A vital function of the free market is to penalize inefficiency and misjudgment and to reward efficiency and good judgment. By distorting economic calculations and creating illusory profits, inflation will destroy this function. Because nearly everybody will seem to prosper, there will be all sorts of maladjustments and investments in the wrong lines. Honest work and sound production will tend to give way to speculation and gambling. There will be a deterioration in the quality of goods and services and in the real standard of living—Henry Hazlitt
In this issue
Bank GDP Underperformed in 2Q and 1H; PSEi 30 Banks Boosted Industry Performance, BSP Bailout: The Financial Index Outclassed the PSEi 30!
I. Despite Massive Bailout and Reopening, Banking GDP Underperformed in 2Q and 1H
II. Bank’s Higher Net Income Not Transmitted to GDP; Rising Rates: The End of Deposit Subsidies, Lower Lending and Profits Ahead
III. Another Record Surge of Held-to-Maturity (HTM) Assets as Bank Liquidity Deteriorates
IV. Accounting Embellishments? PSEi 30 Banks Outperforms the Industry
V. Since the Historic BSP Rescue, the Financial Index Outclassed the PSEi 30; How Will the BSP Respond to the US Fed’s Hawkish Stance?
Bank GDP Underperformed in 2Q and 1H; PSEi 30 Banks Boosted Industry Performance, BSP Bailout: The Financial Index Outclassed the PSEi 30!
I. Despite Massive Bailout and Reopening, Banking GDP Underperformed in 2Q and 1H
For a system designed to assimilate financialization or increased dependence on credit expansion for economic activities, the premier institution for conducting these are the banks.
Proof? The BSP reports indicate that domestic claims of private banks and other financial institutions account for over 70% of the M3 money supply growth. The BSP takes the rest.
That's right. Banks, supported by the BSP, provide most of the liquidity flows through credit expansion. Or, financial liquidity is generated primarily by banks and secondarily by the BSP.
Because banks are systemically important, hence the BSP's historic rescue.
When the pandemic recession occurred, the BSP rolled out an aggressive bailout program for banks. The program consisted of record liquidity injections, an unparalleled combination of historic low monetary policies, cuts in bank reserves, massive operational, capital, and regulatory relief measures, credit allocation, and more.
The public rationalization for such a bailout was the following: extend relief to borrowers, incentivized lending, the continued access to financial services, and support for the continued financial services delivery. (Diokno, 2021)
The BSP rescue package represented not only an unprecedented move domestically but signified the most aggressive in the emerging market sphere. (IMF Blog, 2020)
Because global bankers were awed by such an incredible demonstration of central bank power, they even awarded the ex-BSP Governor "Best Banker of the Year"! (Prudent Investor, 2022)
For these reasons, banks should play a principal role in the evolution of the GDP.
But have they?
Figure 1
Even when the headline 'real' GDP grew at 7.4% and 7.8% in the 2Q and the first semester, the banking industry's 'real' GDP growth stood at 4.8% and 6.2, respectively.
Including non-banks, insurance, and other financial services, the Financial GDP registered growth rates of 4.2% and 5.9% over the same period.
And though banks outperformed their financial peers, their share of the sectoral GDP fell to 46.6% from 58.6% a year ago. (Figure 1, topmost pane)
Nonetheless, the bank's share of the Financial GDP remains on an uptrend, which extrapolates to increasing power from its activities.
More importantly, the 2Q-1H data reaffirmed the long-term uptrend of the Financial Sector’s share of the National GDP, which has accelerated since 2019. It was 10.2% in 2Q but slightly down from 10.8% in Q1. (Figure 1, second to the highest window)
The takeaway is that the underperformance of the banking sector GDP in 2Q and 1H confirms our view that the politicians threw money on the economy for election purposes that financed most of the growth activities during this period.
The second implication is that the unprecedented bailout of the BSP has barely been a boost to the sector and the national GDP.
The next ramification is that the larger its share of the GDP, the greater the economic and financial fragility.
This systemic vulnerability emanates from the massive malinvestments financed by the escalation of leverage.
II. Bank’s Higher Net Income Not Transmitted to GDP; Rising Rates: The End of Deposit Subsidies, Lower Lending and Profits Ahead
But banks were supposed to have generated substantial profits during this period, but where?
Including thrift and rural/cooperative banks, the BSP reported a 16.7% YoY net income/profit growth in Q2, following a 26.3% jump in Q1.
Despite the decline in non-interest income (-7.3%) in Q2, net income was primarily a product of the 8.83% growth of interest income.
Yet the profitability dashboard of the BSP shows a partially different picture. After the Q1 surge; the return on assets (ROA) and return on equity (ROE) at 1.19% and 9.64% in Q2 barely grew from 1.19% and 9.57% in Q1. (Figure 1, second to the lowest pane)
Even worst, the profitability trends appear to be plateauing, similar to the 2H of 2019 and Q1 of 2020.
