Banking stocks: A sector to buy
Saturday, 20 December 2008
Equity Partners Limited
THE banking sector is one of the most important growth engines for any country. To an extent, it's a gauge to estimate the growth potential in the short term and in the long term. According to Ross Levine, an economist at Brown University, numerous cross-country studies show that countries with deeper financial systems tend to grow faster, particularly if they have liquid stock markets and large, privately owned banks. Growth is boosted not because savings rise but because capital is allocated more efficiently, improving productivity. On the other hand, the economic effects of an ailing banking sector are just as striking. According to a study on banking crises by Carment Reinhart of University of Maryland and Ken Rogoff of Harvard, banking blow-ups on a average cut two percentage points from output growth per person. The worse crises reduce growth by five percentage points from their peak, and it takes more than three years for growth to regain pre-crisis levels.
When the positive and negative impacts of a vibrant and stalling banking sector are so high, it's no wonder that, the current banking crisis is turning so many heads. The once revered investment banks have gone belly up, the all conquering Citi bank is in deep trouble, and many other banks have been busted. The Icelandic banks had designed the demise of Iceland's economy, the UK banks are also making the business community there jittery. Some of the biggest names in the business have been forced to write down tens of billions of dollars. How the mighty have fallen!
In all this financial turbulence, the Bangladesh banking sector seems to be an oasis of calm. The banks are performing admirably, and the regulators have been prudent. However, it is necessary to understand why the biggest have fallen and the Bangladeshi banks have been performing well.
Banking is an integral part of the modern financial system, which contains a mass of amplifiers that multiply the impact of both losses and gains, which in turn creates huge uncertainty. The biggest amplifier of all, though, is excessive leverage. According to Koos Timmermans, the chief risk officer at ING, a big Dutch institution, three types of leverage helped propel the boom and have now accentuated the bust. First, many banks and other financial institutions took too much debt in order to increase their returns on equity when asset prices were rising. The leverage ratio at Bear Stearns rose from 26.0 in 2005 to 32.8 in 2007. Second, financial institutions were exposed to product leverage through complex instruments, such as CDOs, which needed only a slight deterioration in the value of the underlying assets for losses to escalate rapidly. Thirdly, they overindulged in liquidity leverage, using structured investment vehicles (SIVs) or relying too much on wholesale markets to exploit the difference between borrowing cheap short-term money and investing in higher-yielding long-term assets.
As a result of this overindulgence, the role of banks has reversed. Banks are basically the wheel-greasers of an economy, allocating and underwriting flows of credit to allow capital to be used as productively as possible. However, banks have seen their capital bases shrink as write-downs have eaten into equity and off-balance-sheet assets have been reabsorbed. Now they need to restore their capital ratios to health to satisfy regulators and to reassure customers and investors. This urge has tightened credit markets, and interbank lending has also become expensive. The spillover effect has stemmed to the corporates. Higher interest rates have translated into higher expenses, and inadequate working capital. The central nervous system has been affected, its only time before the whole body starts to feel the pain.
The banks in Bangladesh have not indulged into these activities at all due to a variety of reasons. Therefore, it is irrational to think that the same fate lies for our banks. In fact, in Bangladesh the private commercial banking industry is the fastest growing industry. Despite the political turmoil in the first half of 2007, private commercial banking industry grew by 37% in 2007 over the last year. Even in the first half of 2008, this industry witnessed approximately 50% profit growth year-on-year (y/y). Banks are now fundamentally stronger compared to where they were in 10 years back.
If we analyze the revenue potential of our banks, we have to look at two important drivers. The first is the growth in interest income, and the other is their ability to generate fee based income. The interest income is generated from the banks' ability to provide loans. According to the Bangladesh Bank, the total estimated bank credit growth to the private sector registered an increase of 23.7% in the first quarter of fiscal year 2009. This growth rate was 17.0% during the same period last year. During the first quarter, total advances for economic purposes increased by 18.8%. A breakdown of bank advances shows that, 25.3% went to trade, 21.4% to industry, 17.3% to transportation and communication, 13.3% for working capital financing, and the remaining for miscellaneous purposes. Total disbursement of term lending by private commercial banks increased by 65.2% in that same time period.
