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How Lloyds Banking Group PLC And Royal Bank of Scotland Group plc Will Shrink

Things have been going well for the UK’s mostly state-owned banks. Both Lloyds (LSE: LLOY) (NYSE: LYG.US) and RBS (LSE: RBS) (NYSE: RBS.US) are benefitting from a healthier-looking economy and riding on the back of a resurgent mortgage market.

It’s likely the upwards momentum will continue, with Lloyds benefitting from the sale of more government shares and RBS’s restructuring delivering improvements to the bottom line.

Both banks are heavily dependent on the UK retail and commercial market: Lloyds especially so, RBS more than it would like since Chancellor George Osborne made it trim the investment bank. Both have been forced to pare down their core businesses with EU-mandated sales of branches.

Disposals

Lloyds plans to float 631 branches under the brand TSB. RBS has found a private equity buyer for its 316 branches. They will be branded William & Glyn’s.

Not much has been said about how this will impact the competitive landscape. The two new banks will have tiny balance sheets in comparison, each having around £1.5bn book value against Lloyds’ £44bn and RBS’s £70bn.

TSB will have about 4.6m retail customers and William & Glyn’s 1.8m, with 25m staying with Lloyds and 22m with RBS. That may just be big enough to make a difference in the marketplace. The government certainly hopes it will spice up competition.

The smaller branch networks of the two newcomers may prove to be an advantage. Banks have been shrinking their networks, with the internet a cheaper and more efficient delivery mechanism. A recent Reuter’s article quoted the views of ‘senior UK bankers’ that 700-800 would be the optimal number of branches. The newcomers might enjoy a significant cost advantage over lumbering Lloyds and RBS, with their legacy networks of around 2,000 branches each.

Competition

The supermarket sector provides an example of how competition might pan out. That’s also a market where demand grows in line with the economy, where competition is based on perceived price and service, and where there’s little difference between different branded products. Tesco has the dominant market share, but it can’t dictate prices. Analysts focus on the market share gains of small players Aldi, Lidl and Waitrose.

I suspect that’s the role that TSB and William & Glyn’s will play in the banking market. Harrying the established incumbents, they’ll ensure that UK banking is never again as profitable as it once was.

Lloyds and RBS shareholders can anticipate some upside yet, but the opportunity for growth is limited.

Ballast

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> Tony owns shares in Tesco but no other shares mentioned in this article. The Motley Fool owns shares in Tesco.