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Brexit Question Raises Risks for U.K. Banks

The Bank of England's new countercyclical capital buffer shouldn't affect valuations, however.

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The Bank of England has warned that uncertainty over whether the United Kingdom will vote to leave the European Union has increased risks to financial stability. The BoE announced several related measures, including extra funding options to be available around the late-June vote, new stress test requirements, and an increase in the countercyclical capital buffer requirement to 0.5% from 0%. We're not concerned about the 0.5% countercyclical buffer and do not expect it to affect our fair value estimates for the U.K. banks; we think it can be absorbed by the banks' existing capital plans. U.K. banks reported capital ratios of 11.4%-15.5% at year-end, well above current requirements. We're further comforted by reassurances by the BoE that it plans to reduce other capital buffers and does not plan to increase requirements overall.

We've long said that we see a rocky road ahead for undervalued  Royal Bank of Scotland (RBS)/(RBS), and we think these risks are already more than priced into the shares. We think the bank has more than enough capital and reserves to absorb the credit and litigation charges we anticipate and emerge in 2018 with as much as GBP 20 billion of excess capital to distribute to shareholders through special dividends or repurchases. The shares are trading well below our fair value estimate, and we see significant upside for patient investors. For less risk-tolerant investors, we prefer the shares of  Lloyds (LYG) /(LLOY). This bank is clearly the strongest of the large U.K. banks. We think investors can be reasonably confident that its high litigation and regulatory charges are in the past, paving the way for attractive near-term earnings and dividend growth.

Erin Davis does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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