Singapore Banks - DBS Research 2017-11-23: A Year Of Greater Conviction

Singapore Banks - DBS Vickers 2017-11-23: A Year Of Greater Conviction Singapore Banking Stocks OVERSEA-CHINESE BANKING CORP O39.SI UNITED OVERSEAS BANK LTD U11.SI

Singapore Banks - A Year Of Greater Conviction

  • Three things to watch in 2018:
    1. NIM acceleration is for real,
    2. cleaner asset quality position with lower credit costs,
    3. sustained loan growth recovery.
  • On a cleaner slate after oil & gas NPL woes; lower credit costs expected.
  • IFRS9/SFRS109 implementation from 1 January 2018; UOB could see earnings upside.
  • BUYs for both OCBC and UOB; OCBC preferred.

Three trends to watch in 2018 

Greater conviction in 2018. 

  • We started 2017 with hopes of NIM expansion but with slow loan growth and that the bulk of NPL issues related to the oil & gas sector would be over. While NIM acceleration was not visible and NPL issues were still plaguing the banks up to 3Q17, the banks had rallied ahead, collectively appreciating by > 30% over 2017, one of the best sector performances. 

Will 2018 be a better year? 

  • The drivers to share price performance are the same ones we identified in 2017 but we have more conviction on the impact of these drivers for 2018. 
  • Three trends to watch in 2018 are
    1. the SIBOR rally has kick-started, hence NIM acceleration ahead will be quite certain,
    2. while there were still upsets in the oil & gas sector, these were dealt with in 3Q17, as such credit costs should ease with higher conviction,
    3. loan growth has picked up and should sustain on a positive GDP outlook forecasted at 3% for 2018. 
  • All these factors should drive valuations up further but we believe the banks’ ability to keep a clean asset quality trend would be the most crucial factor to shift valuations above mean.

(1) SIBOR rally has kick-started; NIM momentum should pick up 

Fed rates rose, but little impact seen in 2017. 

  • The passthrough from rising USD interest rates to SGD interest rates has largely been muddled by strong USD trend that persisted through to September 2017. As a result, SIBOR/SOR hardly moved vs early 2017 even as the Fed hiked rates twice in 2017. 
  • With the USD strength reasserting and the Fed likely to hike by a cumulative 100bps by the end of 2018, we suspect that upward pressure on SGD rates should be more apparent in coming quarters.

History tells us that increases in LIBOR will translate to increases in SIBOR/SOR. 

  • In the last prolonged rally of rising rates (i.e. excluding short-term spikes in 2H08 during GFC), every 100-bp rise in LIBOR translated to an equivalent of c.65-bp to 70-bp rise in SIBOR/SOR. 
  • Historically, SIBOR has tracked SOR quite tightly. But we saw a decoupling of the SIBOR and SOR relationship up to 1H17. The widening gap between SIBOR and SOR had capped NIM from moving up.

SIBOR picked up in 2H17, pass-through normalising. 

  • First signs of SIBOR pick-up was apparent in 3Q17 as the passthrough effect from USD rate hikes started to normalise, we should be seeing early signs of NIM uplift in 4Q17. Such persistent trends are expected to flow into 2018.

NIM uplift more visibly expected in 2018. 

  • With rate hikes almost a certainty in the coming quarters, the 3M SIBOR/SOR have broken out of their trading range, reaching their highest level so far. With a greater pass-through expected from the USD rates to SIBOR/SOR, the Singapore banks are almost surely to deliver higher NIM. The expected sustained rise in SIBOR should see the Singapore banks' NIM on a firmer rise in 2018. 
  • We expect a NIM uplift of 5bps in 2018, taking into account some elements of competition and rise in funding costs outside Singapore operations. Our sensitivity analysis shows that every 25-bp rise in interest rates that reprices the S$, HK$ and US$ book collectively will lift average NIM by 3bps (UOB: +1bps; OCBC: +3bps) with a corresponding 2% increase (UOB: +1%; OCBC: +2%) in sector earnings.

(2) NPL issues are largely over and done with 2017 was better than 2016 but still below expectations. 

  • We did say that credit costs may remain relatively elevated in 2017 (vs 5-year historical trends) albeit lower than 2016’s and that possible earnings surprises could emerge if asset quality recovers quicker than expected in 2017. However, trends were not promising in 2Q17 and we saw new NPL formation creeping up again. 
  • By 3Q17, new NPL formation had further increased but this should be the last significant leg of increase. On the whole, cumulative new NPL formation was lower in 2017 vs 2016 for OCBC and UOB.

Starting on a clean slate in 2018; oil & gas woes largely accounted for. 

