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Why banks deserve a place in a sustainable investment portfolio

My first inkling that something was very wrong with UK banks came from a meeting with the ashen-faced chief executive of specialist mortgage lender Paragon late in 2007.

For many years, the business had successfully relied on a revolving credit facility, but this had suddenly and unexpectedly been withdrawn. “The people in the room had changed,” said the chief executive. It was as if Paragon’s long-term business partner had metamorphosed into a cash-hungry vampire.

Paragon’s weakness was a need for liquidity, but it turned out its creditor’s need was even greater. Its stark choice was to raise capital from shareholders or give its business over to creditors. It chose the former, with a 25-for-one deeply discounted rights issue.

Lehman Brothers collapse: Could history repeat itself?

The big UK banks were running out of cash and this was draining the pool of that other essential commodity – trust​. Since no one knew who was good for their money, those with liquid capital held on to it and those without spiralled further into trouble.

Among the long list of casualties were HBOS, RBS, Bradford & Bingley, Alliance & Leicester, Landsbank and ING, with shareholders wiped out as their tiny sliver of capital was drowned in the rising tide of liabilities and shrinking asset bases.

Most of the survivors had to go cap in hand to the UK government or the Middle East, and trust had to be underwritten by the Bank of England’s long programme of quantitative easing.

The crisis impacted the entire economy, including small and medium-sized businesses, as well as families on the first rung of the housing ladder. It disproportionately hit the poorer in society, who bore the brunt of remedial austerity measures. Then QE, accompanied by reductions in interest rates, resulted in enormous asset inflation. This only benefited those fortunate enough to have participated in the 10-year equity and bond bull market – primarily the wealthy.

Reams have been written about how the it all came about but we believe four factors were to blame.

The first was opaque accounting, with wide-scale misrepresented risk through bundled loans and a blurring of balance sheets. Next was a culture that prioritised growth, incentivising the number of loans sold.

Lehman Brothers’ collapse: What’s changed since 2008?

Third was a dangerous lack of customer focus: there was no measure of the appropriateness of the loan featured and pushing ancillary products such as payment protection insurance was encouraged with disastrous results. Finally, the banks – guilty as many were – should not shoulder the full weight of blame. Shareholders were complicit, or at the very least negligent, in allowing these practices to continue.

Ten years of resolution

Some banks were resilient in the face of the crisis, notably Nationwide and a few Scandinavian names. These provided the recipe for successful banking and the remedy was simple: rebuild capital, simplify business lines and change culture.

Ten years on, this has largely been achieved. Dividends were cut, complexity was reduced and, hardest of all, banks adopted a new ethos to prioritise service and relationships with customers ahead of sales targets. They have also recognised their sense of purpose, with Lloyds “Helping Britain Prosper” and RBS promoting “Strength and Sustainability”.

We prefer traditional retail names over investment banks, as we see them providing much clearer benefits to society. In analysing banks, we identify the main sustainability factors that can have tangible impacts on both their contribution to financial resilience in the broader economy and on individual stock performance.

Preparing for an all-passive world

Taking corporate governance, for example, we look for banks with a clear strategy to align the interest of management to those of customers by increasing the social utility of the services and products they provide.

As for culture, we look for those with an environment that encourages positive behaviour, acts to stop high-risk activity and focuses on employee training and development, and treating customers fairly.

From a financial perspective, a bank’s reputation can be integral to driving top-line growth and deposits, and while being ahead of regulatory requirements might cost more in the short term it should be rewarding longer term. History has taught us banks able to deliver strong returns without excess leverage are likely to outperform through the cycle.

Norway’s DNB is an example of a bank we rate highly both on sustainability criteria and fundamentals. It has reduced its corporate exposure in recent years and focused on areas that provide benefits to society, such as retail banking and SME lending, while delivering returns on equity consistently above its cost of capital.

Peter Michaelis is head of sustainable investment at Liontrust

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