Moody's Investors Service has changed the outlook on the UK banking system to stable from negative. This reflects the expectation that most UK banks will maintain solid financial fundamentals over the next 12-18 months, resulting from a favourable operating environment.

According to Moody's, healthy economic growth in the UK will have a positive effect on banks' operating conditions. As noted in Moody's UK Credit Opinion published on 26 May, the rating agency expects UK GDP growth of 2.7% in 2015 and 2.4% in 2016.

"We expect most banks' balance sheets to improve in 2015, with enhancements in their capital and leverage metrics as lenders position themselves for more stringent regulatory requirements," says Carlos Suarez Duarte, a senior analyst at Moody's.

In addition, banks' asset quality indicators will likely remain strong, despite the prospect of gradual and moderate increases in the Bank of England's base rate, says Moody's. The rating agency expects these increases to start in the first half of 2016.

Moreover, stricter mortgage affordability rules, coupled with enhanced risk appetite frameworks among rated institutions, should prevent a material deterioration in asset quality in the event of an economic downturn, according to Moody's.

The rating agency projects that UK banks' funding and liquidity levels will remain strong as banks benefit from stable retail deposit bases. It expects new long-term wholesale funding issues to replace borrowings from the Bank of England's Funding for Lending scheme, and to contribute to the build-up of loss-absorbing capital layers.

Moody's believes that banks will be able to increase their margins -- benefiting from increases in interest rates that would not be fully passed on to savers -- but notes that UK lenders will likely face stronger competition, especially in the mortgage market as well as for deposits as the Funding for Lending scheme runs off.

"Increased competition could constrain lenders' ability to maintain high margins. This may lead to a rise in lending volumes as well as higher risk appetite," says Suarez Duarte.

"Banks also face sizeable conduct remediation costs, while the implementation of ring-fencing of large banks' retail operations brings added uncertainty."

Moody's assumes a moderate probability of government support for the large rated UK banks and one building society and a low probability of government support for the remainder of firms. The outlook on the UK banking system now fully reflects revised government support assumptions, following the European Union's implementation of a banking resolution framework.