So how come the banking sector is recession proof?

Investors are ignoring corporate collapses and supporting bank shares, but the sceptre of bad debts still looms

Everyone knows that banks become mired in bad debts when the economy takes a turn for the worse, but this time round a different picture is emerging. Despite the collapse of giant global companies such as Enron, Kmart and Global Crossing, shares in UK banks are this year building on the spectacular gains they achieved in 2001. And the momentum shows no sign of slowing.

It was a different story in the recession of a decade ago, when interest rates jumped rapidly from 6 per cent to 15 per cent, making it impossible for businesses and households to service their bank borrowings. Some banks nearly went bust as multimillion-pound loans made in a dash for growth during the late Eighties turned bad. The fad at the time was commercial property, and many banks – notably Barclays – came to grief by building massive exposures to individual property groups.

Then there was the collapse of the housing market, where higher mortgage costs choked off demand leaving thousands of homeowners stranded in negative equity.

The strength of banking shares today highlights investors' scepticism that such a nightmare scenario will be repeated. Indeed, in the run-up to the sector's financial reporting season, which kicks off today with Northern Rock's results, optimism has been sky high. "It's always like this in January – people begin to think there will be sector consolidation and have high hopes for the results. But as we get through the year, they will start to be more objective," says Eamonn Hughes, banking analyst at ABN Amro.

Yet most industry experts say the prevailing optimism is justified. Sure, there are parallels with the earlier Nineties. The boom in technology and telecommunications has sucked in cash from investors and banks alike, while the houses are affordable only thanks to colossal mortgages. But the differences are more significant.

Whereas the last recession was driven by rising interest rates, the present downturn has been accompanied by synchronised rate cuts around the globe, taking the cost of borrowing in the UK down to a 38-year low. The cost of servicing debt remains relatively painless, which is born out in official bankruptcy figures that give more grounds for encouragement than the hullabaloo around Enron would imply. According to Dun & Bradstreet, business failures in the UK in the fourth quarter of 2001 were 6 per cent down on the same period last year.

Robert Law, banking analyst at Lehman Brothers, says: "This time round, there will be bad debts from business failures, and from unemployment, but not from the cost of servicing debt."

Meanwhile, banks have learnt lessons from the past. Instead of making large loans to individual companies, they nowadays spread their exposure by lending through syndicates. Hugh Pye, analyst at BNP Paribas, says banks are more distributors than holders of risk. "What failures like Enron are emphasising is that banks are arranging the debt that turns into a problem, but they usually have sold it into the bond market, where it ends up in our pension funds," he says. "European banks are better at it than US banks."

Robin Down, banking analyst at Morgan Stanley, says: "Investors have factored in a rise in bad debts for this year, and may have been too pessimistic. Crises like Enron and NTL have been more of a problem for equity investors and bondholders than for the banks."

The banking sector also enjoys relatively strong financial health and profitability at a time when growth in the telecoms sector is still slowing, pharmaceutical companies face declining US health spending and oil companies are grappling with weak energy prices. Its price-earnings ratio sits at a discount of some 30 per cent to the wider market, even though its earnings prospects are brighter. Earnings growth of 5 per cent is being pencilled in for this financial year.

Still, the pain may be only just around the corner. It takes time for defaults and bankruptcies to become bad debt charges on banks' balance sheets. ABN's Mr Hughes says: "Enron and Global Crossing have been seen as isolated but how long can you go on regarding every incident as an isolated case?" Indeed, it is by no means certain the consensus among economists that the economy will recover in the second half of this year will prevail. If recovery is delayed, bad debts will rise with a dramatic impact on bank profits. A mere 10 basis-point increase in bad debt provisions would wipe 5 per cent from banking sector earnings.

Yet, perversely, the situation could be even worse if the economy recovers faster than forecast. That would entail rapid rises in interest rates which would leave many consumers and businesses struggling to service their debts.

The Bank of England highlighted the risks in last month's twice-yearly Financial Stability Review. "In the UK, there are few debt-servicing problems in the current interest rate environment, although levels of borrowing in the corporate and household sectors could imply some future vulnerability," it said. Moreover, the Bank has voiced concern about the banking sector's use of so-called credit derivatives to offload risk to insurance and long-term savings institutions.

After all, these companies also borrow from the banks. The banks would share in their pain if a large corporate defaulted on its bonds Enron-style, so it is hard to say they have completely escaped risk.

In business, what goes around tends to come around.