Philippine Banking System: In Bad Shape or in Trouble?

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.

Profits in the sector dropped to 3.71% in the 2Q from 14.6% in the 1Q and 8.92% in 4Q 2017.

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.

Profits of thrift banks shrunk -1.81% in the 2Q from 7.23% in the 1Q and from 29.16% 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/associates take the rest. This small segment continues to post modest growth.

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.

July’s Phenomenal Fiscal Deficit Pushes Government Size to Historic Highs as Debt Servicing Rockets!

Interventionism aims at confiscating the "surplus" of one part of the population and at giving it to the other part. Once this surplus is exhausted by total confiscation, a further continuation of this policy is impossible—Ludwig von Mises

In this issue

July’s Phenomenal Fiscal Deficit Pushes Government Size to Historic Highs as Debt Servicing Rockets!

-Bullseye! July’s Record Deficit Sends Government Size to a Record, Affirms the Socialization of the Philippine Economy!

-Breakneck Speed in Public Spending and Revenues Pushes July and 7-Month Deficit to Historic Levels

-July Public Debt Servicing Soars

July’s Phenomenal Fiscal Deficit Pushes Government Size to Historic Highs as Debt Servicing Rockets!

Bullseye! July’s Record Deficit Sends Government Share of GDP to a Record, Affirms the Socialization of the Philippine Economy!

The multiple records shattered by July’s fiscal deficit have led to a rocketing of the National Government’s expenditure to (nominal) GDP ratio, the largest since 1998

Lo and behold! The most earthshaking chart representing the political economic transformation of the Philippines: A Bull Market in Government!

Figure 1

As of July 2018, the public spending to GDP ratio hit 20.1%, 12.4% more than 2017’s 17.87%, and 17.4% above the 17.12% average ratio since 1998. 

Public expenditures are supposed to represent recorded real activities, whereas econometric models which inputs are derived mostly from surveys constitute the statistical economy or the GDP. That being the case, an inflated GDP would understate the real contribution of the government on the economy. Or, the public spending or government share of the economy could significantly be more!

Besides, the public spending to GDP ratio represents a direct measure of the size of the government. This ratiodoesn't capture the indirect participation of the government.  For instance, in many of Public-Private Partnership (PPP) projects, it is the private sector that spends on political projects.  The $3.7 billion Makati subway project is an example.

Political interventions affect the economy in many ways. These interventions may impact prices, operations, distributions, and output.

For instance, the National Government (NG) restricts supply of the Transport Network Vehicle Services (TNVS) industry, as well as, imposes demand control through the price channel or the ability of these firms to set prices.

Having been stripped of entrepreneurial role through repressive and intrusive regulations, firms of the industry transform into quasi-managers or department heads of National Government. In essence, the NG directs the operating spectrum of these privately owned firms as extensions of its tentacles.  The result of which is to weigh down the industry’s contribution to uplifting consumer welfare and generally on the economy.

The record deficit spending, which in part increases bureaucratic involvement (through the expansion of manpower, logistics and enforcement capabilities), has reduced output, employment, and capital accumulation for the TNVS industry.

At the end of the day, an increase in the share of the statistical GDP pie by the government translates to a proportional decrease in the participation of the private sector. A larger government entails a smaller private sector.

And because there is no free lunch, not only will the trend of record deficits supported by massive interventions shrink the productive sectors of the economy, it embeds higher taxes into the future, weakens spending power (inflation), underwrites the erosion of the domestic currency and upsizes economic and financial risks.

That said, the transformation towards the socialization of the political economy has now manifested itself in government’s statistics.

What I have been predicting all along has been validated!

And economic opportunities will increasingly involve establishing ties with the government at the expense of the marketplace. One has to be an insider or connected with the insiders.

Exemplified by the transition towards a centrally planned and centrally directed economy have been experiences of the PPP and TNVS industries.

What more if the proposed bill on the imposition of the 14-month pay to employees of the private sector, which has now been in the Senate’s third reading, be ratified? Would that not constitute the troika of rigorous labor mandates that would penalize the economy following higher minimum wages and anti-endo practices?

Sutton’s Law becomes increasingly plays a relevant role in crafting financial strategy.

According to Wikipedia, The law is named after the bank robber Willie Sutton, who reputedly replied to a reporter's inquiry as to why he robbed banks by saying "because that's where the money is."

The government is where the money is!

Breakneck Speed in Public Spending and Revenues Pushes July and 7-Month Deficit to Historic Levels

Let us dig down on the booming government bubble.

July’s fiscal conditions produced a stunning set of records.

Figure 2

July’s deficit of Php 84.4 billion was the largest in at least 11 years.  A breakthrough pace in revenue and expenditure growth of 24.21% and 33.9%, respectively, crafted the July record, unmatched since 2009 at the very least. (see figure 2)

July’s phenomenal fiscal expansion helped set landmarks in spending and revenue activities over a 7-month period

Figure 3

At breakneck speed, revenue growth dashed at 20.52% while expenditure growth sprinted at a faster 22.57%. (upper window figure 3)

The outcome: the seven-month deficit bolted to a milestone Php 279 billion! The 7-month deficit represents 80% of 2017’s full-year Php 350.64 billion with 5 months to go!  (lower window figure 3) Another deficit in the scale of July or March (Php 110.7 billion) would wipe off the gap in a month!