This gives us significant insight into the economic growth of the country and also the profitability of the banks. The country can expect considerable GDP growth in the coming year and also the interest income of the banks would go up.
A bank's fee-based income depends on export, import financing, remittances among others. Export earnings in July 2008 increased sharply by 71.0% against a (minus) -21.1% export growth recorded in the same month last year. It may be added that export earnings recorded a growth of 15.9% during fiscal year (FY)08. The higher export growth during July 2008 was mainly due to higher exports recorded in readymade garment (RMG) products of which knitwear products recorded 84.7% and woven products recorded 58.6% growth. Will this growth persist in the downturn in global economy? It is very likely that it will, if not increase. As the consumers in the developed markets scale down to basic products, our RMG exports should flourish.
On the import front, total merchandise imports showed a robust 34.1% growth (on cif basis) during July 2008 over July 2007. During July 2008, food grains import increased by 27.7% which showed a (minus) -12.0% growth in quarter (Q)4 FY08. The import of consumer and intermediate goods increased by 42.7% in July 2008 over July 2007. The growth rate was 40.4% in Q4 FY08. The import of capital goods and others registered a 25.3% growth in July 2008 compared with 26.8% growth recorded during Q4 FY08. The inflow of workers' remittances recorded a strong 48.6% growth (to USD 1.5 billion) during July-August 2008. During FY08, the growth of inflow of workers' remittances was 32.4%. The translation of all these figures is that, the fee-based income of the banks will continue to increase at a reasonable pace.
After many reforms, private commercial banks are now becoming very efficient and yet there is a lot of room for gaining additional efficiency. The main constraints for attaining such goals are the lack of sophisticated IT platform and expert human resources. Banks are now spending reasonable resources to build up an adequate IT infrastructure and develop their human resources. Many banks have already installed softwares, and are centralizing processes to be more cost efficient. As a result, cost to income ratio for banks fell to 33% in the first half of 2008 compared to 45% in 2003.
The margins of the private commercial banks are very stable and increasing over the past few years due to the effective cost control and management efficiency. Some important ratios are provided in the table, which adequately stresses that our banks are on a strong footing.
Over the past five years, private commercial banks (PCBs) have significantly improved their risk management under the guideline of the central bank. Our banks are now following BASEL I accord, and according to the central bank's guideline, all banks will pursue BASEL II accord from the next year. To prepare for BASEL II regime, capital adequacy ratio has been raised from 9.0% to 10% and all banks are maintaining this ratio. According to central bank's guideline, most of the banks have increased or increasing their paid up capital which surely helps them to have better risk management and lending capabilities.
Despite the good fundamentals, and consistent rapid growth, the price performance of bank stocks in the capital market is worrying and sometimes bewildering. One thing we can say is that, for many banks there is no fundamental reason for such low price performance in the stock market. It's all about the investors' psychology and their speculative nature, but it does not mean that bank's fundamental has changed in a negative way; on the contrary, it is getting better.
In the stock market, our banks are one of the safest stocks for investment. Due to the excellent performance of the regulators, the Bangladesh Bank and Securities and Exchange Commission, it is very difficult for banks to engage in mass level fraudulent practices that undercut the very existence of the entity. On the other hand, in this volatile market, banks have shown less volatility.
Currently, bank shares are the cheapest in the market. Most of the banks are trading at 10-12 Price Earning (PE) ratio. For a general investor, it's a dream come true to buy a bank at 7.0-8.0 PE ratio with 35-40% profit growth. Even some banks that are trading at PE ratio over 25 but have a growth rate of 80-90% per year. These banks shares are considerably undervalued, and may be good investment opportunities.
