In this Issue
Philippine Banking System: In Bad Shape or in Trouble?
-Listed Banks Struggled to Generate Income in the 1H
-Banking Profitability Strains Even in the BSP Data
-Heavy Dependence on Interest Margins and Interest Income as Portfolio Concentration Risks Mount!
-Deposits and M3 Drop Sharply in June, Bank Liquidity Conditions Worsens, Banks Turn to Bonds For Financing!
-Banks Stampede to Cram Assets with HTMs, Losses on Financial Assets Balloons, Profitability Ratios Corrode!
-Summary: Philippine Banking System in Bad Shape or in Trouble?
Philippine Banking System: In Bad Shape or in Trouble?
Let me state this up front: The banking system was in bad shape in the 1H and have been so since 2013. The system’s fragility has increased because of this.
The four largest banks, or the banking sector, spearheaded the bear market of the PSEi 30 in 2018.
At the end of the first semester, the banking index bled 20.22%, holding firms lost 18.16%, services contracted 14.03%, properties shed 10.8% and the industrials 7.3%.
Listed Banks Struggled to Generate Income in the 1H
Figure 1
The languid equity performance somehow reflected the health of its financial system
Aggregate net income of the four PSEi banks shrunk in both the 2Q and 1H. And the actions of the big four resonated with its smaller peers. (see upper pane Figure 1)
In the 2Q, while net income growth of the PSEi banks was pared by -1.98% to Php 397 million, net income of the banking index, composed of the largest 10 listed banks, and the 13 listed banks grew 5.04% and 4.85% to Php 1.465 billion and Php 1.458 billion respectively. Net income shrunk in 9 out of the 13 banks.
In the 1H, net income growth of the PSEi banks dwindled by 1.86% or Php 765 million. In contrast, the net income of the banking index and the 13 banks posted increases of 3.61% and 3.82% to Php 2.097 billion and Php 2.284 billion correspondingly. Net income dwindled in 6 out of the 13 banks.
The net income growth of the industry had either been lower or marginally above the 4.3% 1H government reconstructed CPI with a base reference of 2012. Bluntly put, the banking system struggled.
Even more, non-recurring income bloated the net income performance of the banking system in the 1H.
Two instances.
First, “Higher net gain on sale or exchange of assets by P4.2 billion” reported by PNB ballooned the bank’s income growth (+174.5% in 2Q, +103.5% in 1H). Excluding this one-time deal, the pre-tax profit of the bank would have been lower by 13.87% from a year ago. And without this deal, a great deal, if not all, of the banking system’s profit within this period would have been eviscerated.
Second, the lower provision of income tax helped buoyed Metrobank’s 2Q income (net income +21.14% in 2Q, +9.97% in 1H vis-a-vis pre-tax income +13.13% 2Q, +8.3% 1H).
That said, beyond the aggregates, the profitability of listed firms has been under considerable strain in the 1H.
Banking Profitability Strains Even in the BSP Data
Figure 2
Current profit strains of listed firms resonated somehow with the BSP’s data.
Universal and Commercial banks dominate the profit share with about 90%, Thrift banks has 9% to 10%, with the residue distributed to Rural and Cooperative bank groups
Universal and commercial banks generated 7.7% in the 2Q, down from 17.85% in the 1Q and 6.84% in 4Q17.
Because profits of rural banks collapsed by 51.51% in 1Q18, the Bangko Sentral ng Pilipinas (BSP) closed and placed 10 rural banks under the receivership of state-run Philippine Deposit Insurance Corp. (PDIC). The BSP reportedly shut seven and 22 banks in 2017 and 2016.
Recall that the BSP launched QE in late 2015 to combat disinflationary pressures? Now it has been clear that this was in response to the banking system’s profitability which had been adversely affected by disinflation. (see middle chart, figure 2)
Bank profits have been hard to come by since 2013. And the weakest link had been the most affected. So the closure of rural banks should be an example of the periphery to the core transmission.
Heavy Dependence on Interest Margins and Interest Income as Portfolio Concentration Risks Mount!
Why has the profitability of banks come under pressure?
Interest rate margins represent the first factor
Using actual income statements of the 13 banks in the 1H, we note that the average interest margin of these banks dropped by 5.33% to 72.11% in 2018 compared to 76.17% in 2017. Only PNB of all banks managed to eke out a margin improvement. (see lower table in figure 1)
Three important historical factors.
