Banks to sustain growth trajectory

The year 2011 was another banner year for Philippine banks, many of which posted record-high profits and double-digit returns despite the anemic domestic economic growth and external uncertainties. And if the stellar rise of banks’ share prices this year is any indication, the favorable momentum is expected to be sustained. Even feng shui experts predict that this “Year of the Water Dragon” is auspicious for banking and credit.

As the banking performance usually tracks economic cycles, the faster economic growth widely expected this year—especially given the government’s more serious infrastructure spending—is also expected to boost the sector’s core profitability. That said, 2012 will not be without its challenges as asset yields further decline while stiff competition gnaws at operating margins, analysts said. Banks also have to brace for rapid changes in the regulatory environment here and abroad.

While banks will have to work hard to exceed last year’s strong performance, borrowers are, however, the big winners. The cutthroat competition among banks has dramatically reduced interest rates especially on top-tier corporations. It is likewise much cheaper to obtain consumer loans, such as when buying a new home or a car. Only the credit-card business has defied gravity, with interest rates still hovering at 3 percent a month (or 36 a year).

In a nutshell, the banking industry as represented by universal/commercial banks did expand core lending in 2011, turning a bigger share of their deposit liabilities into earning assets. Most of them also improved asset quality and kept adequate capital. Treasury earnings, which had been extraordinarily high in 2010, turned out better than expected last year. But reflective of the industry’s bid to build a more durable earnings stream, 62 percent of the sector’s earnings came from net interest income in 2011, slightly higher than the 61 percent in the previous year.

Overall, banks performed either within expectations or surprised on the upside with their 2011 financial results. Seven out of 10 of the country’s most profitable banks surpassed their net profits in 2010 to post new record levels and nine of them maintained a double-digit return on equity.

“On the eight banks we cover, five were a positive surprise, one was within (expectations) and only one was below (expectations). So overall, the banks surprised (positively) on 2011 earnings,” said Alex Pomento, head of research at Macquarie Securities Group. “The surprise was from the 19-percent loan growth as against guidance of only 15 percent for the whole of 2011.”

For leading online securities brokerage CitisecOnline.com, most banks met its expectations last year. “The positive surprise came from Security Bank only,” said CitisecOnline.com head of research April Lee-Tan.

In 2010, extraordinary treasury earnings boosted Security Bank’s bottom line to a level nearly matching the profit chalked up by tycoon Henry Sy’s flagship shopping mall empire in the same year. Many analysts recognized such profit level could not be replicated in 2011.

Gilbert Lopez, head of research at JP Morgan Securities Philippines, said: “2011 was a banner year in terms of asset expansion and loan growth. We think that this year will be equal if not stronger nominally if the infrastructure spending that we think will happen pushes through and a lot of companies will benefit from that.”

2012 outlook

Macquarie expects publicly listed banks to grow their average earnings per share (EPS) by at least 13 percent this year versus the 10-percent EPS growth last year. “The banks should fare better than overall market given the key index stocks like Philippine Long Distance Telephone Co., Globe Telecom and Energy Development Corp. are likely to show income decline in 2012. The positive surprise on earnings growth would come from banks and properties given that the low (interest rate) domestic environment always translates to better performance for these sectors in the real economy,” Pomento said.

Excluding Security Bank, which it expects to report a 17-percent drop in earnings this year due to high base in 2011, CitisecOnline.com sees publicly listed banks growing their earnings by an average 10 percent this year. This forecast, however, suggests that banks will lag CitisecOnline.com’s forecast average of 15-percent earnings growth for all the companies in the main-share Philippine Stock Exchange index.

“Earnings growth of banks will be tempered due to 1) high base of trading income in 2011 and 2) continuous downward pressure for net interest margins in light of rate cuts by the BSP [Bangko Sentral ng Pilipinas] and removal of interest income on funds set aside as reserves,” Lee-Tan said.

