Banks remain in a ‘sweet spot’

MANILA, Philippines—An extraordinary year is always a tough act to follow, and 2010 was just that for Philippine banks.

Most banks booked record-high profits for the year, thanks to a prolonged period of record-low interest rates that boosted trading gains. At the same time, earnings from core lending businesses were robust, and not surprisingly so, given that the domestic economy had grown 7.3 percent last year, the fastest pace in 34 years.

But after having the best of both worlds in 2010, this year is an entirely different ballgame.

“They had a fantastic year in 2010. Now they have to continue to find new areas to finance. There’s extreme competition. Many of them are trying to go down [the market] and scale a little bit and use their liquidity to get a better return on equity,” said Jesse Ang, International Finance Corp.’s country representative to the Philippines.

Bank of the Philippine Islands president Aurelio Montinola III, who is also president of the Bankers Association of the Philippines, said it might be difficult for banks to replicate last year’s exceptional performance.

“There will be growth as the economy is still good but the growth rates won’t be as good. So you have the possibility that even if business volumes increase by 10-15 percent, revenue and income will not be as strong as in 2010,” Montinola said.

Phenomenal

With emerging Asia expanding at a phenomenal pace, led by China and India, there has been a surge in demand for goods and services that, in turn, is driving up inflation. At the same time, global food and oil prices are rising, especially with the social unrest in the oil-rich Middle East-North African region. Central banks are thus under extreme pressure to raise interest rates or conduct other forms of monetary tightening in order to temper any future spike in inflation and more importantly, to temper rising expectations.

Double-digit growth

This is especially true for the Bangko Sentral ng Pilipinas (BSP), the only one in the region that has yet to make a tightening move.

With interest rates bottoming out from historically low levels this year, trading gains may not be as much as in 2010 as mark-to-market requirements on bond holdings outweigh coupon earnings. Based on our survey of the country’s biggest banks, treasury earnings may decline by at least 30 percent to as much as 50 percent this 2011 compared with last year.

The good news, however, is that most banks may still be able to post double-digit growth in net profits this year, even if the pace of increase is not as impressive as last year. They are, after all, in a good position to increase their core lending activities.

HSBC regional economist Frederic Neumann noted that credit growth in the country started to pick up (as a ratio of gross domestic product) only in 2007 after the decade-long post-Asian crisis “de-leveraging” process.

Sharp currency devaluation and the bursting of a property bubble resulted in a massive wave of corporate loan defaults in the late 1990s. But after cleaning up their post-Asian crisis balance sheet since then, without the state-funded takeout of bad loans seen elsewhere in the region, Philippine banks have emerged in good shape even when a new crisis of global proportion, emanating from Wall Street, wreaked havoc in 2008.

‘Keep things simple’

The biggest lesson from the recent global crisis, Montinola said, was to indeed “keep things simple and go back to basics.”

In general, he noted that Asian banks have the advantage because they have kept their businesses simple and maintained a good funding base.

Most Philippine bankers today were the same ones who lived through the Asian crisis more than 10 years ago and have learned from that episode, Montinola observed. Thus, when the US shockwave came, the local financial system had lower corporate and bank leverage and much higher capital adequacy ratios against risk assets, he explained.

“It also greatly helped that the banking regulators were relatively strict on complex products and maintained an open relationship with the industry,” Montinola said. The result was a commercial banking system with a healthy core balance sheet, steadily expanding earning assets, prudently growing credit, ample liquidity and much improved asset quality.

2010 in review

Aided by robust economic expansion, improved market sentiment and improved cost-efficiency operations, banks were riding the crest of the wave last year. Average return on equity jumped to double-digit levels from less than 9 percent in 2009. While enjoying heftier gains from proprietary trading, commercial banks also expanded their loan book (net of placements with the central bank) by 8.9 percent as of December last year from that of the previous year.

Indicative of a much-improved asset quality, the nonperforming loan ratio of universal and commercial banks eased to 2.88 percent in end-December from the previous year’s 2.97 percent. This was the lowest recorded NPL ratio for the sector since the onset of the 1997 Asian crisis. The industry also provided large provisioning against potential credit losses. For every P1 of bad loan, the banking system set aside P1.18 as buffer.