One. Ever since the banking system shifted to focus more on generating income through loans in 2013 until today, the banking system has become deeply dependent on margins.
Prior to 2013, the distribution share of interest and non-interest income had been in the range of 60:40 to 70:30. Post-2013, the distribution share tilted heavily towards interest income of 70:30 to 80:20. (see lower pane, figure 2)
Two, changes in bank profits manifested changes from non-interest income. Non-interest income category comprises of Dividends, Fees and Commission, Trading and Other income.
By switching to concentrate on loans, the banking system essentially placed its proverbial eggs into almost a single basket. Thus, concentration risks from excessive dependence on loans have rendered vulnerable the domestic banking system. The extended profit drought signifies a symptom of such risks.
Three, the banking system pivoted towards interest income or concentrated on the loan portfolio when interest margins spiked in 2013. (see middle pane, figure 2)
The crucial switch came in the aftermath of a series of interest rate cuts by the BSP. The BSP cut interest rates by 100 basis(1%) points through four installments in 2012: January, March, July and October. These cuts turbocharged money supply growth. M3 growth exploded by 30%+++ from July 2013 to April 2014 or in 10 months!
Because banks previously made a pile out of lower margins, perhaps they acted from premises of path dependency.
That is, they anticipated that the BSP cuts would improve their gross margins materially which would distill into their bottom line. While gross margins did swell, however, the banking system and the BSP were unable to foresee the consequences of money supply growth explosion—the spike in inflation! Higher inflation eroded the margin subsidies that the BSP bestowed upon them!
When the BSP raised rates twice in 2014 (July and September), negative real interest rates turned positive. A decline in demand for credit offset the BSP’s subsidy to the banks. Disinflation marginalized the banking sector’s profits!
And because of the significant reduction, the gravy from non-interest incomes’ participation provided little support.
Since then, the banking system has hardly recovered. Profits have remained elusive.
If high margins hadn’t been enough to boost the banking system’s profits, what happens when margins diminish? Will increases in the loan portfolio sufficiently substitute for reduced margins? 13 listed banks exactly traded off margins (-5.33%) for volume (stunning +19.96%) in the 1H! (see lower table, figure 1)
How about credit quality in the face of volume increases? Will banks not be taking in an unnecessary amount of credit risks to wangle marginal profits?
Compared to 2013 and 2014, statistical inflation is higher today. Higher and unstable rates have emerged from elevated street inflation or price instability to have prompted the BSP to raise policy interest rate to 2014 levels.
Will the BSP’s recent actions stifle demand for credit? If so, how will these help the banks whose portfolio has become concentrated on credit issuance?
Another, the government has embarked on a massive expansion.
What the government spends has to be funded. Will these not intensify competition with the private sector (banks and non-banks) for access to savings and or liquidity pressure rates substantially higher?
If so, will higher rates reduce demand for credit? Will financing costs bear down on the repayment abilities of the borrowers?
Will these not affect interest margins?
Deposits and M3 Drop Sharply in June, Bank Liquidity Conditions Worsens, Banks Turn to Bonds For Financing!
And it has been a curiosity that in spite of the ferocious amount of credit issuance, deposit growth has fallen substantially. (figure 3 uppermost chart)
June’s peso deposit growth rate at 10.8% (May +13.34%, April +13.85%) has dropped to the disinflation levels of 2015 and early 2016! Having peaked in Oct 2017, for most of 2018, peso deposits have been in a decline. Peso deposits accounted for an 83.2% share of deposits and 73.4% share of total liabilities.
And since growth in foreign currency deposits have been falling faster (June +7.81%, May +8.54%, April +8.65%), the total share of total deposits have been in a downdraft too (June +10.26%, May +12.5%, April +12.93%)
Most of the supply of money is created in the form of bank deposits. That is, whenever the bank extends a loan. Household and production loans grew by 19.07% in June, while peso deposits expanded by 10.8%. M3 growth decelerated materially to 11.73% in June from 14.3% in May. The sharp deceleration in M3 appears to resonate with the steep drop in peso deposit growth.
With such enormous credit expansion, just where did all the missing money go?
Figure 3
And there’s more.