Equity Partners Limited is a
full-fledged investment bank. It may be reached at research@eplbangladesh.com
THE banking sector is one of the most important growth engines for any country. To an extent, it's a gauge to estimate the growth potential in the short term and in the long term. According to Ross Levine, an economist at Brown University, numerous cross-country studies show that countries with deeper financial systems tend to grow faster, particularly if they have liquid stock markets and large, privately owned banks. Growth is boosted not because savings rise but because capital is allocated more efficiently, improving productivity. On the other hand, the economic effects of an ailing banking sector are just as striking. According to a study on banking crises by Carment Reinhart of University of Maryland and Ken Rogoff of Harvard, banking blow-ups on a average cut two percentage points from output growth per person. The worse crises reduce growth by five percentage points from their peak, and it takes more than three years for growth to regain pre-crisis levels.
When the positive and negative impacts of a vibrant and stalling banking sector are so high, it's no wonder that, the current banking crisis is turning so many heads. The once revered investment banks have gone belly up, the all conquering Citi bank is in deep trouble, and many other banks have been busted. The Icelandic banks had designed the demise of Iceland's economy, the UK banks are also making the business community there jittery. Some of the biggest names in the business have been forced to write down tens of billions of dollars. How the mighty have fallen!
In all this financial turbulence, the Bangladesh banking sector seems to be an oasis of calm. The banks are performing admirably, and the regulators have been prudent. However, it is necessary to understand why the biggest have fallen and the Bangladeshi banks have been performing well.
Banking is an integral part of the modern financial system, which contains a mass of amplifiers that multiply the impact of both losses and gains, which in turn creates huge uncertainty. The biggest amplifier of all, though, is excessive leverage. According to Koos Timmermans, the chief risk officer at ING, a big Dutch institution, three types of leverage helped propel the boom and have now accentuated the bust. First, many banks and other financial institutions took too much debt in order to increase their returns on equity when asset prices were rising. The leverage ratio at Bear Stearns rose from 26.0 in 2005 to 32.8 in 2007. Second, financial institutions were exposed to product leverage through complex instruments, such as CDOs, which needed only a slight deterioration in the value of the underlying assets for losses to escalate rapidly. Thirdly, they overindulged in liquidity leverage, using structured investment vehicles (SIVs) or relying too much on wholesale markets to exploit the difference between borrowing cheap short-term money and investing in higher-yielding long-term assets.
As a result of this overindulgence, the role of banks has reversed. Banks are basically the wheel-greasers of an economy, allocating and underwriting flows of credit to allow capital to be used as productively as possible. However, banks have seen their capital bases shrink as write-downs have eaten into equity and off-balance-sheet assets have been reabsorbed. Now they need to restore their capital ratios to health to satisfy regulators and to reassure customers and investors. This urge has tightened credit markets, and interbank lending has also become expensive. The spillover effect has stemmed to the corporates. Higher interest rates have translated into higher expenses, and inadequate working capital. The central nervous system has been affected, its only time before the whole body starts to feel the pain.
The banks in Bangladesh have not indulged into these activities at all due to a variety of reasons. Therefore, it is irrational to think that the same fate lies for our banks. In fact, in Bangladesh the private commercial banking industry is the fastest growing industry. Despite the political turmoil in the first half of 2007, private commercial banking industry grew by 37% in 2007 over the last year. Even in the first half of 2008, this industry witnessed approximately 50% profit growth year-on-year (y/y). Banks are now fundamentally stronger compared to where they were in 10 years back.
If we analyze the revenue potential of our banks, we have to look at two important drivers. The first is the growth in interest income, and the other is their ability to generate fee based income. The interest income is generated from the banks' ability to provide loans. According to the Bangladesh Bank, the total estimated bank credit growth to the private sector registered an increase of 23.7% in the first quarter of fiscal year 2009. This growth rate was 17.0% during the same period last year. During the first quarter, total advances for economic purposes increased by 18.8%. A breakdown of bank advances shows that, 25.3% went to trade, 21.4% to industry, 17.3% to transportation and communication, 13.3% for working capital financing, and the remaining for miscellaneous purposes. Total disbursement of term lending by private commercial banks increased by 65.2% in that same time period.
