Banks face future from position of strength

They mostly outperformed the rest of the local stock market in the first semester and did not disappoint when it was time to report their interim earnings. Hardened by the Asian financial crisis of 1997 and some minor hiccups during the Wall Street-centered global crunch that followed the collapse of Lehman Brothers in 2008, Philippine banks are seen on track to post another banner year this 2012—notwithstanding a bleak global economic backdrop.

Not cited often enough, according to Bangko Sentral ng Pilipinas Governor Amando Tetangco Jr., was the fact that the deposit base of Philippine banks even grew faster in the years after the peak of the US crisis. Between 1999 and 2007, deposits grew a little more than 8 percent a year. But from 2007—at the time that the mortgage crisis was unfolding in the United States—Philippine system-wide deposit balances increased by 13.4 percent a year all the way to 2011, he said.

The numbers were even more dramatic when it came to the expansion of banks’ loan book. Loans have been growing at a 10.62-percent pace a year in the last four years (2007 to 2011) compared to the modest annual growth of 3.67 percent in the eight years from 1999, Tetangco told a recent banking forum. Based on the BSP’s latest numbers, commercial bank lending expanded by 16 percent year-on-year in July against the 14.9-percent growth in June.

“Add to this the fact that increased loan portfolio was not a case of liquidity chasing after every credit exposure. A simple look at the numbers will show that the NPL (nonperforming loans) ratio has actually been falling since the turn of the century just as the coverage ratio has been rising,” Tetangco said, noting that for universal and commercial banks, the latest number was an NPL ratio of 2.06 percent and a coverage ratio of 135 percent.

In the first semester of the year, the decline in interest rates boosted banks’ treasury gains. But most were striving to build a durable source of income not just by growing their loan books but by diversifying their portfolio through more loans to households and small and medium enterprises. Going “down-market”, after all, not only addresses concentration risks but also boosts their net interest margins.

ING country manager Consuela Garcia, whose bank operates wholesale banking in the country, said local banking peers were now more focused on looking at different drivers of income. While treasury gains boosted most banks’ earnings because of the fall in interest rates, Garcia said this would be difficult to replicate.

“They are booking more loans and I’ve seen they are very selective. What I see is it’s getting a bit more balanced loan growth. So NIM (net interest margin) is good— NIM that’s still above 3 percent is still very very good. Fee-based income growing. On transaction banking, they have improved a lot on the systems,” Garcia said.

On the declining asset yield, Garcia said it was a matter of who the banks would lend to. “There’s a lot of concentration risk already because you see a lot of the same names. They are very, very good but you’re giving them more and more money and everyone still has a lot of loan capacity,” she said.

But while the Philippine banking system is widely expect to withstand the current global shocks, a more challenging operating environment is seen looming specially if the Bangko Sentral ng Pilipinas cuts its overnight borrowing rate further from the current record-low rate of 3.75 percent.

“Overall, macro fundamentals remain healthy, however lethargic manufacturing output and external head winds could slow loan growth,” said a Citibank research titled “Philippine Banks: Pricing in the Macro Story” dated Sept.4. Authored by Minda Olonan and Robert Kong, the report said prospects for policy rate cuts amid strong competition could cap asset yields. “As seen in the second-quarter 2012 results, rising peso LDR (loan-to-deposit ratio) has begun to push banks to hike peso time deposits, which could trigger higher funding costs in the second half. Regulatory measures, such as stricter monitoring of real estate exposure and likely full adoption of Basel 3 by 2014, while positive for sector risks, could limit room to manage asset mix and lift ROEs (return on equity),” the report said.

So despite strong trading income lifting 2012 profit, Citi said it had trimmed its core pre-provision operating profit forecast by 3-7 percent for Philippine banks for 2012 through 2014.

Higher profits

Based on the first-semester results, most banks got a big kick from the strong trading gains in the first quarter. Nine of the country’s 10 largest local banks reported an increase in net profit in the first six months compared to a year ago, which means they are on track to top last year’s record high bottom-line levels.

