By Scott Wright

HIGHER interest rates and looming recession will curb demand for banking services such as loans and mortgages in 2023. But the outlook for the UK’s major banks has been brightened by the higher cost of borrowing and the prospect of looser regulations in the City of London, analysts have told The Herald.

Michael Hewson, chief market analyst at CMC markets, said the UK’s major banks entered 2023 after profits held up well in 2022 despite widespread challenges in the economy. But he said there are concerns 2023 could prove to be even more challenging for households.

Mr Hewson told The Herald: “As we look ahead to 2023, I think it’s clear that while rising interest rates are good for bank margins and certainly there has been an improvement there, the flip side is demand for loans and mortgages is likely to slow.

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“We are already seeing that in lower mortgage approvals, while the banks themselves are starting to batten down the hatches with higher loan-loss provisions. The air is starting to come out [of] the housing market and valuations are coming down. That seems eminently sensible.”

Mr Hewson said the prospect of higher energy bills and further pressure on consumer budgets this year may “impact demand for banking services”, albeit the most recent figure for annual UK consumer prices index inflation pointed to a slightly lower rate of increase.

He added: “If the Bank of England is right and the UK is about to enter a two-year recession, then the banks could find that 2023 is even more challenging than 2022.”

John Moore, senior investment manager at RBC Brewin Dolphin, said recent increases in the base rate by the Bank of England to counter inflation have given banks the opportunity to improve their net interest rate margins at a scale not seen since before the financial crisis of 2008/09. The base rate has increased from 0.1 per cent in December 2021 to 3.5% following a series of rises throughout 2022 as the Bank sought to put the brakes on surging inflation.

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Mr Moore said the banks’ income-earning potential had been constrained in the decade and more that followed the financial crisis, noting that there had been a “limit to what net interest margin they could achieve”.

But he declared: “Now, the shackles are off for those limits.”

Meanwhile, asked if he anticipates banks making provisions for loan defaults amid the challenging economic conditions this year, Mr Hewson replied: “Yes, without a doubt. You have to. Even if the worst-case scenario doesn’t play out you have to, for purposes of being pragmatic and sensible. You can always basically funnel them back in like they did last year (2021) with their profits. As a result of the pandemic, they set aside large provisions for non-performing loans. When those losses did not materialise, they basically rotated them on to the balance sheet. The same thing could play out [in 2023]. But for the next 12 months I think it is going to be a very cautious outlook for UK banks.”

Mr Hewson said he does not envisage the base rate increasing beyond 4% in 2023 as he expressed the view that inflation will come down this year.

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“The bigger question will be how long rates stay at current levels,” he added. “I think they are likely to remain at current levels for quite some time. Certainly, if the ECB (European Central Bank) is right, we are talking 2025 before rates start to come down.”

Meanwhile, both Mr Hewson and Mr Moore said the Edinburgh Reforms announced by Chancellor of the Exchequer Jeremy Hunt before Christmas to loosen financial regulations in the City of London and boost the competitiveness of the industry could be seen as a positive development, albeit they will not have an immediate effect as legislation still has to be brought forward.

The proposed changes include reforming the ring-fencing regime that separates the retail and investment operations of banks, initially brought in to protect consumers from the riskier elements of banking activities.

Mr Moore said of higher interest rates and the Edinburgh reforms: “Those two things are tailwinds, whereas for the previous 12 years they were headwinds. That is a significant, positive change for the sector.

“That has to be acknowledged as being something that should influence 2023 positively. It should also change the way [people] view the banks going forward. The last decade has been consigned to the history books and it is a different environment going forward.”

But he added: “The only caveat to that is that the environment going forward will be one where the economy will not enjoy a particularly great 2023. That is the headwind, that is the downside to that positivity.”

While some critics have argued that Mr Hunt’s proposals to loosen regulations in the City of London, via the Edinburgh Reforms, could see a culture of risk-taking return to the financial services industry, Mr Moore said: “I don’t view that as something that will result in a step change in behaviour. There was a lot of reform in the aftermath of the credit crunch, but part of that was cultural reform as in, what business do you write? How do you do business? That culture remains and is in a sense self-regulating.”

He added: “I don’t think you will find anybody under SMCR (senior managers and certification regime) or any regime of accountability really wanting to thrash at it.

“Now, might that change in 10 to 15 years’ time as people forget about the lessons of the past and try and push things a bit? Yes, undoubtedly something like that will happen. But the history books are full of that. That is part of that cycle of capitalism.”

Mr Hewson said: “To be quite honest, I think the risks are overstated. Lloyds, NatWest, they don’t have big investment banking operations. NatWest doesn’t have big investment banking operations anymore, and the reforms were designed to basically free up the smaller banks so that they did not have to conform to them in the same way.

“They haven’t relaxed them completely, so I think there is enough wriggle room there. Ultimately, the banks are much better capitalised now, so I don’t think there is the same sort of gung-ho attitude towards risk now as there was then.

“I think lessons have been learned, but I think the sledgehammer to crack a nut approach which penalised smaller banks like Metro Bank, Starling Bank [and] Virgin Money were unnecessary, because none of these banks had big investment banking operations. Let’s not forget, it wasn’t just investment banking that caused the problem, it was also an over-leveraged mortgage market. It wasn’t just about investment banking; it was basically about bad lending practices, lending money to people who couldn’t prove that they earned the income they said were earning – 110% mortgages, 120% mortgages … don’t pretend to me it was all to do with investment banking. It was not.”