  • While it may be too early to call for a recovery of the oil & gas sector, there are early signs of chartering activities picking up but charter contracts are still very short term in nature. Banks had largely accelerated NPL classification in 3Q17; UOB stated that there is one more big name to be classified in 4Q17, while at OCBC, asset quality has largely stabilised with lower new NPL formation. 
  • The market appears to be disregarding downside risk to further NPL issues, anticipating that the bulk of NPL issues and necessary provisions should have been largely dealt with. With the macroeconomic environment on a positive drive, we believe there should be minimal impact for any NPLs potentially spreading to the other sectors for now.

IFRS9/SFRS109 implementation could bring about changes.

  • The Singapore banks will be implementing the IFRS9/SFRS109 from 1 January 2018. The SFRS109 requires banks to maintain a minimum of 1% collective impairment allowance and specific allowance to be set aside on a case-by-case basis. 
  • The Expected Credit Loss (ECL) model includes more forward-looking information to assess credit quality of the bank’s underlying financial assets. It appears that smoothening out earnings by adding or using general provision reserves will no longer be allowed; this could pose upside risk to UOB’s FY18-19F earnings from its sticky 32-bp credit cost guidance. We gauge that the impact would be neutral to mildly positive to capital and P/L. 
  • Banks now are now working on how they will treat excess general provision reserves as they prepare for the implementation of IFRS9/SFRS109. The considerations include how much the bank will need going forward post IFRS9/SFRS109, whether it should take advantage of its excess reserves and bump up specific provisions and whether it should transfer the excess into P/L or keep it in retained earnings. 
  • There are also tax implications the banks will need to consider. There will be more clarity in the 4Q/FY17 briefing.

Lower credit costs in 2018, almost a certainty. 

  • With NPL woes largely addressed in 3Q17, the banks should make a clean start in 2018 and credit costs should ease. We expect credit cost to drop by 6bps to 29bps (2017F: 34bps). Based on our estimates, the through-the-cycle credit cost (2003- 2016) stands at 35bps. The question now begs as to how much credit costs will be booked from FY18 with the implementation of IFRS9/SFRS109. 
  • We will relook at our credit cost assumption when banks guide on the impact post IFRS9/SFRS109. Every 5-bp decrease in credit cost will lift average sector earnings by 3%.

(3) Loan growth pick up; supplementary top-line growth 

Adding a second growth engine - loans. 

  • Loan growth has surprised on the upside in 2017 with banks in generally guiding for a 7-8% loan growth. The momentum is expected to continue in 2018, still driven by property-related (mainly domestic) as well as domestic and regional corporate loans. 
  • Sensitivity of loan growth to earnings is marginal (every 1-ppt increase in loan growth leads to only less than 1% impact on earnings. It would be more important to watch the impact of NIM on earnings.

Growth Opportunities – A longer-term view 

Over time, we need to see sustainable growth drivers. 

  • The focus on NIM, lower provisions and loan growth recovery are short-term catalysts. Over the longer term, we would need to see banks having new or accelerated revenue engines to drive growth. With capital in mind, as there are still pending regulatory issues (i.e. Basel 4), banks will need to be prudent in utilising capital. This is why we believe banks' leveraging in capital light businesses – wealth management – would see improved ROE over time. OCBC would be a proxy for this theme.

Keep watch on wealth management. 

  • Wealth management income has grown exponentially over the years. In the last seven years, wealth management has grown from a small fraction to nearly one-third of total fee and commission income for DBS and OCBC. The three banks did well in their respective wealth management businesses albeit in different focus areas. All three banks registered absolute growth of 48% (OCBC, including Barclays’ portfolio), 38% (UOB) and 33% (DBS) respectively on a 9M17 vs 9M16 basis. 
  • The strong growth registered across the banks has been largely attributed to the banks’ consumer customer franchise network, relationships with SME business owners, as well as bancassurance products. 
  • OCBC’s subsidiary, Great Eastern Holdings (GEH) plays an important role in providing a complete range of wealth management offering from within its suite of products. High-profile acquisitions for wealth and investment management businesses have also contributed to growth as exemplified by OCBC with its acquisition of the wealth and investment management business of Barclays PLC in Singapore and Hong Kong.

Acquisitive growth strategy taken. 

  • An acquisitive growth strategy was opted to grow the private banking/wealth management business over the past few years. 
  • Prior to ING Asia Private Bank’s acquisition which brought in US$16bn AUM, OCBC had approximately US$8bn AUM. Bank of Singapore’s AUM has more than doubled since then and totalled US$79bn by end-2016 after the transfer of an additional US$13bn in AUM from Barclays’ private bank business in Singapore and Hong Kong, puts Bank of Singapore alongside DBS, making it the 6th largest Asian private bank (by AUM) in a 2016 Asian Private Banker ranking board. DBS had US$81bn in AUM as at end-2016.
  • OCBC will complete and fully consolidate its acquisition of National Australian Bank’s (NAB) portfolio by end-FY17 but the impact would be small. With fewer and smaller options in the market, there may be less acquisitive appetite going forward. Integration costs, as well as attrition of both customers and relationship managers (RMs), remain as key risks to such deals. We believe the banks have a sufficiently strong base to go on an organic growth path from here.

