Singapore Banks - Maybank Kim Eng 2016-09-07: Six Smoking Guns

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Singapore Banks DBS GROUP HOLDINGS LTD D05.SI  OVERSEA-CHINESE BANKING CORP O39.SI  UNITED OVERSEAS BANK LTD U11.SI 

Singapore Banks - Six Smoking Guns

Mind the trap! 

• Singapore banks are trading at/below book value. 
• Beware the value trap! ROEs are struggling and we see multiple stress points for returns on capital. These could compress valuations further.

ROE downshift 

• Tailwinds for the sector after GFC may have petered out. A structural ROE downshift may be in the works. The six smoking guns we see are: 
  • sluggish loan volume, 
  • pricing pressures, 
  • reduced headroom for LDR increases, 
  • higher credit costs, 
  • trading-book dependency and 
  • regulatory capital requirements.

New normal; still prefer UOB 

• 2015 P/BV convergence may be extended in the intermediate term, as macro influences such as interest rates and asset quality take precedence over stock specifics. Further out, we believe ROEs and valuations could diverge again. 
• Differences in banks’ capital returns and business strategies could be accentuated by their responses to the above challenges. We think banks may maintain or enlarge their trading books and become more active in asset securitisation. 
• Low ROEs could also force them into more M&As. 
• UOB has much to catch up on but more headroom to manoeuvre, in our assessment. It remains our preferred exposure. Maintain HOLD and SGD18.34 TP, based on 0.9x FY17E P/BV (sustainable ROE: 9.6%, COE: 10.1%, growth rate: 3.5%).

ROEs hassled on multiple fronts 

• ROEs have been under stress since 1997. Before the Asian financial crisis, OCBC’s and UOB’s ROEs consistently topped 12-15% while DBS’ lagged at 11-12%. But the long tail of non-performing assets (NPAs), which peaked at 7-10% in 2002, pressed down average returns to 11% during 2002-2007. 
• Even during the Goldilocks era of 2010-15 when large specific provisions were absent, ROEs reached a high of only 12.2%. Their mean was 11.8%. 2015/16 may well mark another tipping point. We see escalating risks of ROE recapitulation, to single-digit levels.
• Our 2016 ROE estimates for DBS, OCBC and UOB are 10%/10.5%/10.5% respectively. We assume that the credit cycle will blow over in 2019 and ROEs will normalise at 8-9%.

Six charts you must know 

1: Large exposure to China is unwinding.

• Banks are struggling to maintain their lending volumes. After GFC, China attracted large capital flows from DBS and OCBC. This worked well for the two from 2008 to 2014, bumping up their ROEs. Current subdued Chinese growth and high scepticism over the sturdiness of China’s banking system give cause for concern. Trade loans have become much quieter as onshore borrowing turns more attractive. 
• All three banks have been paring down their China books. Greater China lending by DBS was down from 36% of its book in 2014 to 30% in 2Q16. DBS’ trade loans dived 67% from 2Q14 levels to SGD12b in 2Q16. OCBC’s and UOB’s lending exposure to China retreated more modestly, from 26%/13% of their loan books in 2014 to 24%/11% in 2Q16. 
• We think China exposures may be further downsized. All this capital has to find a new home.

2: Banks’ Singapore loan growth outpaced system loan growth.

• Back in Singapore, a sharp deceleration in system loan growth since Jul 2015 already raises the bogeyman of a tussle for market share. Directing excess capital back to Singapore will only worsen competitive pressures.
• In 1H16, all three banks booked faster lending growth locally than the banking system itself. This outperformance could only have been achieved by embracing higher risks or compromising on loan pricing, in our view. We think the latter was more likely.

3: Unable to re-price for higher credit risks.

• Given sluggish domestic lending and the pressure to make up for downsized China exposures, we are not surprised that customer lending rates and spreads have been flat, even as asset quality deteriorates. Unless interest rates rear their heads, NIMs could tighten. 
• After GFC, Singapore banks were spared the worst of pricing pressures as they redeployed their excess capital to Greater China. But price pressures, especially on large corporate and consumer loans, are beginning to be palpable. If banks cannot expand their credit spreads in a heightened risk environment, they could find it even more difficult to sustain NIMs when the credit cycle normalises. Lower ROEs and, hence, valuations may become unavoidable.
• UOB has been able to maintain elevated lending yields thanks to its SME franchise. 
• DBS has been able to push through lower deposit rates, as usual, and manage funding costs through lower customer deposit costs from CASA and/or synthetics. With this, its NIM expanded in 2Q16, much to market cheer. We deem this a blip, however. There is a limit to how low cost of funds can go. Taking on bigger proprietary positions to lower liability costs also carries risks of higher volatility.