The banking system, which controls more than 90 percent of the assets of the financial system, also remained awash in cash despite a high reserve requirement of 19 percent on peso deposit liabilities and deposit substitutes. For every peso accepted as deposit, banks lent out only about 66 centavos as of end-June last year. The BSP cited this practice as “prudent” credit allocation.

After all, the recent crisis showed that over-leveraged financial institutions—or those with loan to deposit ratio of more than 100 percent and without sufficient capital buffers for their risk-taking activities—were likely to collapse, the BSP report said.

Based on full-year 2010 bottom line, this was how the biggest Philippine banks fared in terms of peso net profits (The ranking does not include Philippine National Bank and Development Bank of the Philippines, which have yet to officially release full-year results at press time.):

Bank of the Philippine Islands—P11.3 billion (up 33 percent), equivalent to a return on equity (ROE) of 15.6 percent (up from 13 percent).

Banco De Oro Unibank—P8.8 billion (up 46 percent), equivalent to an ROE of 11.7 percent (up from 10.4 percent).

Metropolitan Bank and Trust Co—P8.4 billion (up 39 percent), equivalent to an ROE of 10.3 percent (up from 8.6 percent).

Land Bank of the Philippines—P8.1 billion (up 20 percent), equivalent to an ROE of 15 percent (up from 14 percent).

Security Bank—P7.2 billion (up 134 percent), equivalent to a 35-percent ROE (up from 20.9 percent).

Union Bank of the Philippines—P5.35 billion (up 24 percent), equivalent to an ROE of 15 percent (up from 13.8 percent).

China Bank—P5 billion (up 22 percent), equivalent to an ROE of 16.69 percent (up from 15.36 percent).

Rizal Commercial Banking Corp—P4.25 billion (up 28 percent), equivalent to an ROE of 14.07 percent (up from 11.95 percent).

It would be worthy to note that the net profit posted by each of these eight banks were all record highs.

Sustained momentum

April Lee Tan, head of research at leading online stock brokerage CitisecOnline, said earnings growth this year could still be at the mid-teen level for Philippine banks.

For this year, CitisecOnline had assumed a 50-percent decline in trading gains, which was the high end of the range budgeted by most banks.

“But that decline could be offset by higher loan growth, higher net interest earnings from such loan growth and low provisions this year as most of them had set aside 100-percent provisioning [versus soured loans] already,” Lee-Tan said.

She said she was expecting banks to expand their loan book by 10 to 12 percent this year. So even if trading gains were to decline, the country’s biggest banks could post record profits.

BPI was projected to chalk up P12.8 billion in net profit this year, while Metrobank and BDO were forecast to book P11.2 billion and P9.5 billion, respectively, based on CitisecOnline forecasts.

Treasury gains, which hit as high as 70 percent of net profits for some big banks last year, would be lucky to peak at 50 percent this year, according to Roberto Juanchito Dispo of First Metro Investment Corp. As for the magnitude of the decline, Dispo projected that most banks might be able to limit the slowdown to the lower end of the 30-50 percent of the assumed range.

‘Rock solid’

CLSA Asia Pacific head of research for the Philippines Alfred Dy said the fundamentals of the banking sector were “rock solid” given a low NPL ratio, low LDR ratio and a high tier 1 core ratio.

“In short, there is huge potential for loans to pick up significantly in the coming years, and we believe that 2012 is the year that loans will move up dramatically. This is so since we expect proponents of the PPP [public-private partnership projects in infrastructure-building] to secure financing for … their respective projects,” Dy said.

For this year, CLSA agreed that loan growth in the country would hit 12 percent and could accelerate further to 14 percent on continued economic growth and the onset of PPP infrastructure development worth $10 billion.

The BSP, for its part, recently approved a separate single borrower’s limit for infrastructure or development projects undertaken under the PPP. Under the new guidelines, banks could extend the equivalent of up to 25 percent of their net worth as loans, credit accommodations and guarantees for infrastructure projects for as long as the National Economic and Development Authority would certify that the projects fall under the PPP program.

Fund manager Michael Ferrer of ATR KimEng Asset Management Group said consumer lending might still grow as most of the country’s lenders had under-allocation for this segment.

“Trading income has been quite bad for the last month [January 2011] and probably won’t be as interesting this year, so banks that rely heavily on trading income I think will not show good results this year. But those that focus on consumers I think should do well,” Ferrer said.

