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Western EuropeJuly 31 2005

UK banks should go Continental

Storm clouds are gathering above the UK banking sector. Azhar Rizvi recommends taking shelter in continental Europe.
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The UK banking industry has had a golden era in the past few years, with profits and returns showing strong growth. The UK banks are strong globally: in terms of market capitalisation, three are among the 10 largest banks in the world and five are among the global top 100 companies. The significance of the UK banking sector as a whole is undeniable and is largely reliant on success in the home market.

However, strains are emerging in the UK economy. Reduced confidence in the housing market, concerns about the servicing costs of consumers’ record levels of debt (with secured debt at around 110% and unsecured debt at 23% of disposable income), potential tax increases and falling employment are all taking their toll. Consequently, consumer spending seems likely to fall from its seven-year high. The future economic backdrop may be less benign for banks, therefore, with limited scope for revenue growth.

At the same time, competition remains intense. Consumers have a wide choice in all product lines as a result of new players entering the market – including non-financial services companies,, such as retailers and motoring organisations, and overseas firms. Abundance of supply in both consumer and corporate business means that competition for share of volume is affecting margins. For example, the margin between the effective lending rate and base rate has reduced from above 200 to around 165 basis points since 2000.

Double hit on costs

Competition is coupled with a tidal wave of regulation – affecting both capital adequacy and market practice compliance – which seeks increased protection for the interests of consumers, investors and society at large. These developments are demanding board level attention, adding costs to banking, placing additional hurdles to the completion of the sales process, increasing the risks and consequences of any non-compliance, and diverting scarce resources from other development activities. Not only is top line growth going to be tougher but it is also likely to cost more and need careful management.

Cost reduction has also been a significant factor in the successful profit growth of the UK banks. The banks are among the most efficient in Europe, benefiting from a flexible labour market, technology investment, outsourcing and offshoring. Although cost reduction is likely to remain on the agenda for most UK banks, the scope for future cost reduction is likely to be more limited, at a time when bad debt charges are likely to start increasing.

Scope for growth

The UK banking industry is at a turning point, with profit growth set to be yet more challenging. In a highly regulated and intensely competitive world of reduced margins and slower growth, the largest and most diversified institutions will be at an advantage. While UK banks will continue to fight to make organic progress in their home market, they should not lose sight of the opportunities to build through mergers and acquisitions.

The scope for further major consolidation in UK banking is limited. Realistically, there is scope for only small to medium-sized deals in the UK – in mortgages, credit cards and personal. The greater opportunity lies beyond UK shores. The UK banks have proportionately less income from international and non-domestic business than the leading European players. They have been relatively slow to build their businesses in continental Europe and risk missing the best opportunities. In contrast, the European banks are being bolder – for example, Santander’s purchase of Abbey and UniCredit’s acquisition of HVB Group – and are breaking new ground.

Scale, growth potential and increasing convergence make European markets attractive. Compared with some other parts of the world, they are lower risk, are increasingly open to corporate activity and, for the UK banks, represent an underexploited opportunity. With growth in the UK looking like hard work (and given the natural limitations on the size of the market), is it not time for the UK players to reassess their European strategies and pay more attention to the opportunities available in continental Europe?

Azhar Rizvi is a senior manager at Impact Plus, a financial services consultancy, which is part of the Eurogroup Consulting Alliance

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Read more about:  Analysis & opinion , Western Europe , UK