The BSP recently decided to remove the distinction between statutory and liquidity reserve requirements, stop paying interest on these reserves and exclude bank’s cash in vaults and demand deposits as eligible forms of reserve requirement compliance. Regulators expect these changes to increase the effectiveness of the reserve requirement as a monetary policy tool, simplify its implementation and improve compliance monitoring. To neutralize the pressure on financial intermediation costs as a result of this move, the BSP reduced its reserve requirement by 3 percentage points to 18 percent.

Based on consensus forecast published by Bloomberg as of mid-March, the country’s biggest bank (in assets), Banco de Oro Unibank, is expected to chalk up a net profit of P12.35 billion this year and P14.36 billion in 2013 compared to P10.5 billion in 2011. Metropolitan Bank and Trust Co. is seen posting P12.27 billion this year and P14.25 billion in 2013 from P11 billion in 2011. The most valuable bank in the market, Bank of the Philippine Islands, was seen posting P13.99 billion this year and P16.83 billion in 2013 compared to P12.8 billion in 2011.

Asked which publicly listed banks are likely to outperform this year, CitisecOnline’s Lee-Tan said her brokerage house likes Metrobank due to the following: Size gives it an advantage in raising low-cost deposits and in growing its lending portfolio; liquid balance sheet with loan-to-deposit ratio of 67 percent and high capital adequacy ratio of 17.4 percent put in an excellent position to grow its lending portfolio as there are no capacity constraints yet; and relatively cheaper valuation compared to BPI and BDO in terms of price to book value.

Macquarie’s Pomento said BDO would likely outperform when tycoon Henry Sy’s banking arm beefs up its tier 1 or core capital ratio, which the market wants to see growing relative to other big banks.

JP Morgan’s Lopez said the market must also consider ROE versus price to book value. “There may be banks that will look cheap on P/BV but profitability level warrants it. But, for instance, BPI may be pricey on price to book but it also has one of the highest ROEs in the sector,” he said.

Asked about the sharply rising share prices of BPI, bank president Aurelio Montinola III said: “Even we were surprised but we’re not complaining.”

Growth drivers

As net interest income accounts for more than 60 percent of the operating income of the commercial banking system, loan growth has a big influence on overall profitability. This year, banking analysts expect the banking system to sustain a double-digit growth in lending, with forecast growth ranging from as low as 10 percent to as high as 20 percent.

JP Morgan’s Lopez thinks that the industry can replicate a lending growth rate of close to 20 percent this year, even when most banks were trying to “talk down” or give ultra-conservative estimates. “Some say they’ll do 15 percent or less or they won’t see a repeat of previous years. I think we will see an outperformance in that regard so long as the infrastructure story happens for 2012, because that’s the big booster.”

Macquarie’s Pomento sees a loan growth of 15 percent this year, underpinned by the so-called “TIM” sunrise industries—tourism, infrastructure and mining. “In my view the TIM sectors will allow our economy to grow beyond 5 percent on a more sustainable basis; thus banks should put more funding to support these industries.

CitisecOnline.com’s Lee-Tan agreed that loan demand would pick up on the assumption that there would be more public-private partnership (PPP)-funded projects and if the government would successfully drive substantial growth in investment spending. She said CitisecOnline’s loan growth forecast this year was “quite conservative” at only 10-12 percent. “However, we expect this number to easily increase assuming that more PPPs are launched and investments pick up,” she said.

The outlook is likewise positive for fee-based income including trust fees, Lee-Tan said, in light of growth demand for fund management services. She said another opportunity this year would be a possible reduction in provisions for some banks in light of much lower nonperforming loan (NPL) burden as a ratio of total portfolio and high NPL cover.

Operating challenges

Stiff competition remains a major challenge for banks alongside the need to boost operating efficiency and perk up margins and asset yields.

With the record-low interest rate environment, the sector’s earning asset yield last year eased to 5.13 percent from 6.13 percent in 2010. Net interest margin, on the other hand, thinned to 3.45 percent from 4.08 percent as banks slashed lending rates (except for credit cards).

“Challenges come from the heightened competition as the big banks continue to gobble market share which hurt the smaller banks. This competition I believe will result to consolidation as mid-size banks that could not survive the moves of the big banks will likely accept (merger and acquisition or M&A) offers,” said Pomento.