Here is how the country’s biggest banks fared in the first six months compared to the same period last year:

Bank of the Philippine Islands grew net income by 52 percent to P9.4 billion, already accounting for 63.5 percent of the market consensus forecast net profit of P14.8 billion for the whole year. The profits translated to a 21 percent ROE and a 2.3 percent return on assets.

Metropolitan Bank and Trust Co.’s net profit went up 21 percent year-on-year to P7.4 billion, achieving 57.4 percent of the P12.9-billion market consensus net profit for the bank for 2012.

Banco de Oro Unibank grew its net income by 15 percent to P5.83 billion, putting the bank on track to meet its full-year profit guidance of P12.5 billion (growth of 19 percent).

Land Bank of the Philippines grew its net income by 4 percent to P5.74 billion, translating to a 16.3-percent ROE.

Security Bank doubled its first-semester net profit to P5 billion, or an annualized ROE of 31 percent.

Union Bank of the Philippines grew its net profit by 42 percent to P4.07 billion; equivalent to a return on equity of about 18 percent.

Rizal Commercial Banking Corp. saw net profit jump by 35 percent to P3.01 billion, equivalent to an annualized return on average equity of 15.43 percent.

Philippine National Bank posted a 94-percent year-on-year growth in net profit to P2.2B billion in the first semester.

China Bank posted a 14.27-percent drop in its first-semester profit to P2.03 billion due to lower margins on lending and the cost drag of its business expansion.

Development Bank of the Philippines grew its net profit by 9.2 percent to P1.9 billion.

Prime benefactor

Local stock brokerage DA Market Securities said it maintained banks as a core holding for its portfolio being the “prime benefactor of the ideal economic environment”—benign inflation, low interest rate environment, continued lending growth due to robust consumer spending due to business growth and public-private partnership (PPP) infrastructure-related deals.

Analyzing the second quarter alone, the Citibank research estimated that attributable profit growth had slowed down without the lift from trading income seen in the first quarter. In general, the research pointed out to a more challenging environment moving forward: slowing loan momentum; net interest margins under pressure; normalizing trading income that capped non-interest earnings, and mixed trends in fee-based earnings.

The research noted that asset yields have likewise fallen largely driven by the decline in yields from other interest-bearing assets. “This is largely attributed to the new BSP rule removing the interest on bank reserves (18 percent of deposits) effective April 2012. As such, we saw an average of 23 percent year-on-year (-5 percent quarter-on-quarter) decline in interest income from deposits with banks and on investment securities,” the research said.

Net interest margin (NIM) is computed as a percentage of what the financial institution earns on loans in a time period and other assets minus the interest paid on borrowed funds divided by the average earning assets for that period.

Citi estimated that BDO’s NIM stood at 3.36 percent in the second quarter of 2012 compared to 3.72 percent a year ago. BPI’s inched up to 3.59 percent from 3.42 percent over the same period and Metrobank’s NIM rose to 3.56 percent from 3.31 percent.

On non-interest income, Citi said peak trading income was likely realized in the first quarter and non-interest income was trimmed by close to a third in the second quarter in the case of its monitored banks.

Further falls in bond yields could provide another upside surprise to banks’ trading income, Citi said. On specific catalysts, the Citi research noted the following:

Sustained gains on cost efficiency remains a key catalyst for BDO;

Metrobank’s potential divestment of its non-financial assets would generate gains and provide an additional buffer for Basel 3 changes;

The execution and progress in realizing the cost synergies of PNB’s forthcoming merger with Allied Bank could trigger a stock rerating.

Upside risk for BPI would be another strategic acquisition, which could further support its non-interest income streams.

