Singapore banks: Rising NPLs will take a toll on earnings

Regionally, Singapore banks compare well on balance-sheet safety, boasting low gearing and high liquidity. However, for investors looking to reward growth, we believe the banks will disappoint as non-performing loans (NPLs) rise to levels similar to emerging economies resulting in negative earnings momentum, falling ROEs and an impetus to preserve capital. We Underweight Singapore banks with UOB our top pick.

Safe, liquid balance sheets. Regionally, Singapore banks’ balance sheets offer relative safety. Balance sheet liquidity is strong (77% loan-to-deposit ratio) compared to other developed markets such as Australia (118%), Taiwan (98%) and Korea (140%). Similarly, gearing levels are low with equity-to-assets at a healthy 8%, compared to peers in Australia (5%) and China (6%). But these ratios are particularly vital only for growth which is important in a recovery, but current macro conditions mean the medium term will be defined by the provisioning cycle.

Loan quality risks . . . Emerging-market style credit growth over the past two years means Singapore NPLs (3.7% FY09) will be akin to developing market levels (for example 4.1% in Indonesia and 5% Philippines). This is even higher than China (1.9% FY09) where lending growth is resilient (especially towards state-owned enterprises (SOEs)) underpinning a low NPL ratio. There are no such backstops for Singapore, where lending is focused on large corporates and small- and medium-enterprises (SMEs). Here banks have to take on individual credit risks rather than sovereign risk; hence the appetite for loan growth is limited. But FY08 total provisions to loans is at 2.3% for the sector; lower than countries with similar NPL levels.

Indeed provisioning levels in Indonesia (4.4%), Philippines (4.0%) and Malaysia (3.5%) are significantly stronger. As macro conditions continue to deteriorate, expect banks to aggressively build up provisioning. Note UOB (UOB SP - S$14.34 - BUY) and DBS (DBS SP - S$11.68 - SELL) were adding to provisioning from 2Q08 when macro conditions were significantly more benign. Even then we expect the FY09 provision cover to fall below 100% for the first time since 2006. Compare this with Indonesia which will see a provisioning cover of 147% and Korea at 133% in FY09. Hence, expect Singapore credit charges to be in the higher end regionally.

. . . will disappoint growth. While improving net interest margins and trading income are structural positives, regionally Singapore fares poorly in pre-provision operating profits to equity (19% versus HK: 25% and Indonesia: 38%). This is driven off low interest rates and a corporate biased lending book versus a higher margin consumer book in developing regional peers. In addition, expect headwind to fee income, which has a strong capital market component at c. 45% of non-interest income (excluding insurance). While in cost management Singapore is top-of-the-class, this isoffset by high credit charges (recall DBS saw 124bps and UOB 148bps in 1Q09 alone). This means FY09 earnings will contract -29% YoY vs. HK (+16%), Australia (+8%). While FY10 will see a modest recovery (+8%), this will still lag HK (+14%).

Remain Underweight. The sector trades at 1.3x FY09 PB, cheaper than history, but FY09-11 ROEs are 250bps lower than history, too. UOB is our only pick in the sector given proactive provisioning since 2Q08 which can potentially support an early write-back cycle. Similarly, the group’s asset quality is the strongest compared to peers based on recent Pillar 3 disclosure. With the lowest provisioning level amongst peers (2.2% vs. 2.5%) and a loan book which is c. 20% exposed to construction lending, we remain negative on OCBC (OCBC SP - S$6.78 - SELL).

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