RBS Is Getting Healthier, But Its Biggest Market Isn't

(Bloomberg Gadfly) -- The U.K. economy is cooling and Brexit hasn't even happened yet. The outlook for business investment is getting worse, according to the Bank of England, while real wages are falling.

The country's big banks, though, seem to be doing just fine, as Brits keep loading up on debt, spurred on by cheap rates. This doesn't feel sustainable: Central bankers, ratings agencies and executives are getting jumpy. There's an ominous feeling in the air that the British economy is ordering a fresh round of drinks at the pub instead of going home to sober up. Bullish bank investors should take note.

Royal Bank of Scotland was the latest U.K. bank to report results on Friday, and like domestic rivals its core lending business is growing -- net interest income in the first six months of the year picked up to 4.5 billion pounds ($5.9 billion), from 4.3 billion pounds.

These banks have different target markets and aren't all making a push in consumer loans; the credit-card sector, for example, has attracted investment from Lloyds but criticism from RBS. Yet they are all pumping out more loans in a slowing economy to defend market share and help offset pressure on margins from low interest rates.

It's not just the big banks. Britain boasts over 40 upstart challenger banks looking to make their mark. Virgin Money Holdings U.K. Plc, for example, reported a 14 percent jump in net interest income for the first six months of 2017. Its shares fell last week after warning of "areas of weakness" in the housing market.

This is still a benign environment in terms of credit risk, to be sure, with loan impairments historically low and banks' balance sheets less-bloated than a decade ago. RBS shares rose as much as 5 percent on Friday, testament to the bank's efforts in cutting costs and gradually working its way through litigation bills. Lloyds, despite disappointing investors with more provisions for past misconduct in payment protection insurance, still boasts a stock-market valuation that's higher than the European average, according to Bloomberg Intelligence.

But it's hard to see how long the combination of juicy revenue growth and low loan losses can last. BOE chief Mark Carney has warned of a "spiral of complacency" in consumer lending; the central bank is trying to gently curtail the market without killing it. It raised capital requirements for U.K. lenders in June and this week said it will stick to a plan to end in February a special ultra-cheap cash facility to spur bank lending. It has also tightened mortgage affordability rules. The point is to restrict lending, and a hit to profitability can't be too far behind. 

Borrowers are also becoming increasingly stretched: The ratio of household debt to disposable income is the highest in over 5 years, according to Bloomberg data. The pound's weakness has raised the cost of imported goods. Companies don't seem very confident, judging by the central bank's cut to its business investment forecasts. 

The support to margins from re-pricing deposits, hedging strategies and central-bank funding schemes will run out of steam. If there's a cyclical downturn in store as well as regulatory tightening, banks will feel the strain. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Lionel Laurent is a Bloomberg Gadfly columnist covering finance and markets. He previously worked at Reuters and Forbes.

To contact the author of this story: Lionel Laurent in London at llaurent2@bloomberg.net.

To contact the editor responsible for this story: Jennifer Ryan at jryan13@bloomberg.net.