SINGAPORE (Mar 13): This past week, investors around the world have been compelled to swallow and digest fast-unfolding news by the day, if not the hour. The widening Covid-19 outbreak and the shocking breakdown of ties between Saudi Arabia and Russia have caused a volatile cross-infection of uncertainty. “We are living in a period of discovery,” says Bhaskar Laxminarayan, CIO at Bank Julius Baer in Asia.
About the only sure bet is that central banks will cut interest rates further. On March 11, the Bank of England announced an emergency cut of 50 basis points (bps) to 0.25%. This took place less than a week after the US Federal Reserve on March 3 slashed the Fed funds rate (FFR) by 50bps to between 1–1.25%, in what it called a pre-emptive move to avert a recession in the United States.
Now, another cut is seen at the next Federal Open Market Committee (FOMC) meeting scheduled on March 17–18. “We are heading into a very low interest rate environment for the foreseeable future. We have to accept zero, or negative rates, which was unthinkable 10 years ago,” adds Laxminarayan.
And right on cue, banks have been at the forefront of the market sell-off in Singapore and in the US. They are being pressured by an economic slowdown and possibly recession from Covid-19, low interest rates from stimulus packages and most recently a sharp drop in the price of crude oil.
Bank of Singapore has cut the three-month WTI and Brent forecast to US$30 per barrel ($42 per barrel) and US$35 per barrel respectively (from US$45/bbl for WTI and US$50/ bbl for Brent). This could cause headwinds for US shale producers where the average breakeven prices are above US$40 per barrel, hence the knee-jerk sell-off in US banks on March 9.
However, unlike the GFC 12 years ago, the stress of shale producers is not likely to ricochet around the world and should be confined to the US (see sidebar). That is because local banks have the balance sheets to weather the storm.
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As of Dec 31, 2019, the three banks had “stocked up” on plentiful capital as evidenced by their common equity tier 1 (CET1) capital ratios. Since the GFC, banks are required to maintain certain levels of CET1 which were gradually phased in and implemented by 2014. All three local banks have CET1 ratios — which comprise retained earnings and ordinary equity measured against risk-weighted assets — of more than 14%.
Moreover, the banks have already cleared their balance sheets of troublesome loans to oil and gas (O&G) companies and offshore service vessel (OSV) providers in 2016 and 2017. And the banks were profitable in 2013–2016 when the FFR was at 0.11% to 0.66%.
This year though, the banks suffered a selldown as the contagion spread from the US markets to Asia, and have lost between 13–19% so far (see table 1). Oversea-Chinese Banking Corp and United Overseas Bank are trading below their historic book values, and all three have dividend yields above 6% based on their latest annualised dividends. Assuming that the banks trade near their book values — and these could fall by 8–10% which is pretty drastic — the trio are at levels where they provide both dividend yield and book value support. But the outlook is murky and there are unknown unknowns with the banks themselves recalibrating guidance given just last month as Covid-19 went global.
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“Given the volatility in the financial markets arising from the recent plunge in oil prices and the escalating Covid-19 situation worldwide, we can expect more impact on credit costs than first guided,” says a UOB spokeswoman. UOB had guided credit costs of 25–30bps for this year on a base case scenario.
“However, we believe the impact would be moderated with the decisive actions being taken by governments around the world to support their economies, including Singapore which is planning additional stimulus measures,” she adds.
DBS Group Holdings which had indicated credit costs in the 20–30bps range for the year is keeping to that forecast.
“DBS has a solid capital position that will enable us to weather the present uncertainties. We are closely monitoring the situation; as of now, the guidance that we gave at our 4Q2019 results on credit costs still holds,” says DBS CFO Chng Sok Hui.
Sudden interest rate cut
US Fed chairman Jerome Powell said the latest cut was to support overall economic activity as well as in response to Covid-19 which is starting to spread in the US. “It will support accommodative financial conditions and avoid a tightening of financial conditions which can weigh on activity, and it will help boost household and business confidence. That’s why you’re seeing central banks around the world responding as they see appropriate in their particular institutional context,” Powell said in a press briefing.