Citi’s preferred banking play is BDO, believing that the bank’s recent $1-billion equity infusion gave it more flexibility to manage NIM challenges. Also, the research noted that this was a laggard due to recapitalization concerns and was trading below its historical mean price to book value (P/BV). Meanwhile, Citi changed its rating on Metrobank and PNB from “buy” to “neutral” given the limited upside to their price targets. “BPI is still poised to sustain above-sector ROE, which we believe has been fully priced in by its outperformance and premium 2.4x P/BV. With potential earnings risk on NIM pressures, we downgrade our rating from neutral to sell,” the research said.

Citi’s target prices for the three biggest Philippine banks are P73.50 for BDO, P71 for BPI and P100 for Metrobank.

On net profit forecast for 2012, Citi upgraded its outlook on BDO to P12.43 billion (from P11.93 billion), on BPI to P14.88 billion (from P13.07 billion) and on Metrobank to P12.31 billion (from P11.94 billion). For 2013, the bottomline forecast for BDO was also raised to P15.82 billion (from P14.92 billion) and for BPI, to P15.41 billion (from P15.02 billion). The 2013 forecast for Metrobank was trimmed to P13.8 billion from P14.08 billion.

Regulatory hurdles

The biggest challenge for Philippine banks moving forward, according to ING’s Garcia, would be the preparation for Basel 3, which introduces a complex package of reforms designed to improve the ability of banks to absorb losses, extend the coverage of financial risks and have a stronger firewall against periods of stress.

“The BSP is really very serious to make sure that banks comply by January 2014 and you don’t just become compliant: you start already to get your bank ready for that,” she said.

Citi’s banking report said more stringent regulatory measures on real estate exposures—as well as the implementation of Basel 3 would have an impact on banks’ operating flexibility.

To further address Basel 3, Citi sees more banks choosing to issue new shares to refinance tier 2 instruments, which are not eligible under Basel 3, such as the case for BDO’s $1-billion rights offer, part of which would be used to redeem its P10-billion tier 2 debt in November. In addition, Citi said banks would likely move to divest their nonfinancial holdings, which will now be be fully deducted from common equity tier 1 under Basel. “As an example, Metrobank will likely transfer its stake in Toyota Motors, power assets and maybe even its insurance stake in its JV (joint venture) with Axa to the parent, GT Capital,” Citi said.

In a recent report, global credit watchdog Fitch Ratings said it did not expect the capital and liquidity standards under the Basel 3 framework to be “overly onerous” for most major Philippine banks, noting they were generally “well-capitalized and with adequate liquidity.”

Fitch said it believed that the lengthy legislative process in the Philippines might affect the progress on further banking-reform initiatives. For instance, the enactment of the national credit bureau has taken five years. Other notable proposed changes still pending in Congress included a wider regulatory scope (to include nonbank entities owning local banks) and legal immunity for BSP employees.

Asian slowdown

BSP chief Tetangco said that having the governance structure in place was “certainly not a panacea. We recognize that the work agenda is complex and far reaching,” noting that aside from Basel 3, key reform initiatives identified by the banking regulator included corporate governance, consumer protection and financial education, financial market infrastructure and crisis preparedness. “These initiatives are on our radar screen today in the context of unifying the prudential architecture of financial stability. None of these is trivial, each one of these requires a keen eye for details and a broader appreciation of how each interconnects with another, and each is essential in the proactive management of any underlying pressure points that may be brewing,” Tetangco said.

Tetangco added that regulators were not underestimating how weaknesses in the West would leave their imprints on Asia, specifically on the Philippines. Although better off than other jurisdictions, he noted that some economies in Asia were also experiencing an economic slowdown. Coupled with the deleveraging or reduction of corporate balance sheets in Europe, he said Asia would feel some of the repercussions, either from releveraging, capital inflows or stronger local currencies—which are concerns for regulators.

“In retrospect, we believe that the Philippine banking system is in a position of strength. Such strength has been achieved through the reforms that we have invested in the past and whose benefits have come to fruition. Moving forward, we expect to further evolve with the needs of the public at large as well as the institutions that we oversee,” Tetangco said.