Secure Trust Bank — Resilient numbers

STB’s H120 results reflect the impact of the lockdown and sharp slowdown in the UK economy. Loan balances declined by 3% from the end of 2019 and impairments doubled (if we add the charges resulting from loan holidays). STB still managed to post a pre-tax profit of £5.1m and a return on equity (ROE) of 3.0%.

Operating income grew 4% y-o-y. Net interest income grew 10.5% y-o-y and this compensated for the 36% decline in fees due to the fall in new business generation.

In the Motor Finance portfolio, 18% of loans were given payment holidays; the figure was 2.5% for Retail Finance. STB has followed government guidance on the matter of payment holidays. Under IFRS 9, it has already made impairments on estimates that some of these loans will eventually default. The change in contracts to incorporate these payment holidays led to a £3.6m deduction in the value of the loans and this was accounted in H120. These are related to an alteration (delay) in the timing of the contractual payments.

Loan impairments jumped from 1.7% of loans in H119 to 2.6% of average loans as they rose by 76% y-o-y from £17.9m to £31.5m. If we add the £3.6m losses from the payment holiday-related loan value adjustments, total impairments and losses were 2.9% of average loans.

The significant increase in impairments was mostly in the Motor Finance portfolio (from 5.2% of loans to 11.1%) and Retail Finance (from 2.7% to 4.0%). These numbers include losses from payment holiday contract adjustments. The outcome is likely to have been worse in Retail Finance if STB had not started to cut back on risk in this portfolio early in the crisis in February.

Management was able to make significant reductions in operating expenses. These came in £8–9m below our pre-crisis forecasts, falling to £44.7m from £45.5m in H119. Some of this was cutting back on certain investments. This is another example of STB’s nimble reaction to changing market conditions and the cost savings helped it avoid reporting a loss in H120. The cost to income ratio fell from 56% to 53%. The bank’s income before impairments rose 12% y-o-y in H120.

STB’s CET1 ratio strengthened from 12.7% in H119 to 13.5% due to a reduction in risk and the dividend suspension. The loan to deposit ratio rose from 114% to 119%, but balance sheet liquidity remains good and the cost of funding is now coming down with the policy rate cut.

STB had a very good start to the year before COVID reared its head. Along with the tightening credit criteria and additional underwriting that started in February, the lockdown led to a general decline in lending balances which, although up 4% y-o-y, declined by 3% from the end of 2019 (FY19). New loan origination in the first half of 2020 fell by 31% y-o-y to £488m and led to the aforementioned significant reduction in fee income in the period.

STB’s Real Estate Finance portfolio is its largest one and represents about 40% of its loan book. Real estate loans grew 18% y-o-y and 7.8% since end of 2019. This robust performance boosted STB’s overall performance and offset declines in the other portfolios that were more sensitive to the lockdown. The portfolio benefits from being significantly weighted towards modestly leveraged residential investment lending – the investment to development lending ratio is 70–30%. The portfolio average LTV of around 60% has been relatively stable in recent periods. However, we note that 11.6% of borrowers in this portfolio were offered payment holiday on loans amounting to £126m (about 12% of total Real Estate loan balances).

In contrast to Real Estate Finance, the Commercial Finance, Motor Finance and Retail Finance portfolios fell by 24%, 11% and 6% respectively in the six months to 30 June 2020.

Commercial Financing at STB is essentially invoice discounting and the shortest duration of the various portfolios. As such, it quickly felt the impact of lower client business volumes. Fortunately, the reverse is also true and with the end of the lockdown, there has been a rapid pick-up in business. The Commercial Finance business has also been providing Coronavirus Business Interruption Loans (CBILs) and Coronavirus Large Business Interruption Loans (CLBILs). These business loans are 80% guaranteed by the UK government and form part of the aid packages set up to help businesses through the downturn.

Before car dealerships were allowed to reopen in early June, used cars sold on credit at the point of sale in the UK fell by 63% y-o-y in the three months to end May. The slowdown was severe and STB temporarily stopped writing any new Motor Finance loans in March. STB restarted used vehicle stocking loans in June and £1.2m in loans was made that month.