For local banks, the second-order impact from the US is likely to be felt through lower interest rates. The large cut is problematic for the local banks if it flows through to Sibor, Swap Offer Rates (SOR) or Singapore Overnight Rate Average (SORA). This year, banks are transiting to SORA which is derived from the volume-weighted average rate of transactions reported to Monetary Authority of Singapore by brokers in Singapore.
Indeed, some analysts and economists expect further cuts this year. Citi analyst Robert Kong says Covid-19 and GDP slowdown fears have led to the market pricing in more rate cuts. Citi’s US economists expect Fed rates to fall to zero by June and remain at or near the zero lower bound for the rest of 2020, Kong says.
How low can NIM go?
The outlook for interest rates does not bode well for banks. Net interest margin (NIM), which measures the average spread between banks’ yields on their loans and assets, and what they pay their depositors, are likely to compress in low interest rate environments. Since February, three-month Sibor has lost 36bps (see chart).
For the local banks, with slower growth and possibly even a technical recession by 2Q2020, loan demand is likely to be anaemic. This, cou pled with falling interest rates, will cause banks’ NIMs to fall.
“As a result of [trade tensions and Covid-19 outbreak], loan growth is expected to be low and a low interest rate environment is likely to persist. NIM is likely to be slightly below 2019 but we believe we can achieve NIM above that of 2018,” Samuel Tsien, CEO of OCBC guided during a results briefing in February. And although Tsien added that OCBC’s ratio of current account savings account (CASA) to overall deposits improved to 48%, CASA deposits are still the cheapest.
In FY2019, OCBC’s NIM was 1.77% and in FY2018, 1.70%. According to Tsien, OCBC’s average NIM for the year is likely to be above 1.70. Back in FY2013, when the FFR ranged from 0.09– 0.13%, OCBC’s NIM was 1.64%. Similarly, the NIM of DBS in FY2013 was 1.62% and UOB’s 1.72% (see table 2).
Meanwhile at UOB, CFO Lee Wai Fai expects NIM to face downward pressure and he is looking to mitigate this. “There are various things we’re doing to stop the downward pressures. Cost of funding will have to moderate downwards,” Lee says. UOB could also move towards a higher CASA ratio and raise its loan to deposit ratio which at 85.4% was lower compared to 86.5% for OCBC and 89% for DBS.
DBS was guiding for a 7bps drop in NIM for this year based on one FFR cut assumption. However, some market watchers expect the Fed to cut rates to as low as 2013 levels. About a week ago, Nomura had estimated that a 125bps cut would take FFR to virtually 0.05bps or 0.08bps, levels last seen some seven years ago.
After the banks released their results in February, Citi had forecast NIM declines of 3–5%. Now, Citi says “assuming a 60% pass-through of 50bps Fed cuts, a fall in Singapore dollar rates by 30bps may hurt bank NIMs by a further 3-6bps on a full-year basis, but the actual re-pricing impact may lag by 3–6 months”.
O&G bad loans done and dusted
For those who remember, local banks had already made one round of provisions and write-offs for the O&G sector. The drop in crude oil prices by 46% in 2014 and 30% in 2015 caused banks to make higher provisions — including specific provisions for their O&G portfolio — and suffer NPL (non-performing loan) formation. “These O&G borrowers have weathered low crude oil prices for the past five years. Banks would also have beefed up provisions for exposures to the O&G sector under [financial reporting standards SFRS(I)9], which was implemented after Jan 1, 2018,” notes Jonathan Koh, an analyst at UOB Kay Hian.
“Our conversations with the banks suggest UOB only has 0.6% of its loan book exposed to the upstream/support services segment,” notes Nicholas Teh, an analyst at Credit Suisse, in an update following the Opec+ fallout. (See story on Page 8) “DBS’s upstream/support services loan book will be less than 2% of its loan book, most of which will already be classified as NPA (non-performing assets) given the kitchen-sinking in 2017.”
Koh reckons that DBS’s exposure to government-linked shipyards is likely to have “whittled down” after Sembcorp Marine retired $1.5 billion of bank borrowings using proceeds from issuance of a five-year subordinated loan facility of $2 billion to parent Sembcorp Industries in June last year.
