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Why Lloyds Banking Group PLC, Barclays PLC & Royal Bank of Scotland Group plc Will Disappoint

Generally, the banks appear to be shedding assets and narrowing there focus to concentrate on the UK banking market.

Unwieldy and highly geared investment operations face the chop, or massive streamlining, at Lloyds Banking Group (LSE: LLOY), Royal Bank of Scotland (LSE: RBS) and Barclays (LSE: BARC).

Yet, just as the banks pull back from previously high-earning markets and business lines, the competition hots up in the domestic market. However, even that situation isn’t the biggest threat to an investment in the sector right now.

A fierce regulatory headwind

The regulators want to break the grip that Britain’s big banks apply to the nation’s finances. That stance comes with the full backing of credit-crunch ravaged public, no doubt. Just last week, news reports had it that a senior Bank of England official said it will take another five years or more to make real inroads into the dominance of Britain’s five biggest banks — the intent is as sharp and determined as it ever was, though.

Around two years back, the government and its regulators made it easier for new firms to enter the UK banking market to compete with the likes of Lloyds, Royal Bank of Scotland, HSBC Holdings (LSE: HSBA), Barclays and Banco Santander (LSE: BNC). Those big-name banks control about 85% of customer accounts in the UK, but that’s a percentage that seems destined to fall.

The pace of challenge from new players will probably take years to gain traction, rather than months. The Prudential Regulatory Authority (PRA), the regulatory arm of the Bank of England, expects to issue just five or six new banking licences a year to new entrants for the next year or two. Yet the threat is there and it could accelerate.

Cyclical uncertainty

That structural challenge to the banking industry runs alongside the sector’s joined-at-the-hip attachment to general macro-economic cycles. Banks are among the most cyclical of businesses and that makes an investment in banks unattractive right now. Share prices in the sector go up and down along with profits and cash flow in accordance with the undulations of the macro-economic cycle.

On top of that, the forward-looking nature of the stock market causes it to mark down the value of banks as we travel mid-macro-cycle, as now, in anticipation of the next economic turndown, which could lead to profit collapse at the banks.

What we tend to see with the banks and other cyclicals is gradual P/E compression and rising dividend yields. Paradoxically, such characteristics make the cyclicals look attractive at what could end up being the most dangerous time to own the shares of cyclical firms. That’s because the older the macro-cycle becomes, the closer we move towards the next occurrence of falling profits and share price collapse. 

A potential double-whammy

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.