The National Government set a target deficit of 3% of the GDP or about Php 530 billion.

The 7-month deficit has accounted for about 3.3% of the first semester nominal GDP. At the current pace, the government’s programs seem on track to reach its objective. 

 

Figure 4

And if the NG hits its deficit target, the spending share of GDP could be expected to rise by even more!

To emphasize, while nominal expenditures are about to break beyond the recent highs, revenues are currently being bolstered by the expanded tax base from TRAIN 1.0. (figure 4 upper window)

Or, authorities have programmed public expenditures in contrast to revenues which depend on economic performance as well as administrative efficiency on collections. More pointedly, expenditures are fixed, revenues are variable. A slowdown in the economy will blow the deficits through the roof.

The rate of current and proposed spending indicates that TRAIN 2.0, which should add to the expansion of the tax base, as noted before, will have to be enacted.

July Public Debt Servicing Soars

Since fiscal deficits are no free lunches, how was the July record financed? Has it been through debt or the BSP’s monetization or a combo?

The BSP and the Bureau of Treasury has yet to publish the relevant statistics

So far, the debt service data from the Bureau of Treasury provides a clue. (lower window, figure 4)

And the numbers are just phenomenal!

The 7-month debt service at Php 463.11 billion has accrued to about 94% of the annual Php 490.31 billion of interest payments and amortization spent in 2017.  

Debt service as a share of total government revenues, which was at 28.03% in July, appears to have reversed its downtrend.

The debt service to revenue ratio hit a low of 19.83% in 2017.  In June 2018, public domestic debt grew by 9.34%. The burden of debt servicing must have increased by the recent acquisitions of debt

At the current pace, the annual debt service for 2018 will likely approach Php 800 billion, Php 54.4 billion shy of the record established in 2006.

With rising interest rates and with record deficit spending in part financed by debt, the National Government’s debt service should be expected to increase significantly.

And rising financing costs will not only add to the deficits it will compound on the National Government’s competition with the private sector for access to people’s savings. Expanded debt and debt servicing should magnify the crowding out syndrome.

The repercussion would be to amplify upside pressures on interest rates!

And not only will the government’s broadening role in the economy require significant amounts of financing, it will bring about substantial rearrangement in the economy’s production and distribution structure that should affect earnings and the GDP.

Until it becomes evident, current statistics will hardly capture such changes.

Instead, what has been conspicuous has been the fast-expanding role of the government in the economy as noted above.

Nevertheless, government policies set the directions.

The monumental shift in the nation’s tax regime from income tax to a broad-based consumption tax is a depiction of such pivotal change.

The goal, as declared by officials of the Department of Finance, is to become investment-led.

As the record fiscal deficit and public expenditure to GDP shows, a government ‘investment led’ economy it is, to be precise.  

Bereft of market prices and economic calculation, what the government sees as an investment is in reality consumption

Attachments area

Bullseye! The Mainstream Finally Sees the Unsustainable Philippines’ Corporate Debt Problem!

What I have been saying here has finally been picked up by the mainstream!

From the Businessworld's “Big firms hard-pressed amid rising interest rates” August 21, 2018

(bold added with comments in italics)

‘A HARD TIME ONWARDS’

Natixis economists Alicia Herrero and Gary Ng said overall financial conditions have “worsened” especially for large companies and could signal deteriorating fiscal health for these firms.

“All in all, when push comes to shove, the Philippines’ firms are not in the best of circumstances to handle rate hikes.Externally, the Fed is hiking and the BSP will have to increase rates in the light of higher inflation and to stem off capital outflows,” the economists said in a report published last week.

“With the high corporate leverage, firms could face a hard time onwards in the rate cycle.”

Natixis said segments of the economy have been under pressure from a weaker peso, an “underperforming” stock market, a growing trade gap and a potentially bigger budget deficit as the government spends more on infrastructure. (my comment: record budget deficit is no free lunch, someone pays for it; that's you and me)

“The top 25 firms by asset size have high leverage, low repayment ability and worsening financial health,” the France-based research group said, noting that the peso’s depreciation has also driven up business costs as they absorb rising prices. (my comment: the peso dilemma is a symptom, not the cause)

“As a consequence, profit margin is down even though they are divesting. On the basis of structurally low revenue stream, a lack of capex and much higher leverage in a higher interest rate period, their prospects are poorer.” (my comment: price instability affects margins)

The 25 biggest companies in the country had an average leverage ratio — or debt against equity — of 228% in 2017, against a 114% average of smaller counterparts, according to Natixis.

Remember this?

Coming up: the Philippine banking system was in a bad shape in the 1H of 2018.