British banks’ profits should rise strongly over 2010-12 as impairment charges fall, suggesting that tax-payers will gain from their stakes in Lloyds Banking Group, the Royal Bank of Scotland (RBS), Northern Rock and Bradford & Bingley lending.

British banks in aggregate lost £2 billion in 2009, according to recently-released annual results. Underlying net income rose to a record £51 billion – the prior peak was £42 billion in 2007 – but was outweighed by impairment charges of £53 billion*.

Impairments, however, fell by 19% between the first and second halves and should continue to decline steadily – assuming no “double-dip” recession. Guidance about their trajectory is provided by bad debt experience in the early 1980s and early 1990s, associated with the 1979-81 and 1990-91 recessions. Impairments totalled 4.7% of “assets at risk” over the five years 1982-86 and 7.1% over 1989-1993.  The first chart shows projections based on losses over 2008-2012 falling within this range – low real interest rates suggest that higher numbers are unlikely. From £53 billion in 2009, impairments are forecast to fall to £30-40 billion in 2010, £15-32 billion in 2011 and £8-25 billion in 2012.

On the conservative assumption of no further increase in underlying net income from its 2009 level of £51 billion, this would imply a recovery in profits after charges to £11-22 billion in 2010, £19-36 billion in 2011 and £26-43 billion in 2012. In other words, profits could surpass their 2007 peak of £31 billion as early as 2011 – second chart.

Lloyds and RBS lost a combined £13 billion last year, with underlying net income of £27 billion offset by £40 billion of impairments. If charges fall in line with the industry average, and the underlying surplus is stable, the two banks could earn profits of £8-21 billion in 2012. Taking the mid-range figure of £14.5 billion and applying a corporation tax rate of 28% and a price/earnings ratio of 10, the equity of the two banks could be valued at about £104 billion in 2012, up from £65 billion at Friday's close. (The P/E of UK banks averaged 10.8 between 1965 and 2009, according to Thomson Datastream.) Assuming no change in equity outstanding, this would be consistent with share prices of 96 pence for Lloyds and 71 pence for RBS versus 60p and 44p respectively on Friday, implying a paper profit on tax-payers' stakes of about £25 billion. (The National Audit Office has estimated average in-prices of 50p for RBS and 74p for Lloyds, with each 10 pence increase boosting the value of the stakes by £9 billion and £3 billion respectively.)

* These numbers cover the main high-street banking groups: Santander UK, Barclays, Bradford & Bingley lending, HSBC Bank (the UK subsidiary of HSBC), Lloyds Banking Group, Northern Rock and RBS.