Darren Tan, CFO at OCBC, provided more colour on his bank’s O&G exposure. “Our O&G exposure makes up about 5% of our total customer loans. This figure encompasses lending across the industry that includes the oil majors, trading companies and the OSV sector, and this has been relatively stable over the past few quarters. The NPL ratio for O&G loans is 0.8% against total customer loans, down from 0.9% a year ago and we have prudently set aside allowances for this sector,” he explains, adding “we continue to exercise vigilance over our credit portfolio and proactively monitor these for early signs of weaknesses”.
Hence, Credit Suisse’s Teh reckons “the banks should not see the same kind of direct impact as they saw in 2016.” However, the oil price shock is another risk towards the overall macro environment. Already, before the Opec+ fallout, oil prices were falling due to the sharp decline in air travel as Covid-19 turned from an epidemic in China to a global pandemic in all but name. The leisure cruise industry is also set to see a sharp fall-off in demand.
Support for dividends
The capital of a bank is a function of its retained earnings and capacity for growth. Unlike companies, when banks lend, the loans carry risk weights. For instance, mortgages and loans to large, highly rated corporates carry lower risk weightings.
However, when loan growth is slow and banks are unlikely to make acquisitions, CET1 can accumulate. DBS, which pays dividends quarterly, raised its final dividend in 4QFY2019 ended Dec 31,2019, to 33 cents, taking full-year dividend to $1.23 per share for FY2019. From next year onwards, DBS will keep its core dividend at the higher 33 cents per quarter level, or 10% higher than FY2019. CFO Chng said that the bank is confident it can sustain the annualised $1.32 per share as long as its net profit grows and CET1 is at 12.5–13.5%.
UOB raised its final dividend for 2HFY2019 ended Dec 31, 2019, to 55 cents per share up from 50 cents a year ago. It also announced a special dividend of 20 cents, taking total dividends for FY2019 to $1.30, up from $1.20 in FY2018. Lee of UOB says its “core” dividend of $1.10 is sustainable, subject to a minimum CET1 ratio of 13.5%.
OCBC has the highest CET1 ratio. It was widely believed that OCBC had plans to acquire Bank Permata of Indonesia which was eventually sold to Bangkok Bank. During OCBC’s results briefing, CEO Tsien said he was not in any serious M&A talks. This means OCBC has excess capital with its CET1 ratio of 14.9% (see table 3).
OCBC raised its 2HFY2020 dividends by 22% y-o-y and 12% h-o-h to 28 cents per share giving a total dividend for FY2019 of 53 cents and if sustained, a dividend of 56 cents for FY2020.
For OCBC investors wondering whether is the 6% yield (see table 1) is too good to be true, CFO Tan says, “We have always managed our business with a healthy respect for the ‘unknown unknowns’. This philosophy translates to us having a diversified portfolio of businesses in banking, wealth management and insurance, and having strong levels of capital, funding and liquidity. In turn, we believe we would be able to ride this period of turbulence well, and remain well-positioned to support our customers and grow our franchise.”
Rare 6% yield
Koh of UOB Kay Hian reckons the higher dividends of these banks are sustainable although yields of 6% come but rarely. “Over the past 30 years, DBS and OCBC had hit above dividend yield of 6% once (GFC) each and UOB twice (Asian Financial Crisis and GFC). A steep share price correction that causes dividend yield to overshoot to 6% tends to be followed by a sharp rebound,” Koh says. As such he is maintaining his “buy” ratings on DBS and OCBC.
Since the local banks have more or less kitchen-sinked their O&G exposure, Maybank- Kim Eng says in a recent update that stimulus measures announced in the Singapore Budget this year should provide cushioning for the Covid-19 slowdown.
“We seek shelter in names that offer strong O&G provisioning, a clear structural growth story and visible dividend yields. Our selection of UOB and DBS in Singapore hinges on strong dividend visibility, underlying growth through regionalisation, and high provisioning levels for their limited O&G exposure” says Maybank-Kim Eng.
Citi’s Kong, on the other hand, is recommending investors to sell the three banks given that the Fed is likely to cut FFR to zero by June and there could be a US recession on the horizon.
