The UK banking sector has been through an incredibly tough handful of years. Indeed, 2014 is forecast to be the first year where Lloyds (LSE: LLOY) (NYSE: LYG.US) and RBS (LSE: RBS) make a profit since the start of the credit crunch. However, along with sector peer Barclays (LSE: BARC) (NYSE: BCS.US), their share price performance has been rather lacklustre and all three banks have underperformed the FTSE 100 during the course of 2014.
The future, though, could be a lot different and a revised (and lowered) medium term outlook for interest rates could prove highly beneficial to the banks. Here’s why.
Low Interest Rates Aid Banks
Since banks pay interest on deposits and receive interest on loans, their interest rate spread (the difference between the two) should not, under normal circumstance, vary too widely over the long run. However, the level of interest rates does have an effect on demand for savings products and demand for new loans.
Clearly, only loans generate an income for the banks, so with interest rates set to stay low over the medium term, as evidenced by the Bank of England stating that the traditional 4-5% level may prove to be too high during the current cycle, banks could see demand for loans increase. This would be positive news due to an expanded loan book, more fees and, ultimately, more profit.
Low Interest Rates Aid The Economy
As well as increasing demand for loans, low interest rates help the economy, too. That’s because more investment occurs as there is less incentive to save and more incentive to invest. An improving economy is helping the banking sector to reduce its write-down of assets (which directly hits the bottom-line) as asset prices continue to benefit from a resurgent economy. This improvement in macroeconomic outlook then causes more people to invest, meaning more loans and feed, and so there is something of a snowball effect.
As mentioned, the Bank of England seems happy to keep interest rates low over the medium term. This means that the banking sector could enjoy a purple patch, as it benefits from continued UK economic expansion, as well as higher demand for loans to businesses and individuals. With shares in Lloyds, RBS and Barclays trading on price to book values of just 1.3, 0.3 and 0.6 respectively, they remain very attractively priced. As such, they could prove to be winning investments as long as interest rates remain low, which looks likely to be for a good while yet.
Peter Stephens owns shares of Barclays, Lloyds Banking Group and Royal Bank of Scotland Group. The Motley Fool has no position in any of the shares mentioned.