Outlook for UK banks remains negative

The fundamental credit outlook for the UK banking system remains negative, reflecting the weakness of the domestic macroeconomic environment and its likely continuing effect on the UK banks' financial performance, Moody's Investors Service said in its new Banking System Outlook on the UK.
Moody's expects the sustained weakness of the UK macroeconomic environment to continue to feed through into higher loan arrears with ensuing pressure on profitability and capital from higher loan loss provisions and the raised cost of funding, as well as uncertainty regarding the effect of certain regulatory developments.
"Since the start of the global financial sector crisis in 2007, the UK banking sector has absorbed losses of around GBP 110 bln on loans and securities by the end of 2008, and has raised or arranged around GBP 120 bln of new capital by the middle of 2009. Moody's current rating levels incorporate its estimates of further losses of around GBP 130 bln from the loan books and securities portfolios of rated UK financial institutions, on the basis of its assumptions about the performance of key asset classes, earnings and available capital," said Elisabeth Rudman, Moody's lead analyst for the UK banking system.
These developments have underpinned the change in the weighted average bank financial strength rating (BFSR) of rated UK banks to C- from B over the past 12 months and the weighted average senior debt and deposit rating to Aa3 from Aa1. The ongoing pressure on earnings and capital remains the rating agency's key analytical focus for UK financial institutions. However, Moody's does not expect a large number of further rating downgrades in the UK over the next 12-18 months, given that it has already incorporated estimates of these risks into its ratings.
"Importantly, government support has provided a certain amount of stability to the banking sector through large-scale capital injections, credit guarantees and support for depositors. This has resulted in relatively little change to senior debt and deposit ratings, which Moody's expects to remain stable throughout the crisis," explained Rudman.
The banks will continue to face many challenges over the next couple of years as they work their way through the problems on their balance sheets, Moody’s said. Apart from the asset quality problems and pressure on capital, UK banks face pressures on their profitability (due to the higher cost of deposits and wholesale funding) and depressed revenues. Moreover, Moody's expects regulation and government intervention to remain a key driver for developments in the UK banking sector over the next one-to-three years. EU requirements could potentially lead to significant changes in the franchises of large banks that have received state aid.
As a result, Moody's may need to adjust the ratings of individual institutions that perform worse than under its base-case scenario. The rating agency adds that consolidation, particularly in the building society sector, could drive further rating changes. "Moody's is already taking a conservative view on future developments in the economy," Rudman said.
"However, in the event of the downturn becoming significantly worse than its base-case scenario (which incorporates a 40% peak-to-trough house price fall, 60% peak-to-trough commercial property price fall and GDP contraction of 3%-4% in 2009), Moody's could implement further downgrades of the BFSRs and possibly also the senior debt ratings of some institutions," Rudman cautioned.
Furthermore, Moody's said that any explicit or implicit reduction of the currently extraordinarily high probability of state support, at a time when the intrinsic strength of banks is still low, may result in Moody's further downgrading banks' senior debt and deposit ratings.