin Money UK PLC||139||£3.5 billion||6.1||12.4||48.4||95.2||61.4|
|Nationwide’s year end is April 4, while its Q1 is to June 30. As such, the information in this table for Q2 2023 represents Nationwide’s Q1 2024 position. LCR--Liquidity coverage ratio. TFSME--Term Funding Scheme with additional incentives for small and medium size enterprises. Virgin Money data for Q2 2023 is as of March 31, 2023. Source: S&P Global Ratings.|
Retail Deposit Funding Anchors U.K. Banks' Balance Sheets
Deposit franchises anchor U.K banks' regulatory net stable funding ratios. On average, retail deposits constitute more than 50% of stable funding sources at half-year 2023, and for U.K.-centric banks with deep deposit gathering businesses, like NatWest, Nationwide, or SanUK, this value is around or above 60%. By contrast, retail deposits represent as little as 34% of total funding for an international transaction bank like Standard Chartered. To this end, wholesale deposit funding provides ballast for major domestic commercial banks and transaction banks alike. For example, international transaction banks' operational deposits, or stable wholesale deposits, form 10%-15% of deposits, reflecting their cross-border payment and trade models.
Wholesale funding forms a bedrock to U.K. banks' funding bases--through wholesale debt and deposit markets--and is an essential source of stability on top of the stable retail deposit funding of rated banks. Given the varying business models of U.K. banks, not all entities use wholesale funding in the same way. Barclays, for example, has a larger wholesale funding base than NatWest given its material trading balance sheet. This results in a greater share of short-term wholesale funding given the role of secured repurchase agreements in creating trading balance sheets.
As Attention Shifts To Wholesale Markets, U.K. Banks Have Long-Term Funding Flexibility
With deposit balances beginning their normalization, we expect U.K. banks will look to wholesale debt markets to support their funding base. This will not revolutionize the system--the industry's pre-pandemic loan-to-deposit ratios show how important wholesale funding has been to the banks. To this end, we see bank balance sheets as having the capacity to accommodate a rising pace of wholesale funding. However, turmoil in the global banking system and rising rates have made this funding more costly, and led to some instability in supply in the past six months, notably following the collapse of Silicon Valley Bank and Credit Suisse. Of note, spreads have widened on banks' additional tier 1 bonds from the start of the year, reflecting a rising risk premium following the write-down of Credit Suisse's notes in April.
Beyond banks' capital instruments, wholesale secured and unsecured funding will be the bedrock of their wholesale funding. Of importance, asset encumbrance excluding TFSME is at multiyear lows for U.K.-domiciled banks, speaking to their limited recent reliance on traditional funding channels that increase encumbrance, such as covered bonds, residential mortgage-backed securities, or asset-backed securities. Still, TFSME has increased encumbrance in that drawings rely on the bank preplacing collateral, typically mortgages, at the central bank. So, if we assume that these drawings are encumbered at a 120% rate at the central bank, encumbrance is actually at a more typical level for many of the U.K.'s major banks, and is actually above pre-pandemic levels for the program's heaviest proportional users, like Nationwide, SanUK, or Virgin Money.
We don't expect the encumbrance from TFSME to undermine U.K. banks' long-term funding plans, and anticipate that fresh secured issuance will offset a steady tapering in TFSME. Indeed, rated banks that were the biggest users of TFSME have begun to repay their drawings in the past 12 months, running down liquidity portfolios that had been in significant surplus. The impact of this has been more normalized LCRs, rather than to create what we see as material changes in balance-sheet liquidity profiles. In fact, we estimate that if banks repaid their TFSME drawings in full using excess cash, their average LCR would still be 130%, £320 billion above the 100% LCR level, although this masks greater liquidity drawdowns for users like SanUK or VMUK, for whom we estimate LCRs post-TFSME repayment from liquid resources below 100%. For rated banks, then, we expect to see TFSME repaid steadily through to the earliest maturities in 2025, with banks using earmarked liquidity and secured wholesale funding to meet these needs. This repayment will also help normalize banks' LCRs through to 2025-2026.
