What’s next for Asia’s banks?

Asia’s banks rose to prominence in the aftermath of the global financial crisis, when Asian policymakers set in motion massive stimulus and low funding costs allowed them to flood the region with cheap loans.

While credit in the US and Europe grew, at best, by 1% on average from 2009 to 2012, the Asia ex-Japan region gobbled up an average 19% more credit per year during that period. China led all markets with 25% average growth.

Our ROE decomposition analysis suggests this debt boom helped banks boost their return on equity (ROE) by 3.3 percentage points over the three-year period. Lower credit costs added another 0.9 percentage points to ROE. But with the money flowing in, cost discipline was thrown to the breeze – non-interest expenses ballooned, cutting 0.4ppt from ROE. The shift toward more capitalized balance sheets chipped another 0.4ppt from ROE.

Consequently, valuations flipped from trading at an average discount of 14% to global peers from 2000 to 2006 to an average premium of 43% from 2009 to 2012. At the peak in 2012, Asian banks accounted for around half of global banking profits – a substantial rise from less than a third in 2006. The region's banking giants became global heavyweights, and they remain at the top echelon of the global banking industry today.

But things started to go south in 2012. By 2010, the region started to show signs of overheating following years of rapid growth of cheap credits. Average inflation for the region more than doubled from 2.9% in 2009 to 5.9% 2011, forcing regional policymakers to tighten monetary policy. This marked the start of a multi-year decline in Asia ex-Japan banking profitability, which peaked in 2011–12. Though the rate hikes were reversed in the subsequent years for most economies, the structural decline in credit growth continues today.

Loan growth slowed and net interest margins plunged, and as economic growth started slowing and commodity prices crashed, asset quality deteriorated. China, Singapore, Indonesia and Thailand recorded nearly 30– 50bps of net non-performing loan (NPL) formation per year from 2014–16, while India's NPL formation swelled by nearly 200bps – a trend that continued until last year. As a result, Asian banks' loan-loss provisions skyrocketed and ROEs fell by 4.8ppt.

For many, the advent of digital banking was a saving grace. Banks in China, Singapore, Korea, Hong Kong and Taiwan led the digital banking charge, helping to reduce the costs of transactions by 40%–60% (our estimates) and boosting revenues through cross-selling opportunities. Nonetheless, the damage wrought forth from the economic backdrop caused valuations to derate by about 30% from 2012–18 to trade nearly at parity with global peers.

Looking into the future, the outlook looks brighter in the near term than in the long term. Although the sector's earnings growth is slowing both structurally and cyclically, it's still attractive relative to the region – we forecast 7%–8% average growth during 2019–20, versus 5%–6% for the broader MSCI Asia ex-Japan (AxJ) Index. Valuations are attractive – the sector's ROE of around 11.5% is above the MSCI AxJ's, yet its price-to-book and price-to-earnings ratios are 20% and 30% lower – and its average dividend yield of around 3.7% is above the MSCI AxJ's 2.8%. And unlike other sectors that are directly exposed to rising trade barriers, the impact on financials should mostly come from second-round effects.

So, over the next 3–6 months, we are constructive on select financial names.

We favor Asia's insurance leaders, which are well positioned to capitalize on the secular growth in the industry; banks in markets less exposed to trade uncertainties, such as India, Indonesia and the Philippines; and attractively valued banks in Singapore.

But while the region's financial industry might be resilient in the near term, its longer-term outlook isn't so rosy. Growth is moderating for most economies in Asia, uncertainties from US-China trade tensions are weighing on business confidence and investment appetite in the region, and inflation – which correlates with nominal interest rates (and therefore bank profits) – is likely to remain anchored at low levels over the medium term.

Meanwhile, the rise of fintech companies adds competitive pressure. China's two major tech firms, for example, have increasingly ventured beyond the low-margin payment business and into margin-accretive segments in consumer lending, insurance and wealth management. Not only do these initiatives provide additional stream of revenues, they help keep customers inside their ecosystems. As such, these trends raise disintermediation risks for incumbent banks.

Against this backdrop, we believe the pace of consolidation in the industry may accelerate over the next decade. Large, adaptable and technologically superior banks will likely be able to safeguard their market share and margins, while the smaller, rigid ones may gradually lose relevance. Thus, in the years ahead, digital bank leaders with sizable IT spending and proven track records in leveraging digital technology should be well positioned to rise above their peers.

Written by Delwin Kurnia Limas, CFA, Analyst

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