4: LDRs are more or less maxed out.

• Steady increases in loan-deposit ratios have mitigated part of the contraction in banks’ net interest margins, caused by easing rates and lower credit spreads. DBS’ group LDR went from 59.9% in 2002 to 91.8% in 2Q16, an all-time high. UOB’s was lower at 84% and OCBC’s, at 82.2%. DBS typically has a big catchment of SGD deposits and a lower SGD LDR than peers. Its high group LDR was partly attributable to a high USD LDR of 99.2% vs peers’ 63-64% as of 2Q16. With its high LDR and tighter liquidity than peers, it would be hard-pressed to lift its LDR further, in our view.
• Indonesia’s recent tax amnesty adds to the uncertainties. Anecdotal evidence already points to the repatriation of some Indonesian funds parked in Singapore. Any large outflows could tighten liquidity in the system, spike LDRs and squeeze banks which fund loans through the interbank market. Capital outflows may exert subtle pressure on the SGD. Private banking in Singapore may reel from AUM losses. The timing is unfortunate since wealth management features prominently in the growth plans of the banks. OCBC and DBS, in particular, have been investing heavily in this business.

5: Macro volatility will not make it easy for trading.

• VAR measures potential losses in value of risky assets or portfolio over a period of time for a given confidence level. The above chart in percentages shows the confidence level of the VAR method used by each bank.
• Trading income formed 6-11% of banks’ total income in 2015. They have been the chief engine behind their revenue growth since 2008. To be fair, not all have the same risk appetite. At a 97.5% confidence level, DBS’ Value at Risk or VAR for its trading book is about 3x UOB’s, even when UOB’s VAR is based on a 99% confidence level. Since 2008, trading books have also gotten bigger. 
• DBS’ revenue outperformance in the last eight years was propelled by its bigger proprietary positions. Macro uncertainties will raise VAR. Its larger trading position also exposes it more to Basel rules which require higher risk weights for trading books. More capital will be needed to support its trading desk and returns could shrink, ceteris paribus.

6: Provisions are not adequate.

• There is no magic formula for estimating credit costs. Offshore marine services are facing a liquidity crunch. High business costs in Singapore and low productivity are edging out Singapore companies from global markets. Bankers face a major dilemma of whether to pull credit lines from weak borrowers – jeopardising their exposure - or throw good money after bad, while waiting for the tide to turn. Another leg down in oil prices may just tip the scale.
• On our part, we think the problem is likely more cyclical than structural. As long as mortgages and property loans are not under threat, systemic risks should be low and manageable. That said, asset quality does have a long tail. The shakeout in offshore marine has barely started and industry rebalancing is not yet in sight. Indonesia, China and commodities such as steel, coal and oil & gas are equally under stress. The pain could get worse before getting better, especially as provision coverage has fallen.
• Between 3Q15 and 2Q16, coverage fell the most for DBS, by 47ppts. Next came 21ppts for OCBC and 18ppts for UOB. UOB has the highest coverage and a bigger buffer from 1.5% general provisions vs peers’ 0.9-1.0%. Logically, it should be better equipped for further asset-quality deterioration. It seems to have taken a hit on NPLs earlier and provided more, given its larger SME clientele.
• Currently, MAS Notice 612 requires banks to set aside general provisions of a minimum 1% of loans, net of collateral and deductions for any specific provisions. IFRS9 impairment implementation will present new challenges come 2018. This accounting rule requires banks to book impairment charges based on expected losses rather than incurred credit losses. Under the new rule, they are likely to recognise losses earlier as it requires their models to have forward-looking information and inputs such as forecasts of macroeconomic indicators.

If that’s not enough … banks’ leverage can only move in one direction: DOWN.