As previously noted, the banking system has been suffering from a liquidity crunch. It has only gotten worse. (figure 3 middle window)
As of June, the BSP’s ratio of Cash and due banks to deposits has dropped to 2009 and 2010 levels. The ratio of liquid assets (cash + financial assets excluding equity) to deposits have retraced to levels lower than 2008.
These ratios have plunged primarily because the banking system’s most liquid asset “cash and due banks” contracted or shrunk by 12.55%!
So far, the banking system’s liquidity continues to fall in spite of the first Reserve Requirement Ratio (RRR) cut announced inFebruary which took effect in March. Since the effectivity date of the second RRR cut was on June 1, its effects should be apparent in the 3Q.
The record fiscal deficits have been one reason for this liquidity squeeze! And the banking system’s liquidity drought implies the intensifying competition with the government for access to savings. It will compete with the non-bank private sector too.
To shore up its liquidity, the banking system has likewise indulged in borrowing. (figure 3, lower window) The lender is a borrower. Though bank leveraging has shifted from bills (short-term) to bonds (long-term) in 2018 and grew by Php 115 billion or 2.5%
And it’s why PNB announced the issuance of a Php 20 billion bond. And it is why after the stock rights, BPI will offer US$ 2 billion in Medium Term Note Programme. And it’s why Philippine Savings Bank will raise a total of Php 15.0 billion in Long-term Negotiable Certificates of Time Deposit (LTNCTD) from which it has successfully secured Php 5.0845 billion from its first tranche.
Why has the banking system been engaged in continuous funding programs in the form of issuance of equity, bonds or notes? Where has all the money gone?
Banks Stampede to Cram Assets with HTMs, Losses on Financial Assets Balloons, Profitability Ratios Corrode!
Figure 4
Here are the other sources of the banking system’s liquidity drought.
In the asset side of its balance sheets, the banking system continues to amass Held Until Maturity (HTM) assets which grew by a remarkable 36.9% in June, 37.5% in May, and 36.94% in April. HTMs have grown by over 35% each month in 2018. For this reason, HTM’s share of the Financial assets jumped from 52.92% at the close of 2017 to a whopping 64.21% in the 1H!
Because HTMs are reported as an amortized cost, notes Investopedia, in the form of a debt security with a specific maturity date, temporary price changes for held-to-maturity securities do not appear in corporate accounting statements. Needless to say, because the HTMs don’t reflect on the market value of the underlying security, it can be an accounting means to camouflage losses.
Well, if HTMs concealed potential losses, deficits from other Financial assets subject to mark-to-market still surfaced. The banking system reported a Php 13.7 billion in accumulated market loss last June, the most since January 2014.
Investment in financial assets constitutes 93% share of total investments. Investments in direct investments and joint ventures/subsidiaries/
Even the BSP’s profitability ratio shows a declining trend in the banking system’s return on assets (ROA) and the return on equity (ROE). (figure 4, lowest pane)
Summary: Philippine Banking System in Bad Shape or in Trouble?
Let us recap by enumerating the symptoms.
1 Profits have diminished even as loan growth continues to sizzle.
2 Interest margins have recently dropped as banks become heavily reliant on a significant spread in margins.
3 A huge gap between the rate of growth of deposits and loan issuance has emerged.
4 Deposit growth, along with M3, has fallen substantially.
5 Bank liquidity, mostly from cash and due banks, has increasingly become scarce.
6 Banks have attempted to resolve this liquidity problem partly by borrowing.
7 Banks have crammed their investment portfolios with assets that have not been subject to market prices.
8 Losses in financial investments have reached 2014 levels last June.
9 The BSP’s profitability ratio shows a decaying trend in the banking system’s return on assets and the return on equities.
And yet we always hear the echo chamber of “solid macroeconomic fundamentals” in the mainstream.
Of course, as a last resort, the banks may use the BSP facilities to raise cash.
On the other hand, if they do so, they could begin conserving their assets. Calls on loans may commence. Liquidations may be next. NPLs, which I believe are the root of liquidity dilemma, may surface accentuating the risks of a deflationary spiral.
Under such circumstance, those vaunted capital ratios will be tested for its veracity
Sad to say, at best, the domestic banking system has been in bad shape, at worst, it seems to be in trouble.
More writing on the wall for the end of the era of easy money.
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