East West Bank president Antonio Moncupa Jr. said that the Philippines “has one of the lowest consumer loan penetration in Southeast Asia. Foreign banks, except for a few doing credit cards, are generally in wholesale banking. This leaves the corporate middle markets and the broad consumer market as big open opportunities.”

Lending to consumers or households, such as for the purchase of cars, homes or shopping charged to credit cards has been a strong proposition for banks especially because this is an area where they get better margins. The Metrobank group’s publicly listed thrift unit PSBank, for instance, ended 2010 with a record net profit of P1.8 billion, up 46 percent from a year before.

The good outlook for the domestic economy and a growing population are also seen to favor banks over the long run. The Philippines is among the 11 “most promising” countries likely to stand out in a globally integrated economy in terms of high growth rates and investment returns over the next four decades, according to global banking giant Citigroup.

Challenges ahead

Among the key challenges for Philippine banks moving forward are to improve operating efficiency, turn the large pool of foreign currency deposits under their foreign currency deposit units (FCDUs) into earning assets and prepare for stiffer capital adequacy requirements under Basel 3.

Philippine banks spent about 65 centavos to earn P1, based on BSP data as of end-June last year. Such cost-to-income ratio of 65 percent—a key measure of operating efficiency—still surprised a lot of people, Sun Life of Canada managing director for Asia investments Michael Manuel said.

Manuel noted that the comparative ratio in Taiwan, for instance, was at around 30 percent.

“Thailand is much more efficient, and I know that Hong Kong is super-efficient,” he said.

Manuel said the Philippines could probably sustain inefficient operations because net interest margins—or the spread they earn when they lend out deposits accepted from the public—were still high at more than 4 percent.

“If you look at other countries like Taiwan, the net interest margin there is 1.5-2.5 percent, therefore they can’t afford to be inefficient,” Manuel added.

Bankers, however, already feel a narrowing on the spreads from the top tier corporate to the consumer portfolio. Competition is seen as key in prompting banks to improve efficiency. Eliminating redundant branches and using the power of technology to better manage overhead are also some of the factors that can drive down cost-to-income ratio in the years ahead.

Another key challenge seen is to make the most out of $20 billion in deposits lodged in banks’ foreign currency deposit units (FCDUs).

“A lot of the banks have big dollar deposits. When you take their consolidated LDR [loan-to-deposit ratio], it may mislead you into thinking they have a lot of liquidity and therefore can participate in growth. I want to see which banks have scale and which banks have low peso LDR because, when they report, that’s consolidated,” Manuel said.

Philippine banks will also have to brace for the phase-in of the Basel 3 global standards for capital adequacy.

The standards were developed to correct the shortcomings of Basel 2 that were unearthed when the global financial crisis erupted in 2008.

Basel 3 proposes many new capital, leverage and liquidity standards to strengthen regulation, supervision and risk management of the banking sector. For instance, the capital standards and new capital buffers will require banks to hold more capital and higher quality of capital than under Basel 2 rules.

Finally, another major challenge to the banking system is the volatile external environment. After the European fiscal crisis and the political tension on the Korean peninsula, an even bigger risk is coming from the political upheaval in the oil-rich region of North Africa and the Middle East, given the consequent surge in oil prices and displacement of overseas Filipino workers.

At risk

Remittance fees from banks, which have an extensive overseas Filipino worker network were at risk, said Jose Mari Lacson, head of research at Campos Lanuza & Co.

“While democracy may be scoring a victory in the region, this should be seen as a potential area of concern for the Philippines. A further deterioration of the social situation in the region could eventually lead to weaker OFW inflows as actual and potential jobs would be lost if governments fight back, as in the case of Libya and Bahrain,” Lacson said.

As remittances substantially fuel domestic consumption, a potential decline in demand if the crisis escalated would not be good for banks or to enterprises they serve. But as long as the turmoil would not spread to other Arab nations, particularly Saudi Arabia, the Philippines may withstand external shocks given its record gross international reserves, which have now exceeded the country’s total foreign debt stock.

Locally, BPI’s Montinola said business optimism would still be high, following last year’s election of a new president with a popular mandate. He said the key would be to “convert into action” the upbeat view on the administration of President Aquino.