By Daniel Hunter

It is simply impossible for banks to satisfy the conflicting requirements to strengthen capital ratios to satisfy regulators, while simultaneously increasing lending to businesses to stimulate economic growth, says KPMG.

A new report from KPMG warns that while banks have made real progress in strengthening balance sheets and capital reserves, significant challenges lie ahead as the broader banking industry, including regulators and Government, struggles to articulate exactly what the sector should look like and what its role in the economy should be.

The UK Banks: Half Year Performance Benchmarking Report, which analyses the interim results of the five major banks, shows that statutory profits increased 20% relative to the first half of 2011 but were down 17% compared with the second half of last year. Overall the big five banks made combined pre-tax statutory profits of £9.5 billion in the first six months of 2012, compared with £7.9 billion in the first half of last year and £11.4 billion in the second.

“While there were some bright spots, notably in underlying retail and commercial banking performance, a key challenge for banks is to plot a route back to strong and sustainable profitability," Bill Michael, UK head of financial services at KPMG, commented.

"Individual bank’s results were mixed, reflecting their legacy positions and geographic and business focus. Retail and commercial businesses enjoyed a modest recovery in contrast to investment banking divisions which were hit hard.

“Banks face a number of conundrums. Firstly, while it has become increasingly clear that it is not good for the economy if banks continue to reduce lending; the role that banks can play in the broader UK growth agenda remains undefined.

"Secondly, banks continue to be impacted by a major regulatory agenda which is difficult to implement whilst operating in an unstable market. The other key challenge for banks is around return on equity and investment. Banks are increasingly being treated as regulated utilities; yet when compared with other utility companies such as telecoms and energy businesses, their returns, and subsequent appeal to investors, are currently significantly lower.

“The banking sector has been plagued by a number of exceptional events and issues since the crisis which are making it difficult to predict what the ‘new normal’ looks like. The latest series of incidents and failures have further eroded customers’ trust in banks and may possibly lead to a new wave of regulation.

"Despite the ongoing cost cutting exercises that have been implemented across most organisations, these have not generated the required improvement to cost income ratios, which have remained flat. If the business climate does not improve markedly in the near term, more severe restructuring programmes may be necessary.”

Retail banking

Bill Michael continued: “The remediation of PPI mis-selling has taken a painful toll on bank profitability over the past 18 months. Banks are now very conscious of the major financial and reputational threat that misconduct poses to their business and are actively trying to future-proof their products and sales approach. This is not without risk because customers, more than ever, need access to savings products that will generate long-term returns. If banks increasingly ‘playing it safe’ by concentrating on lower risk products to avoid future accusations of mis-selling, investors may find it harder to meet their aspirations from long-term savings.”

Investment banking

Bill Michael concluded: “Investment banking divisions remain under intense pressure being damaged by tough market conditions as the Eurozone crisis drags on and the long-term regulatory environment looks hostile. As such, banks continue to shrink their activity and trading capacity by winding down or divesting business units while trying to leverage opportunities in targeted growth markets.”

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