• Since Jan 2013, the adoption of Basel 3 capital-adequacy requirements has lowered Tier 1 and total capital adequacy ratios. Under Basel 3 transition rules, banks have to apply: 
  1. higher risk weights to their exposure to financial institutions and central counterparties; 
  2. new capital charges on over-the-counter derivatives; and 
  3. more stringent definitions for preference shares and subordinated notes. 
• Singapore banks met the minimum CET1 CAR of 6.5% for Basel 3. As of 2Q16, fully-loaded CET1 for DBS, OCBC and UOB was 13.4%, 12.7% and 12.2% respectively. UOB has applied scrip dividends to shore up its capital. 
• Upcoming Basel 4 rules could demand higher risk weights. These rules have not been finalised and it is not yet certain whether the banks have the capacity to increase their risk-weighted assets, without the need for fund-raising or dividend cuts.

Conclusion 

Beware the downshift in ROEs & sector de-rating risks 

• Tailwinds for the sector’s returns after GFC may have petered out. Sluggish loan volume, pricing pressures, reduced headroom for LDR increases, higher credit costs, trading-book dependency and regulatory capital requirements could crimp returns and valuations.
• While trading income may still prop up earnings, we think that the low-hanging fruits are likely over.
• Global banks that have been unable to sustain their returns have been punished by markets. Witness Deutsche Bank, Citigroup, Standard Chartered and Credit Suisse, which are trading at less than 0.6x P/BV. The liquidity provided by central banks may just be underpinning their survival. Excess capacity in the system and depressed pricing globally may continue to erode returns for all players. With this, slippages below double-digit capital returns may have consequences for valuations.
• Already, with each economic crisis, Singapore banks’ valuations have slipped down a notch. From more than 2x P/BV in the 1990s, they drifted down to 1.5-2x after the Asian financial crisis. After GFC, they were further compressed to 1-1.5x. They now hang precariously around 1x. In all likelihood, we are on the cusp of a new normal for returns and valuations.

ROE divergence may be masked, short term 2016-17 earnings visibility is poor. 

• ROE forecasts for our three banks converge, largely shaped by lumpy delinquency classifications. But we think their underlying core earnings are masked by a few things: potential interest-rate changes; provision coverage for problematic loans, primarily attributable to SOEs and the commodity, oil & gas and property sectors; and trading profits. 
• Interest rates would have a big impact. Banks reckon that every 100bp decline in interest rates could reduce the economic value of their equity (present value of assets less present value of liabilities) or net interest income by SGD250-463m, as of 2015. We think this is contingent on the positioning of their books. 
• During uncertain times, sector dynamics would be more important influences on stock prices than bank specifics, in our view.

Expect divergence to return 

• From our analysis, it is clear that banks’ strategies vary and operating results will diverge over time. DBS’ pre-provision profits starkly outperformed in 2002-15. The three banks’ differences are likely to become more pronounced as they map their strategic responses to the challenges we have identified.
• We expect their variances to centre on the size of their trading books: DBS has the largest but UOB has the greatest scope for additions. We also expect more active asset securitisation. Here, DBS is likely to be the trail blazer. 
• Low ROEs could also force banks into more M&As, likely led by OCBC and DBS. This quest for growth could turn them into regional forerunners back to Hong Kong / China - again DBS and OCBC - and fintech innovators. 
• Above all, we think whether banks succeed in defending or expanding their ROEs will hinge on their fee-income growth as regulations push for greater capital intensity. Although DBS has and will likely be more aggressive regionally than UOB, we caution that returns from the region - barring Indonesia - may not beat Singapore’s, based on our ROA analysis.

UOB still our preferred exposure 

• UOB is the most conservative domestic bank. It has the smallest trading book, highest provisioning coverage, biggest Singapore exposure, smallest China exposure and lower USD LDR. 
• We also think that its higher NPL ratio has more to do with its more pre - emptive classifications. It is also the most cautious in M&As. The bank has the biggest scope to upsize its trading book, in our estimation. 
• As risks heighten, UOB remains our preferred exposure to the Singapore banking sector.

Ng Li Hiang Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2016-09-07

Maybank Kim Eng SGX Stock Analyst Report SELL Maintain SELL 14.30 Same 14.30

SELL Maintain SELL 7.49 Same 7.49

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