Increased internet sales helped soften the blow from store closures in STB’s Retail Finance division. However, sports & leisure was the only one of STB’s three retail subgroups that saw increased volumes – both furniture and jewellery volumes fell. STB’s market share remained stable within retail stores and online credit.

There is still much uncertainty regarding the depth of the downturn following the lockdown as well as the shape of the recovery. Exhibit 4 shows the IMF forecasts (latest from June 2020) and the average of independent forecasts collected by the Bank of England (July 2020).

The midpoint of expectations is not very dissimilar to many other more developed European countries: a sharp recession (9–10%) with a significant rebound (c 6%) in 2021, albeit from a lower base. Private consumption forecasts are relatively similar to those for GDP.

Forecast unemployment is 8.1% at end of 2020 and then drops to 6.4% in 2021. The latter is still 2.6pp higher than the 3.8% unemployment rate recorded at the end of 2019 before the crisis. Unemployment is a key issue for banks during recessions. As much as banks are willing to restructure a loan to improve the prospects of repayment, borrowers experiencing an extended period with insufficient or no sources of income are a real challenge, which leads to more loan impairments in the banking system.

Furthermore, there are still question marks about a post-Brexit trading arrangement (or lack of) with the EU. If the UK had to trade with the EU under WTO rules it would be a further headwind for the economy, coming at an unwelcome time.

The benign inflation outlook and staggering economy suggest that interest rates will remain very low in the coming years. Indeed, this is what the market is pricing in with yield curves. Very low interest rates can have an adverse effect on banks by compressing lending margins. However, this is likely to be a boon for STB. On the asset side, only some of its current lending is linked to variable rates (mostly in the Business Finance portfolio) and thus negatively affected. There is a real benefit on the liability side since the very low policy rates help smaller banks such as STB to reduce the funding cost disadvantage compared to the larger commercial banks.

STB believes that it will keep its credit criteria ‘tight until the extent of the economic impact of the pandemic is clearer’. In the Business Finance division, the bank expects to keep supporting its clients through this difficult economic time. In real estate, it expects to continue to grow the loan book, ‘managing [its] appetite in respect of new lending opportunities’.

The bank expects Commercial Finance to continue its recovery after the initial rebound in June this year. This is one of the segments that STB had earmarked for strong long-term growth. STB will continue to offer CBILs and CLBILs facilities to help drive more business and further increase their presence in this market. STB’s comments were relatively bullish for this segment: ‘with lockdown restrictions easing allowing businesses to resume trading and some financial sponsors eyeing opportunistic M&A, we expect a strong new business performance in the second half’.

STB reported that the number of Consumer Finance customers has increased despite the lockdown and this should help grow volumes as market conditions normalise. The recovery seems to be quicker in Retail Finance compared to Motor Finance. STB said in its statement that retail sales in the Retail Finance business were back to pre-COVID levels in July. The bank is investing in this business to improve services in areas such as ‘telephony systems, customer application processes, and increased functionality for customers using our online portal to help them self-serve their needs’.

Although STB has restarted writing business in near-prime motor finance since July, it has done so with restricted lending criteria and partners. It expects to ease these restrictions as the economy picks up, but Motor Finance loan balances will still likely fall in the second half of 2020 and there is an overhang from loans being on payment holidays. Nevertheless, Motor Finance remains a key engine for future long-term growth and the plan remains to expand into the prime motor credit segment with the V12 Vehicle Finance brand and a broader product range. STB continues to invest in the technology platform to deliver this (£7.8m invested since 2018). Planned product development includes development of Prime Hire Purchase and Personal Contract Purchase (PCP) products, and technology integrations with key providers of dealer management systems and auction partners.

STB feels ‘it is too early to say to what extent the reduced collections activity during the COVID-19 pandemic will impact the longer term collections performance in its Debt Management portfolio, but following an initial decrease we expect collections levels to recover’. The expected increase in default levels in the consumer lending market should provide a good tailwind in this segment.

Both Consumer Mortgages and Asset Finance continue to be in run-off mode, with no expected new lending in the foreseeable future.

Under IFRS 9, banks use the expected credit loss (ECL) model in which they have to assess probability of default (PD) along the entire life of a credit. This conservative approach has its advantages, but does not mean it is necessarily easy to implement or accurate and there is a risk of overstating losses.