This gives us significant insight into the economic growth of the country and also the profitability of the banks. The country can expect considerable GDP growth in the coming year and also the interest income of the banks would go up.
A bank's fee-based income depends on export, import financing, remittances among others. Export earnings in July 2008 increased sharply by 71.0% against a (minus) -21.1% export growth recorded in the same month last year. It may be added that export earnings recorded a growth of 15.9% during fiscal year (FY)08. The higher export growth during July 2008 was mainly due to higher exports recorded in readymade garment (RMG) products of which knitwear products recorded 84.7% and woven products recorded 58.6% growth. Will this growth persist in the downturn in global economy? It is very likely that it will, if not increase. As the consumers in the developed markets scale down to basic products, our RMG exports should flourish.
On the import front, total merchandise imports showed a robust 34.1% growth (on cif basis) during July 2008 over July 2007. During July 2008, food grains import increased by 27.7% which showed a (minus) -12.0% growth in quarter (Q)4 FY08. The import of consumer and intermediate goods increased by 42.7% in July 2008 over July 2007. The growth rate was 40.4% in Q4 FY08. The import of capital goods and others registered a 25.3% growth in July 2008 compared with 26.8% growth recorded during Q4 FY08. The inflow of workers' remittances recorded a strong 48.6% growth (to USD 1.5 billion) during July-August 2008. During FY08, the growth of inflow of workers' remittances was 32.4%. The translation of all these figures is that, the fee-based income of the banks will continue to increase at a reasonable pace.
After many reforms, private commercial banks are now becoming very efficient and yet there is a lot of room for gaining additional efficiency. The main constraints for attaining such goals are the lack of sophisticated IT platform and expert human resources. Banks are now spending reasonable resources to build up an adequate IT infrastructure and develop their human resources. Many banks have already installed softwares, and are centralizing processes to be more cost efficient. As a result, cost to income ratio for banks fell to 33% in the first half of 2008 compared to 45% in 2003.
The margins of the private commercial banks are very stable and increasing over the past few years due to the effective cost control and management efficiency. Some important ratios are provided in the table, which adequately stresses that our banks are on a strong footing.
Over the past five years, private commercial banks (PCBs) have significantly improved their risk management under the guideline of the central bank. Our banks are now following BASEL I accord, and according to the central bank's guideline, all banks will pursue BASEL II accord from the next year. To prepare for BASEL II regime, capital adequacy ratio has been raised from 9.0% to 10% and all banks are maintaining this ratio. According to central bank's guideline, most of the banks have increased or increasing their paid up capital which surely helps them to have better risk management and lending capabilities.
Despite the good fundamentals, and consistent rapid growth, the price performance of bank stocks in the capital market is worrying and sometimes bewildering. One thing we can say is that, for many banks there is no fundamental reason for such low price performance in the stock market. It's all about the investors' psychology and their speculative nature, but it does not mean that bank's fundamental has changed in a negative way; on the contrary, it is getting better.
In the stock market, our banks are one of the safest stocks for investment. Due to the excellent performance of the regulators, the Bangladesh Bank and Securities and Exchange Commission, it is very difficult for banks to engage in mass level fraudulent practices that undercut the very existence of the entity. On the other hand, in this volatile market, banks have shown less volatility.
Currently, bank shares are the cheapest in the market. Most of the banks are trading at 10-12 Price Earning (PE) ratio. For a general investor, it's a dream come true to buy a bank at 7.0-8.0 PE ratio with 35-40% profit growth. Even some banks that are trading at PE ratio over 25 but have a growth rate of 80-90% per year. These banks shares are considerably undervalued, and may be good investment opportunities.
Equity Partners Limited is a
full-fledged investment bank. It may be reached at research@eplbangladesh.com