OCBC’s insurance business, a beneficiary of a rising interest rate environment. 

  • OCBC’s insurance business could surprise on the upside in a rising interest rate environment. Life insurance businesses tend to be able to price new products more attractively in a rising interest rate environment.
  • Investment income tends to also increase from investing/reinvesting premiums with higher yields. Such attractive returns would tend to see net business embedded value (NBEV) and total weighted new sales (TWNS) increase, positively benefitting GEH in the longer term. From an accounting perspective, there could be some risks when it comes to discounting the insurer’s liabilities at higher rates vs assets, which may result in unrealised mark-to-market losses or gains. 
  • We believe OCBC will keep its majority stake in GEH. Management believes that it remains logical and beneficial to keep the insurance product manufacturing in-house. OCBC has increased its stake in GEH over the years, from 48.9% in 2004 to 87.75% in 2016 (additional 0.02% stake acquired in July 2016), reflecting the importance of an insurance subsidiary to the group’s wealth management business.

Keep watch on GEH’s Malaysian operations. 

  • Great Eastern Holdings (GEH) is exploring options for its Malaysian operations, as reported. GEH is reported to have engaged at least one Malaysian bank to explore selling its stake in its Malaysian operations.
  • It has also been noted that several other foreign insurance companies operating in Malaysia (including Prudential Malaysia and Tokio Marine Insurance Malaysia) could be exploring similar options. This move is in reaction to Bank Negara Malaysia’s (BNM) stricter enforcement of the 70% foreign ownership cap on insurers, which was issued back in 2009. We understand the timeline could be fluid, and negotiations could be managed on a case-by-case basis. In our view, there are three viable options for these companies to pare down their stakes:
    1. List (IPO) 30% of their shares to the public;
    2. joint-venture with a local partner; or
    3. divest to local institutional investors. 
  • OCBC’s official stance on this is “GEH is exploring options to meet the necessary requirements”.

Regional agenda remains imperative. 

  • The sun may be shining on the Singapore operations for the coming year as banks continue to leverage on interest rate uplift. But in the longer term, there will still be a need to diversify revenue streams geographically amid the competitive environment in Singapore. 
  • UOB and OCBC’s second largest source of profits are in Malaysia; both banks have strong and long-term track record in Malaysia, competing closely with the Malaysian banks. Both banks are still building their presence in Indonesia. Although still a small contribution, we believe, over time, this will be an ROE-changer for them.

Valuation & Recommendation 

Trading close to 10-year historical mean. 

  • The Singapore banks have had a fantastic rally in 2017, starting from the first rate hike at end-2016. The banks have collectively appreciated by > 30% over 2017, one of the best sector performances for the year. 
  • Sustained momentum of NIM, loan growth and lower credit costs with contained NPLs should lift valuations at least to mean P/BV multiples. To see a further re-rating, we would need to see stronger and sustainable revenue drivers and a clear path for asset quality OCBC preferred although UOB is also a BUY. 
  • Although we have BUY ratings on both UOB and OCBC, the latter would be our preferred bet for three reasons:
    1. its ability to maintain lower-than-peer credit cost trends,
    2. it serves as a better wealth management play, and
    3. possible earnings surprises from its insurance business in a rising interest rate environment. 
  • Our BUY rating on UOB is premised on
    1. the property market recovery (UOB has the largest proportion of property-related loans vs peers),
    2. imminent NIM improvement,
    3. potential upside risk from lower credit costs (away from the sticky 32-bp credit cost guidance) with IFRS9/SFRS109 implementation.

Key Risks 

Relapse of oil & gas woes. 

  • While the banks have articulated that the oil & gas NPL issues are largely behind them, risks of these companies running out of cash flow as their funding instruments (bonds) mature remain a risk. 
  • We understand that most of these have been restructured or are undergoing restructuring, which means these accounts would have been classified as NPLs. The remnants of these may still trickle into some NPL formation in 2018.

NIM and loan growth fail to deliver. 

  • We have continuously been positive on NIM uplift and new loan growth. A disappointment in macro indicators could temper the better loan growth expectations. Although loan growth is less sensitive to earnings, sentiment of loan deceleration could dent top-line prospects. 
  • A slower-than-expected passthrough of Fed rate hikes to SIBOR/SOR could also derail the NIM uptrend. Competition in loan rates could be an added dent to NIM.

Sue Lin LIM DBS Vickers | http://www.dbsvickers.com/ 2017-11-23
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