Regulators in the UK and Europe have encouraged banks to account all central bank relief measures and programmes and government supporting actions in assessing future losses. The Bank of England also introduced a helpful measure in March that eased rules on covenant breaches – if a particular breach would not have been caused if it were not for COVID, the bank can waive the covenant breach and does not have to make an impairment.

Since the introduction of IFRS 9 in 2018, banks have been allowed to add new Stage 1 and Stage 2 provisions to their statutory capital for a transitional period of five years. In this period there is a sliding scale for the proportion of new provisions that may be added back. This started at 100% in 2018 and ends at 25% in 2022, and has now been extended for two years. This means that 100% of new Stage 1 and Stage 2 impairments will be added back to capital this year and next year. Otherwise, the scale would have been 70% and 50%, respectively for FY20 and FY21. This helps reduce the impact of higher expected credit losses on capital.

Other Bank of England regulatory measures include offering banks long-term funding at rates at or close to 0.1%, easier bank liquidity facilities, term funding schemes with incentives for companies, corporate financing facilities and easier prudential and supervisory rules. The latter two include measures such as a reduction of the countercyclical buffer in required bank capital, cancellation of the annual bank stress test and easing regulatory compliance procedures.

In its ECL modelling, STB found that its Retail Finance and Motor Finance divisions are sensitive to ‘reasonable’ changes in PD assumptions. STB disclosed in its interim statements that a 10% change in PD for Motor Finance and Retail Finance would have led to additional impairments of £1.7m and £2.2m on the H120 numbers (total reported group impairments were £31.5m).

STB also disclosed that the Motor Finance portfolio was the only one that was also sensitive to ‘reasonable changes’ in assumptions regarding the loss given default (LGD). This is because used car prices can be volatile in an economic downturn, which affects collection values and the effective loss. STB estimates that a 20% change in the LGD for Motor Finance would have resulted in £2.5m extra provisioning in H120.

In its interims statement, STB also disclosed a range of forward-looking scenarios that it uses internally under IFRS 9 to help it set provisioning levels. The scenarios and their weightings help calculate PD and the consequent ECL. Exhibit 5 shows the four scenarios with varying levels of unemployment and house price movements, which reflect different degrees of severity in the economic recession.

STB estimates that if it had changed the weightings of the above to 100% severe case, it would have resulted in an additional £23.2m in impairments in H120. This would involve heavier estimated impairments in Retail Finance, Motor Finance and Real Estate Finance (as shown in Exhibit 6). On the other hand, a 100% weighting on the low case scenario would have led to £16.1m reduction in impairments. To put this into context, STB reported operating profit of £40.2m before impairments in H120 and £35.1m in impairments (including the payment holiday-related value adjustments). Therefore, in its 100% weighted internal worst-case scenario, STB would have reported a theoretical £18.1m loss (all other things being equal) for H120 due to these higher impairment levels.

If we removed £23.2m from STB’s £279.3m capital base, its CET1 ratio would drop to 12.5%, even assuming no tax shield. This is still a very decent level of capital and suggests that STB should be able to withstand a severe case scenario relatively well.

STB’s management is not currently providing any forward guidance due to significant uncertainty in the trajectory of the pandemic and the economic recovery. We have reinstated our estimates on the back of assumptions that the economy will recover next year and that there will not be another significant and widespread lockdown. However, given the situation, the outcome may be different from our assumptions.

STB has already started to see loan growth in its portfolios following lockdown and we have modelled the assumption that loan balances will recover to where they were at the beginning of the year after falling 3% in the six months to June. STB’s balance sheet, business model and operating capacity allow it to resume lending fairly quickly as lending conditions improve.

We estimate that the loan book will be flat in FY20 vs FY19 after falling 3% in the first six months of the year. Our forecasts are shown in Exhibit 7. We assume that loan growth will resume in all key segments except Motor Finance and the two portfolios in run-off: Consumer Mortgages and Asset Finance. We expect the quickest rebound in Commercial Finance, aided by the fact that because of the short duration of those loans they fell the quickest in lockdown. We assume that by the end of the year, Commercial Finance loan balances will still be 8.6% below end FY19. Retail Finance will be -2.7% and Motor Finance -16.6% vs the end of FY19. Of the four key segments, we assume that only loan balances in Real Estate Finance will be above FY19 levels at 11.7% y-o-y, after growing 7.8% in the first six months of the year.