Has the trailing performance of the ROA and ROE been indicative of actual profit conditions? Yet, BSP measures have massively distorted profit/loss definitions and the actual state of capital held by the industry.
But here is the thing.
First, rising Treasury yields have forced the BSP's hand to raise rates dramatically in a short period.
As a reminder, most of the relief measures of the BSP remain in place until the end of 2022.
Again, such measures, which disguise balance sheet risks, obscure the reporting and statistics shown by the BSP. Hence, profits, NPLs, and other stats before these measures signify apples-to-oranges comparisons.
These rate increases have virtually eroded the deposit subsidies of banks that drove their net income during the pandemic. (Figure 1, lowest pane)
Figure 2
Interest expense fell 6.9% in June. It was down by 10.7% last May.
With the coming negation of deposit subsidies, the requirement for banks is to increase profitability and/or obtain more funding for operations.
And with the relief measures in place, banks opted to gamble by initially and presently magnifying exposure on speculative activities, and when this has proven insufficient, expand lending.
Bank exposure to financial investments hit a record in June 2022, but so did market losses! Accumulated losses reached a Php 97.12 billion milestone in June 2022! (Figure, topmost pane)
Also, the long-term downtrend in deposit liabilities from the easy money policies of the BSP means that the sector has to compete with the government and non-financials for access to the public's savings.
Like in 2018, the BSP rate hikes have incited a bounce in deposit liabilities. June deposits increased 9.12% from 7.16% a quarter ago. (Figure 2, second to the highest window)
The intensifying competition for funding should translate to increased pressures on interest rates over time.
Second, when the BSP did the same hikes in 2018, bank lending fell, and so did profits. (Figure 2, second to the lowest and lowest pane)
In turn, in the first step toward the rescue, the BSP also initiated its first cuts in the bank’s reserve requirements in 2018 to infuse liquidity.
Bank lending has raced higher since July 2021. It was up by 10.6% in June.
Will this time be different? How? Is the economy immune to the law of demand? Are the balance sheets of banks and the economy in tip-top condition for them to ignore the influence of higher rates on their increasingly leveraged portfolios?
Symptoms of overleveraging have surfaced even in PSE-listed firms. Several heavily indebted firms continue to raise liquidity by selling assets (Globe, PLDT, JGS and Udenna).
Figure 3
III. Another Record Surge of Held-to-Maturity (HTM) Assets as Bank Liquidity Deteriorates
Third, a record shift in bank investment assets towards Held-to-Maturity (HTM) constituted part of their loss avoidance mechanism. HTM assets soared 63% YoY last June. (Figure 3 topmost window)
In 2021, the BSP noted: "From a market valuation standpoint, the higher yields also mean that holders of tradable securities face mark-to-market losses. Shifting tradeable assets into held-to-maturity may address valuation risks, but it does come at the price of locking-in liquidity." (BSP, 2021)
Again, HTMs have served as a conduit to conceal the investment losses of banks. Simply stated, record HTMs extrapolate to a massive disguising of losses and risks.
True enough, the corrosive effects of shielding losses have manifested in financial liquidity conditions.
The cash reserves of the industry have recently plummeted. It reported a reduced contraction of 16.72% YoY last June. (Figure 3, middle pane)
Meanwhile, the BSP's liquidity dashboard consisting of cash-to-deposits slid to approach the 2019 lows, while the recent bounce in liquid assets-to-deposits appears to have crested. (Figure 3, lowest window)
Rising rates, diminishing liquidity, deteriorating non-bank balance sheets, lower lending, mounting bank losses from investments, and increased credit impairments presages a new round of rescue activities by the BSP.
Aside from the likelihood of extending the relief measures, it may chop bank reserves to inject liquidity. The BSP has telegraphed RRR cuts in December.
As a reminder, the BSP sees liquidity as the sine qua non factor of keeping the banking system glued: For the authorities, lesson #1 states the obvious: financial market activity is dependent on market liquidity. When the distribution of that liquidity stalls, the financial market stalls as well… Yet, one must see beyond the coincident demand for market liquidity when conditions are stressed. In normal times, liquidity propels the funding markets. Banks can only create new loans if they are able to generate new deposits. In the securities market, new issuance is viable only if there is liquidity that can absorb these securities. Whether through loans or securities, then, the ability of the private sector to expand beyond their own capital depends on market liquidity…On a going concern basis, funding liquidity is the foundation of leverage which can translate into economic activity. But when stress is introduced, liquidity can quickly dry up and a dash for cash can disrupt markets…More liquidity though can create its own challenges. The injection of liquidity is an adrenaline to the system to counter the slowdown brought about by the crisis. But there is always that concern that too much liquidity will fuel inflation, and that high inflation can be persistent rather than transitory. [bold original, italics and underline mine] (FSCC, 2021)
Paradoxically, by raising rates, the BSP is withdrawing liquidity. But they seem to be hoping that their econometric models can foresee sufficiency levels and tolerable limits of liquidity conditions to prompt them to act on time.
Good luck to them and their adherents.
