Valuations across UK domestic banks have recovered strongly with a 140% total shareholder return since the start of 2024 but the sector still offers value, even if it is slightly less attractive than before, analysts at Jefferies believe.
The implied cost of equity (COE) is now below 14%, which makes the investment case "less compelling" than before, the broker remains constructive on the sector and sees Lloyds Banking Group PLC (LSE:LLOY) and Barclays PLC (LSE:BARC) over NatWest Group PLC (LSE:NWG).
"When implied COE was 15-20%, we spent little time worrying about what the 'right' level was," the analysts said. "However, at <14% and most of the earnings upgrades behind us, this is increasingly important.
"With over half of NII now driven by deposits, assets materially de-risked, and sterling AT1 yields at 6%, COE can fall further. But it is a less compelling argument than before."
Jefferies noted that the operating environment remains favourable, with loan and deposit growth both around 4%, a yield curve that supports deposit margins, and gilt swap spreads of 30-50 basis points underpinning lending margins.
The Bank of England’s £100 billion funding programme at close to base rate is also helping to contain costs.
"The UK fiscal position is the elephant in the room. But we aren't overly worried about bank taxes (albeit slightly more worried than this time last year).
"A big increase in impairments would require a significant weakening in the macro. And a marked reassessment in rates would be required to disrupt the distribution story (this is arguably our greatest concern, though)."
The analysts highlighted that differences in hedge maturities -- aka 'hedge sunsets -- will drive diverging outcomes from 2027 onwards.
While NatWest could see hedge income decline in 2028 as shorter-dated positions roll off, Jefferies expects Lloyds and Barclays to retain tailwinds until 2029.
It sees NatWest’s yield predictability as attractive, but flagged its valuation at 1.5x 2025 tangible net asset value and the prospect of investor focus shifting to post-2026 dynamics.
Barclays remains rated 'buy', with Jefferies expecting management to provide guidance on post-2026 prospects soon, with a dividend of around 20p possible and a forward book value approaching 500p by the end of 2026.
Lloyds, also rated 'buy', is forecast to generate more than £17 billion of distributions between 2025 and 2027 -- about 20% above consensus -- and to benefit from Basel 3.1 rule changes reducing risk-weighted assets.
Among smaller lenders, Jefferies kept OSB Group PLC (LSE:OSB) on 'buy' and Paragon Banking Group PLC (LSE:PAG) on 'hold', noting that while Paragon has stronger loan growth and lower cost of equity, it trades at a significant premium to OSB, leaving more relative upside at OSB.