As the banking sector acc-ounts for nearly 30 per cent of the FTSE 100 and, as the reporting season is upon us, I thought it timely to comment further on this particular sector. I aim to look in more detail at some of the constituent members and give some thoughts on individual stocks and future prospects. Record profits for Northern Rock recently came in at over £431 million, Barclays posted profits of £4.6 billion, and analysts are predicting profits of £9.4 billion for HSBC, the UK’s largest bank.

The largest influence on any bank’s business is interest rates. The market is not short of different views of where the independent Bank of England will go next. Many view the interest rate as having peaked at 4.75 per cent. The informed predict one – or possibly two -quarter point moves. Some feel rates must fall, but few feel they will rise or fall significantly.

The main influence will be inflation, which appears to be creeping up. Lower rates will slow demand for traditional loans, which could spell problems for the sector.

The important influence for the banks is the demand for housing. Undoubtedly the last round of rate rises has slowed house price purchase, traditionally the largest requirement of borrowing for most people. It’s fair to say interest rates are traditionally low, which will help a soft landing for housing, the only concern for government being a re-igniting of the housing market when people realise how cheap money is. For banks, it means lower mortgage volumes, thus affecting profit margins. On the flip side, whilst base rate rises have been good for banks, more competition now exists – especially from other providers of savings products – with banks offering loss-leading rates to entice clients, placing even greater pressure on margins.

Looking at some of the main players, HSBC has had difficulties with its international division; however, with little exposure to the mortgage market, its results give all the indications of being positive. Royal Bank of Scotland (RBS) is a favoured growth play concentrating on business banking, which looks set to grow in comparison to retail banking. Lloyds has long been favoured with income investors, the old trick of a 7 per cent yield in holding the shares being better than money on deposit, but some analysts feel Lloyds TSB will be under pressure if the dividend is cut.

Barclays does look attractive for a takeover, especially from a number of American banks, and some are concerned that any expansion to the investment bank could strain finances. With a quality covered yield, the bank remains attractive. Halifax Bank of Scotland (HBOS) does look one of the cheapest and is one of the few showing rising profitability; again results look likely to be upbeat. Despite its recent strong share price performance, HBOS still trades at a discount to the sector while delivering premium to sector earnings momentum. Its relatively low risk profile, strong retail savings business and growth potential outside its traditional mortgage and savings businesses should support continued outperformance through 2005.

The smaller banks should be treated with more caution. Alliance & Leicester looks high enough and is too dependent on unsecured lending; but with 14 per cent of profit dependent on personal loan sales, it is unlikely to be a takeover target. Beware of Bradford & Bingley: though the shares have performed well of late, the recent restructuring and sale of the estate agent business again leaves the bank open to buy-to-let and riskier mortgages. Northern Rock has delivered growth in operating profit in each of the past 16 years, and 2004 is expected to be number 17.

Even with a slowing property market in the UK, market-share gains enable Northern Rock to continue to deliver double-digit earnings growth through 2005 and beyond. It is not likely the group’s credit quality will weaken in the second half of 2004. Margins in the second half will have benefited from market expectations that the interest rate cycle is near its turning point in the UK.

One must be cautious of the future performance of UK banks, which is unlikely to be representative of sustainable growth into 2005. UK total consumer loan growth at well over 10 per cent is unsustainable with UK average earnings and nominal GDP growing at less than half that level. With that in mind, and taking into account interest, any updates from the banks regarding the outlook or current trading will, in many ways, be more important than the actual figures. During the statement period last December, the banks presented a broadly confident picture, from which the market has taken much reassurance.