Lee-Tan said the base of high trading income in 2011 would be a key challenge this year. She added that net interest margins would continue to be under pressure to narrow further this year.

Some fund managers said rising loan-to-deposit (LDR), an indicator of how much liquidity is maintained in the process of financial intermediation, may become a constraint for some banks. In 2011, the banking system’s LDR rose to 68.4 percent from the previous year’s 62.6 percent. This meant that out of every P1 generated by banks as deposits, 68.4 centavos were lent out.

Lee-Tan said, however, that the latest LDR was still low. She said she would be more concerned if the LDR hits close to 80 percent given the reserve requirement of 18 percent. “In fact, it might even be beneficial in the sense that it would minimize margin pressure as banks won’t need to cut lending rates as they compete to lend out extra cash in their balance sheets,” she said.

Other analysts said one way for banks to avoid asset yield and net interest margin compression would be to maintain their loan portfolio but reduce cheap lending to top corporations. Banks that are too focused on top-tier corporations may continue to face such pressure while those that will go further down-market will be able to boost their margins. One likely trend will thus be to say no to bilateral lending to corporations and instead encourage them to raise longer term financing from the retail bond market instead.

Meanwhile, the banking industry still spends nearly 62.8 centavos to earn every peso. This high cost-to-income ratio is usually attributed to high costs of maintaining brick-and-mortar presence, having too many branches in a certain location and the still-low penetration of alternative channels like mobile or online banking that require less manpower to reach out to more people. On the other hand, some of Asia’s largest banks have cost-to-income ratios of only 20-30 percent.

Regulatory hurdles

While lending by commercial banks grew 19 percent last year, deposits rose at a much slower 5.3 percent. Part of this was due to a natural shift to higher-yielding instruments given the low-interest rate environment, as proven by the surge in the managed funds industry. Note that the trust and other fiduciary business and investment management activities (which are off the balance sheet) of commercial banks as estimated by the BSP hit a record high P2.69 trillion as of September last year, up 24.5 percent from the end-2010 level.

Pascual Garcia III, president of the Metrobank group’s thrift banking arm Philippine Savings Bank, expects banks to be less aggressive in deposit-taking this year. Gone are the days of “war of the elephants,” Garcia said, referring to the stiff competition among the top three banks BDO, Metrobank and BPI in generating deposits that thereby pushed up deposits rates.

Another factor that banks will watch out for, Garcia said, was the prospective impact of a tighter law on agri-agra, which requires banks to set aside and lend to both agriculture and agrarian sectors equivalent to at least 25 percent of loanable funds (deposits plus capital).

“For every P100 (deposit generated), you have to lend P25 to agri-agra but the sector’s absorptive capacity is very low,” Garcia said, citing a Bankers Association of the Philippines study estimating such agri-agra absorptive capacity at only 15-16 percent. “So naturally, there’s cost penalty for every peso of deposit that you’re not able to lend out,” he said. Based on the penalty of 50 basis points a year for such violation, he said the net increase in cost was about 12.5 basis points based on the 25 percent mandatory lending ratio.

BSP managing director Johnny Noe Ravalo, for his part, said banks would have to brace for further changes in the regulatory environment.  “There’s a lot of challenge on the table,” he said, citing the Basel 3 capital adequacy framework as just one of the examples.

“That’s why we announced the timeline for Basel 3. We give them the two years to adjust and make their strategic decisions now,” Ravalo said. Universal and commercial banks are required to adopt by Jan. 1, 2014, the capital adequacy standards under Basel 3, which introduces a complex package of reforms designed to improve the ability of bank capital to absorb losses, extend the coverage of financial risks and have stronger firewalls against periods of stress.

But aside from Basel 3, Ravalo cited new accounting rules, new corporate governance framework, as well as changes in the rules on outsourcing, compliance and even cross-selling. For Ravalo, the biggest challenge for banks would thus be the fast-changing environment. “It’s putting all of these little details together because the world isn’t static,” he said. For him, the biggest challenge for banks is “change.”