Banks in better shape to cope with UK CRE price drops

Falling UK commercial property prices are likely to put pressure on several domestic and Irish banks, although the reduction of their exposure to the sector in the last five years means that their capital provisions have materially improved, according to an analyst report published by JPMorgan Cazenove.

Based on the investment bank’s analysis, the sensitivity of tangible net asset value (TNAV) to stress scenario losses of 30 percent could be up to around 5.5 percent for Lloyds and Royal Bank of Scotland, albeit a manageable 90 to 100 basis points of CET1 capital.

CET capital is a measurement of banks’ core equity capital compared to its risk-weighted assets and is a measure of their financial strength.

Banks have broadly maintained prudent underwriting standards in recent years, the report said. UK bank and building society exposure to CRE has reduced from more than £150 billion in 2011 to £86 billion today, with capital positions also materially improved.

JP Morgan Cazenove set out individual bank level exposure to CRE and showed the sensitivity of TNAV to stress scenario losses. The investment bank said that it is cautious on domestic-exposed UK banks, but noted that Standard Chartered, HSBC and Barclays are relatively less exposed.

In its sensitivity analysis, JP Morgan Cazenove extrapolated the Bank of England’s (BoE) 2014 stress test losses to the banks’ current CRE exposure. The BoE’s 2014 findings tested the prospect of CRE prices dropping 30 percent leading to three-year cumulative losses of between 5 and 20 percent.

JPMorgan Cazenove’s findings on an individual bank level were:

  • Lloyds has total UK CRE exposure of £18.1 billion. The 2014 BoE stress test estimated three-year cumulative impairment charges of 16 percent. JP Morgan Cazenove estimated an impact of TNAV of 5.5 percent and an impact on CT1 of 100 bps.
  • RBS has a total UK CRE exposure of £25.2 billion and an 11 percent estimated impairment charge according to the BoE’s 2014 stress test. JP Morgan Cazenove’s estimate is a TNAV impact of 5.5 percent and 90 bps CT1 impact.
  • Barclays has total UK CRE exposure of £11.6 billion and a 5 percent estimated impairment charge in the BoE 2014 stress test. JPMorgan Cazenove estimated TNAV impact of 0.9 percent and a CT1 impact of 10 bps.
  • HSBC has £13.7 billion of exposure and a 7 percent estimated impairment charge in the BoE stress test. JP Morgan Cazenove’s estimate is 0.6 percent TNAV impact and 0.1 percent CT1 impact.
  • Bank of Ireland has £3.9 billion of exposure and was subject to an 8 percent estimated impairment in the BoE test. JP Morgan Cazenove estimates 3.5 percent TNAV impact and 0.5 percent CT1 impact.

The 2016 stress test will assess the UK banks for a 42 percent decline in UK CRE prices, which JPMorgan Cazenove expects would remain an overhang on banks with material exposure. The investment bank said that it views the reduction in the counter-cyclical buffer to zero percent from 0.5 percent, announced by the governor on 5 July, as a marginal positive given the negative outlook for asset prices, which is likely to be a bigger driver of bank lending standards.

JPMorgan Cazenove calculated the main UK and Irish banks’ exposure to UK CRE at FY15 as:

  • Barclays: 11.6 percent (43 percent average LTV, 24 percent of TNAV)
  • Lloyds: 18.1 percent (46 percent of TNAV)
  • RBS: 25.2 percent (66 percent average LTV, 66 percent of TNAV)
  • HSBC: 13.7 percent (12 percent of TNAV)
  • CYBG (Clydesdale Bank and Yorkshire Bank): 0.5 percent (18 percent of TNAV)
  • Bank of Ireland: 3.9 percent (58 percent of TNAV)

The firm provided a comparison with the banks’ CRE exposure as a percent of TNAV back in 1H 2011. Barclays was at the same 24 percent level, while Lloyds was 105 percent, RBS was 79 percent and HSBC at 16 percent.

While the major UK banks have £69 billion of CRE exposure, smaller banks and building societies, including challenger banks, have exposure of £17 billion at higher loan-to-value ratios, the research warned, including 31 percent at higher than 70 percent LTV.

Referring to the asset managers which have halted redemptions in their open-ended UK CRE funds in the wake of the Brexit vote, JPMorgan Cazenove noted the BoE’s warning in its Financial Stability Report that the behaviour of open-ended funds could amplify any market adjustment in prices. Open-ended funds account for £35 billion of assets under management, equating to around 7 percent of total investment in the UK CRE market.

The report also referred to the Bank of England’s warning that an amplified adjustment in the CRE market could affect economic activity through the widespread use of CRE as collateral for corporate borrowing. Bank of England research indicates that for every 10 percent fall in UK CRE prices is associated with a 1 percent decline in economy-wide investment.