Sri Lanka banks in ‘perfect storm’, buying opportunity: report
ECONOMYNEXT – Sri Lanka’s banking sector is caught in a ‘perfect storm’ with margins expected to tighten due to weak credit growth, rising non-performing loans, increasing regulatory costs and higher taxes, an equities research report said.
"On one hand, weak economic growth and austerity measures enforced by the government have led to a moderation of credit growth, while opex headwinds and rising impairment cost due to elevated non-performing loans will bear down on industry profitability," Asia Securities, a Colombo based brokerage said in a banking sector report.
But depressed prices show a buying opportunity, with larger banks, such as Commercial Bank, Sampath bank and Hatton National Bank, likely to see the first investor interest after negative sentiment clears, the report said.
"Here’s a fact, Sri Lanka’s banking sector is forecast to generate the highest returns on equity of all the comparable banking sector’s in the in the region," Asia Securities chief Dumith Fernando said at an investor forum organised by Asia Securities.
"Here’s another fact, Sri Lanka’s banking sector as measured by price to book, price to earnings multiples, is the cheapest sector of all the regions, trading at the lowest valuations since the end of the war," he said.
According to Asia Securities, implementation of Basel III capital requirements and increasing provisioning for non-performing loans under IFRS 9 are expected to slow-down growth for Sri Lankan banks.
"We believe the dip in asset quality will run its course until the second half of 2019, but take comfort in the fact that the banks have taken prudent measures to arrest the situation," Asia Securities said.
However, the higher capital and liquidity requirements from Basel III will leave the industry more stable and sturdier to weather future credit events, it said.
"One risk to our view, and an important one for investors, is the impact of government policy on the industry."
"The debt repayment levy, for example will lead to an 8.5 percent drop in profitability across our covered banks, if implemented in the current form, and was partially the reason for the dip in industry valuations since August 2018," Asia Securities said.
Excerpts of Asia Securities’ banking sector report are as follows:
Asset quality deterioration is a cyclical trend; systemic risks not seen: Credit cycles typically have a strong linkage with economic cycles, and the Sri Lankan services sector (both banks and non-bank financial institutions) is currently in the midst of a cyclical asset quality deterioration phase. However, the current phase is less intense than the last one in 2013/14.
Banks are seen taking a more prudent approach to manage the situation, and with tighter capital and liquidity regulations being implemented, there does not seem to be a major risk to the system. In the short run, however, this would create earnings headwinds in the next few quarters.
Loan growth to moderate to about 15 percent in 2018-2020: Following three years of strong credit growth which averaged 18.8 percent, licensed commercial banks are expected to enter into an era of structurally low credit growth as credit supply tightens and demand weakens.
On one hand, higher capital requirements from the last Basel III implementation would encourage banks to be more measured in lending.
Alongside this, the implementation of IFRS 9 (locally enacted as SLFRS 9) would lead to higher impairment books for each loan disbursed (given the shift to an ‘expected credit loss’ model).
As a result, banks are expected to be more cautious on managing lending exposure, further slowing down credit disbursement.
On top of this, sluggish economic growth momentum courtesy of high oil prices, a weakening currency and large government debt repayments falling due in 2019-21 are expected to moderate credit demand to some extent.
On the other hand, private banks are expected to take up a higher share of the lending from the undercapitalized state banks.
"While tightening regulatory conditions seem to constrict growth, we strongly believe that the banking system will emerge more stable as a result," Asia Securities said.
SME lending remains a key opportunity; retail lending to be sluggish until 2019: SMEs remain the backbone of the economy, contributing to about 52 percent of GDP growth according to the Ministry of Finance.
Unsurprisingly, banks have been heavily focusing on this segment for the past few years. With more upside left to fill SME lending penetration, banks would continue to focus on this segment. However, SMEs are more susceptible to economic cycles than their larger counterparts, the corporate sector.
A large part of the of the non-performing loans increases this year was driven by cash flow stresses in the SME segment, and his would lead the banks to step up their risk-assessment with SME lending.
"Consumer loan-affordability remains weak, on the back of austerity measures implemented by the government, and we argue that the key consumer-related products (housing loans, vehicle loans and credit cards) would not see material growth until the second half of 2019" Asia Securities said.
Interest rates show upward bias, but signs of liquidity pressure weighing on NIMs (net interest margins): The central bank in April 2018 signaled the end of (the) policy tightening era with a 25bps cut in the Standard Lending Facility Rate (SLFR).
However, the six months that followed saw a strengthening US dollar and subsequent capital outflow from government securities and the equity market, rising LIBOR pushing up government refinancing cost and elevated oil prices burdening the trade balance.
"Consequently, we see upward pressure on policy rates, but consider this likely in the first half of 2019, if the negative externalities intensify," the report said.
While rising interest rates generally bode well for banks given the asset-liability structure, there is some pressure on deposit rates in the market as the cost of borrowing (both locally and internationally)—a sizeable source of funding for local banks—is increasing.
"We do not see significant pressure on lending rates, and on balance, see signs of NIMs trending down, albeit modestly".
Profitability face short term headwinds; large banks better positioned to take the hit: Asia Securities said it sees the largest impact coming from high impairment charges, which saw a surge of 144 percent from a year earlier during the first half of 2018.
While this figure includes some prudential-impairments taken by the banks, the continued tepid economic conditions would lead to elevated credit costs in in 2018 (forecast at about 80bps).
In addition, IFRS 9 implementation is expected to push up credit costs structurally to about 50bps per annum in 2019-2021, versus an average of 40bps 2015-17.
Market has aggressively discounted the sector; key picks are COMB, HNB, SAMP and NTB: Within the listed licensed commercial banks, our coverage of nine banks has seen their stock prices decline by about 20 percent on average.
Following this, the sector now trades at a price to book value multiple of 0.7x estimated for 2018 and 0.6x estimated for 2019, with the valuation overhang bearing down on the more stable banks as well.
"We believe COMB (0.8x book value estimated for 2019), HNB (0.7x) and SAMP (0.6x) offer more attractive entry points at these levels, and once the negative sentiment clears, will see first-investor interest as they offer better liquidity and stable fundamentals in the long run," Asia Securities said. (COLOMBO, 25 October 2018)