We then assume that STB’s loan book continues to grow in 2021 at a rate of 10.7% on the back of the economic recovery. By the end of 2021, we estimate STB loan balances at £2,711m, compared to pre-crisis estimate of £3,263m. We stress that these are assumptions and the outcome may be quite different depending on the shape of economic recovery.

We expect impairments to remain elevated throughout 2020–21. STB has been de-risking its portfolio for the last few years and we had been forecasting impairment charge of 1.8% and 1.5% of average loans for FY20 and FY21 before the pandemic. In H120, STB reported 2.9% if we include the payment holiday loan value adjustments.

In the middle scenario, we have used assumptions of 3.0% in impairments for H220 and 2.0% in FY21. We expect to see the highest impairments in Motor Finance due to the nature of the product, the near-prime status of many borrowers and the 18% payment holiday take-up. Retail finance has a much lower payment holiday since the loans are usually used to fund 12-month interest-free purchases. The portfolio breakdown and impairments forecasts are shown in Exhibit 7.

We have made some adjustments to the interest margins, but these have been relatively minor compared to the impairments and volumes. We have allowed for a lower cost of funding due to the rate cuts by the Bank of England. We highlight the reduction in the net interest margin (NIM) in Real Estate Finance, which is also a bit of a sector trend. The mid-year NIM was 5.3% (previously we forecast 6%), and we have cut our assumptions to 5.25% for FY20 and 5% FY21 due to the lower interest rate environment.

We have also factored in the cost cutting that STB delivered in H120 and we now estimate that the cost to income ratio drops from 56.9% in FY19 to 52.3% in FY20 and 52.5% in FY21.

We have assumed no dividend payments in 2021. Together with lower loan growth assumptions, this helps boost our CET1 forecasts for STB. We estimate CET1 at 13.1% and 12.6% in FY20 and FY21, up from 12.4% and 11% in our pre-crisis estimates. Under these estimates, we believe there is capacity for the dividend to be reinstated in FY21, but at this stage there is no formal guidance from STB.

Under our assumptions, STB’s PBT is forecast to be £6.5m in FY20 and £31.4m in FY21. This corresponds to an ROE of 2.0% and 9.2% for FY20 and FY21.

Under IFRS 9, impairment calculations have to be forward looking for the foreseeable future for the entire life of the asset. However, there is much ongoing regulatory support and fiscal stimulus including payment holidays and job furloughs. We would therefore expect provisioning levels to remain elevated in the second half of FY20 as well as (but likely lower) in FY21.

While we do not wish to add to the uncertainty, we believe the various scenarios are useful in trying to show the possible trajectory through this period of higher impairments and how it could look for STB in terms of profitability with different levels of provisioning. It is quite conceivable that impairments end up lower than even the favourable assumptions shown below. STB has tightened its criteria as a result of the current crisis and believes that its new book lending quality is better than its back book. Therefore, a good FY21 recovery combined with IFRS 9 rules could conceivably lead to impairments closer to FY19 levels than those shown in Exhibit 9.

After the recent cost cutting, we estimate that STB can absorb about 3.2% of average loans in annual impairment as its break-even point in FY20. This is without assuming any further remedial actions in terms of costs or balance sheet.

More adverse scenario: in the more adverse scenario, we have added £23.2m in additional impairments above our base assumptions of already elevated impairments. The £23.2m in impairments corresponds to management’s calculation of the extra impairments were it to weight its internal severe case scenario by 100% in Q220. All of these impairments have been placed in Q220. In this scenario we assume that the macro outlook deteriorates very quickly and so under IFRS 9, STB will need to do some heavy provisioning fairly quickly.

