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Revealed: The Storm Clouds Looming Over Lloyds Banking Group PLC & Royal Bank of Scotland Group plc

Last week Lloyds (LSE: LLOY) (NYSE: LYG.US) pleased the market with good results and a return to the dividend list. Results for RBS (LSE: RBS) were predictably disappointing, but the announcement of a further retreat from overseas and investment banking (so, becoming more like Lloyds) was well received.

But I believe there are significant secular factors at play that will exert downward pressure on the profitability of UK banking over the longer term:

  • The retrenchment of Lloyds and RBS to the UK commercial banking market intensifies rivalry amongst the established players. They have nowhere else to make profits and little ability to differentiate themselves;
  • New entrants are increasing competition. These include: the forced divestments, TSB and William & Glyn; new challenger banks such as Metro, Virgin and Aldermore; and supermarket-sponsored ventures such as Tesco, Sainsbury and Marks and Spencer, which are extending their product offering into the lucrative mortgage market. It’s a double-whammy: more players in the same market will reduce individual market shares whilst increased competition reduces profit margins across the board;
  • Substitute products such as peer-to-peer lending allow personal and small businesses to lend to and borrow from each other, sidestepping the banks altogether. Zopa’s CEO thinks peer-to-peer lending will take half the total personal loan market. The new internet platforms lack the banks’ legacy cost base. More significantly the traditionally high barriers to entry of the deposit-taking and lending business, a banking licence and a lot of capital, have effectively been removed;
  • The bargaining power of customers is increasing through regulatory moves such as making account switching easier, and the competition review of retail and small business banking which could result in unbundling of current accounts from other products.

Anyone who has done a business course will see where I’m going: the italicised phrases are four of former Harvard Business School professor Michael Porter’s famous five forces that determine industry profitability. To have four of these five forces so fiercely set against the sector’s fortunes is bad news for profits, and hence for share prices and dividend growth.

Be careful what you wish for

There’s an irony here. Investors have cheered banks’ retrenchment: not just Lloyds and RBS, but also Barclays — where every cut-back of its investment bank is applauded — and increasingly HSBC, which is acquiring the reputation of being too big to manage. UK-focused commercial banking looks fine now, whilst the UK economy is out-performing, but there will come a time when all these competitors fishing in the same small pond will struggle to make decent profits.

I haven’t mentioned Porter’s fifth force, the bargaining power of suppliers, because its interpretation in the banking sector is less clear-cut. But certainly the suppliers of banking licences — i.e. the government and the FSA — have been ratcheting up pressure on the sector. Capital and liquidity requirements forced Barclays into a rights issue and deferral of its profitability targets in 2013. Higher capital requirements were the main reason HSBC reduced its long-term financial targets just last week.

A couple of years ago, many investors thought banks were uninvestable until capital shortfalls, doubtful loans and past misdemeanours were fully dealt with. It’s beginning to look as if, even after those issues are addressed, the sector will still have little to recommend it.

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Tony Reading owns shares in HSBC, Tesco and Sainsbury. The Motley Fool UK has recommended HSBC Holdings and owns shares in Tesco. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.