IV. Accounting Embellishments? PSEi 30 Banks Outperforms the Industry
Of course, the financial conditions of PSE-listed banks resonated with the BSP report.
But individual disclosures provide the supposed particulars of the activities of specific banks.
Figure/Table 4
In the 2Q and 1H, PSE-listed banks reported a volatile distribution of net income.
Powered by Metrobank and BPI, PSEi 30 banks posted a 33.8% and 48.4% jump.
However, the PSE's banks reported a 10.75% and 4.78% increase in net income in the first semester and the 2Q, respectively. The 9-issue Financial index gained 9.06% and 3.92% over the same period. Because of incomplete data, excluded from the above table is the recently listed Bank of Commerce.
Net income declines by Union Bank (-3.84%, -27.16%), PNB (-59.44%, -50.1%), and East West Bank (-42.9%,-60%) offset the stellar outcomes of PSEi banks and the others.
As a result, net income among the listed banks fluctuated widely.
Interestingly, from the viewpoint of gross revenues and net interest income, there seem to be little disparities in the aggregate performance of all the banks, the financial index, and the PSEi banks.
Such deviances reveal that the chasm in net income emanated from accounting idiosyncrasies. For instance, lower provision of credit losses led to the bulk of net income gains of PSEi 30's Metrobank and former member Security Bank.
Also boosting net income were outsized gains from asset speculations. BPI was one of the beneficiaries.
Aside from BSP relief measures, a sizeable segment of the energized improvements in the published net income of the banks of the PSEi 30 and the aggregate looks like a product of accounting embellishments.
V. Since the Historic BSP Rescue, the Financial Index Outclassed the PSEi 30; How Will the BSP Respond to the US Fed’s Hawkish Stance?
Finally, after a winning streak of 5-weeks, the PSEi 30 posted its first weekly drop of 1.62%
The decline emerged from a two-day plunge at the start of the week, with more than half of the deficit erased during the last three days. This week’s deficit pulled down the six-week return to 8.99%.
By sector, while most of the index fell, banks ironically braved the profit-taking storm to post a hefty gain of .97%.
Weekly returns of BDO (+1.7%) and BPI (+1.2) helped support the PSEi 30 from a selloff.
Since the depths of 2020, the market cap share of the three banks has been on an uptrend.
Figure 5
How has the financial index performed in the face of rising Treasury yields?
In 2018, the markets initially priced banks benefiting from the surge in inflation through widening spreads/margins. However, the Financial Index tumbled when the BSP started to raise rates. (Figure 5, highest window)
Here is another angle: the Financial Index began to outperform the PSEi 30 since the BSP used the pandemic as a pretext to launch a historic bailout of the banking system.
The backdrop for its outperformance? The widening spreads of domestic Treasuries since 3Q 2020. Meaning: the implied expansion of bank margins. Also, a further rise in inflation. (Figure 5, middle and lowest window)
This episode demonstrated the effects of redistribution, not just to the PSE but to the banks in particular. Bank shares and the PSE boomed at the expense of the average citizenry.
But since the BSP has started to tighten, such spreads have come down, or bank margins should narrow.
Yet, how is it that rising financial markets won’t translate to higher CPI?
The US Federal Chairman Jerome Powell has "hawkishly" signaled that it will continue to take liquidity off the markets until it quells its inflation problem.
Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain…These lessons are guiding us as we use our tools to bring inflation down. We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done. [bold emphasis added] (Powell, 2022)
Will the BSP follow suit? Or, will they diverge from the hawkish US FED? What are the consequences to the financial markets, the banking system, and the economy?
If the BSP didn’t see the inflation wave coming, subsequently, the global response to it, how can they deliver effective policies?
_____
References
Diokno Benjamin E. Philippines: Traversing the Path to Economic Recovery, Speech at the Eastern Communication E-Huddle Webinar Series "Making Remote Work and Creating Opportunities", 4 May 2021.
Drakopoulos, Goel, et al. Emerging and Frontier Markets: Policy Tools in Times of Financial Stress, IMF Blog, October 23, 2020
Prudent Investor, 2022: The Diminishing Returns of Trickle-Down Rescue Policies and The Illusion of a Political Superhero January 9, 2022
BSP, Statement on the State of Financial Stability, June 04, 2021
FINANCIAL STABILITY COORDINATION COUNCIL, 2nd SEMESTER 2021 FINANCIAL STABILITY REPORT, p.4-5, BSP.org December 2021
Jerome H Powell, Chairman US Federal Reserve, Monetary Policy and Price Stability, Board of Governors of the Federal Reserve System, August 26, 2022
Yours in liberty,
The Prudent Investor Newsletters
____
Nota Bene: The newsletter intends to apprise readers of the market conditions based on the information available at the time of the items’ writing, whose accuracy and timeliness of the issues concerned are subject to change without prior notice. Solicitation to trade is neither intended by the contents. In the meantime, the discussion of occasional positioning on particular issues are opinions of this author.