Significant Preplaced Collateral At The Bank Of England Serves As The Last Resort For U.K. Banks
Even if their business-as-usual liquidity were insufficient in an extreme stress scenario, our cohort of rated banks can turn to preplaced resources (excluding assets encumbered by TFSME) in excess of £410 billion at the Bank of England to boost liquidity in a stress scenario. While this only serves as liquidity support in extreme situations, and the actual liquidity value of collateral is uncertain given central bank haircuts, we see this as further evidence of U.K. banks' cautious liquidity planning, their ability to monetize a sizable portion of their asset bases, and an endorsement of the proactive nature of central bank support to the system.
Rapidly Falling Rates Would Dent Earnings For Major Banks, Despite Balance-Sheet Hedging
Although U.K. rates have risen rapidly, medium-term rate expectations remain for a tapering of the U.K. base rate. Indeed, the three-year market implied policy rate is now 4.4%, down 100 basis points from the August 2023 base rate. With falling rates, we expect all U.K. banks to take earnings hits as their interest income compresses and liability costs remain elevated given that deposit repricing lags rate decisions--in essence, a reversal of the tailwinds that have led U.K. net interest income upwards so quickly. The most pronounced hits to capital from falling rates are in the U.K.'s major current account and transaction banking franchises, which saw the most rapid increases in income via rising rates.
Still, a crucial component of bank sensitivity is the extent of balance-sheet hedging. For U.K. banks, this varies, reflecting the nature of their banking franchises and their strategic approach to balance-sheet hedging. In general, the largest and most stable current account franchises have the largest balance sheet hedge positions, but some banks with meaningful current account franchises will run with minimal to no structural hedging. These hedges are invested at fixed rates, so simultaneous downward shifts in rates have no effect on the related interest income.
Even so, from today's elevated positions, declining rates and subsequent fall in net interest income represents a normalization for banks, rather than a radical change in dynamics. Versus the extended period of near-zero rates of the past half decade, we expect that consistently high rates will continue to support income, and we forecast U.K. bank net interest margins to remain above the five-year average in the next 24 months.
What About Smaller Banks?
Through the journey to normalization, we expect divergent experiences in the system. We anticipate that smaller U.K. banks with narrower deposit franchises will have to continue to compete intensely for funding as deposits taper (for more information, see "U.K. Banks Compete Strongly As Rates Climb," published June 16, 2023, on RatingsDirect), much like their small peers in the eurozone or U.S. So, while rated banks face normalization from a position of strength, supporting our stable outlooks on the U.K. and its peer systems' largest banks, others have work to do to maintain their stable funding and liquidity positions.
- U.K. Banks Enjoy Another Strong Half Year As Margins Peak, Aug. 24, 2023
- U.K. Banks Compete Strongly As Rates Climb, June 16, 2023
- U.K. Bank Credit Losses Will Rise Modestly To £5.2 Billion In 2023 As Marginal Borrowers Feel The Strain, April 26, 2023
- Economic Outlook U.K. Q2 2023: Growth Eludes This Year Even As Inflation Eases, March 27, 2023
- Interest Income Fuels Bumper U.K. Bank Profits As Rates Near Their Peak, March 10, 2023
- The 2023 Credit Outlook For U.K. Banks: Higher Rates Buttress Earnings As Loan Losses Rise, Jan. 5, 2023
- Banking Industry Country Risk Assessment: United Kingdom, Dec. 12, 2022
- U.K. Banks' Funding And Liquidity Are On A Solid Footing As They Navigate A Turn In The Cycle, Dec. 1, 2022
This report does not constitute a rating action.
|Primary Credit Analyst:||William Edwards, London + 44 20 7176 3359;|
|Secondary Contact:||Richard Barnes, London + 44 20 7176 7227;|
|Research Contributors:||Joe Hudson, London +44 2071766743;|
|Aashish Mundhra, CRISIL Global Analytical Center, an S&P affiliate, Pune|
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