We are being particularly punitive in this scenario as we are placing these extra impairments on top of already elevated impairment assumptions at 3.0% of average loans. Under this scenario, STB’s impairment charge would climb to 4.0% of average loans. This is above the break-even point and the estimated pre-tax loss would be £19.1m in FY20. We also increase the FY21 impairment assumption by 10% (from 2.0% of average loans to 2.2%), leading to forecast PBT falling by a third to £21.9m. We also cut loan growth and profit before impairments by 3% pa in FY20 and FY21 from our base assumptions (eg FY20 loan growth of -3% y-o-y instead of 0%). The ROE would be -5.7% (FY20) and 6.4% (FY21) in these assumptions. STB’s capital structure is robust with a CET1 of 13.5% easily above to absorb losing about 6% of equity in FY20 in this scenario. Furthermore, under IFRS 9 new loans that have moved to Stage 1 and Stage 2 in asset quality can be added back to capital under the transitional rules.

More favourable scenario: in the more favourable scenario, we remove £16m in impairments from our base assumptions in H220. This corresponds to the scenario whereby STB 100% weighted its low stress internal scenario (see Exhibit 6). Again, we are removing these provisions from elevated levels. The FY20 impairment ratio assumption comes down from 3.0% (it was 1.5% in FY19) to 2.3%. FY21 impairment assumptions are cut by 10% to 1.8% of average loans. We keep loan growth flat for FY20 as in the base assumption, but we increase loan growth and earnings before impairments by 10% in FY21 (eg loan growth by 2pp to 12% y-o-y). The ROE in these scenarios is 6.8% and 11.2%.

We believe that currently the share price is being determined more by current market sentiment than fundamentals. Market concern and fear regarding impairments has seriously affected STB’s shares, along with most banks. As the current downturn and subsequent recovery plays out, we would expect fundamentals to be increasingly reflected in the share price.

STB’s shares are currently trading at an FY20e PBV of 0.48x (0.50x excluding intangibles). It has a track record of returning well above its COE (which we assume at 10%). Before the crisis, we forecast ROEs of 15% and 18% for FY20 and FY21. While earnings will be considerably depressed in FY20 and FY21, we expect them to start normalising in FY22, especially as STB has an average short duration of the portfolio.

We currently do not envisage any sort of capital destruction that could even begin to justify the current low PBV ratio.

We value STB based on a net asset value approach using the (ROE-g)/(COE-g) formula. We have maintained our assumptions of 13.5% sustainable ROE, 10% in COE and used a 2% increase in long-term earnings growth. We have assumed that this valuation is for end FY22 when the earnings will have started to normalise. We then discount this value back to end FY20. We have assumed no dividend payments in FY21 and FY22. This is very conservative, since we think it is a good chance that STB will pay dividends in 2021 and this will be quite likely in 2022. Besides our explicit forecasts for FY20 and FY21, we have assumed an 8% addition to equity in FY22 from retained earnings.

This results in a fair value (FV) of 1,704p per share, down from pre-crisis valuation of 2,428p (published on 15 January 2020). The lower value is mainly driven by our assumption of no dividends and a lower book value. However, this is more than 2.5x above the current share price of 680p. The P/BV FY20e at fair value is 1.2x, which suggests that STB is a value-creating stock (ie where ROE is consistently above COE) and therefore deserves to trade well above its book value if viewed principally on fundamentals.

Exhibit 11 compares STB’s market multiples with some of its peers. The valuations and forecast earnings are heavily affected by the COVID lockdown and economic outlook. The FY20e P/E comparisons are of limited usefulness due to the depressed earnings of the companies and the high degree of uncertainty in broker forecasts. However, we note that on pre-COVID earnings, STB is currently trading at a significant discount of 27% below its peers. STB shares have fallen more than its peers as seen in Exhibit 12. STB is also trading at a largest discount of 32% to its peers on the basis of the last reported P/BV (0.49x vs 0.75x) yet it delivered of ROE 13.4% in FY19 that is well above (19%) above its peers. STB’s H120 once again demonstrated its credentials to adapt to both opportunities and adverse developments. It is a well-capitalised bank with a good business model that is still intact. We therefore believe that market multiples suggest room for the share price to recover strongly as clarity improves and as we move through the recession and the pandemic.

We also note that Invesco Perpetual has reduced its position in STB from a 20% stake at the beginning of 2020 to 16.0% by the latest filing on 23 July ahead of the interims release date on 6 August. Invesco Perpetual may be seen as an ongoing seller by others in the market, which could put some pressure on the share price. Having said that, it is not clear whether Invesco is going to reduce its stake in STB further.