Banking Sector Update: Recent yield trends as Trojan horse for Banking Industry


September   25, 2012 / ARM Research

Recent macro-economic developments suggest the tougher operating environment we expected banks to face coming into H2 2012 is about to get even worse. The latest MPC decisions maintained the tight monetary tone on the heels of further tightening in July’s meeting when the committee hiked the CRR by 400bps to 12% – a move directly targeted at banking system liquidity.  The implications of tight monetary policy for the banking sector are a common refrain by now. At the same time, yields are falling on government securities fast eroding the alternative that has significantly supported banking industry revenue in recent months. In light of these, we proceed to reassess the emerging impact on the sector and update our expectations throughYE2012.

Falling securities’ yields: faster than envisaged with added competition

Within the past month, yields on government securities have declined over 400bps on average reflecting the increased appetite for government paper, primarily from foreign investors on the back of Nigeria’s inclusion in the JP Morgan EM Bond index. The CBN indicates that after a cumulative flow of $5bn in 2012, through July, foreign portfolio inflows jumped $3bn in August alone coinciding with the announcement. To put this in context, the August inflow cited by the CBN was sufficient to cover supply at all primary market auctions for both T-bills and bonds for that month and is about 7% of total secondary market issues outstanding – significant for a single month – and implies the impact on yields could last a while.

However, in line with our earlier views that, despite temporary sell-off in July in response to the hike in reserve requirements, yields for government securities will generally trend lower as demand rises; there has also been substantial domestic interest in bond buying, possibly targeting capital gains. Given increased competition and growing constraints in the corporate lending market, and the fact that investment in government securities are unhindered by regulatory considerations, bond and money market instruments has emerged as the most effective way to grow assets for the more liquid banks and this trend was only held back by uncertain outlook, which appears to have moved decisively.

We believe the pressure on sector earnings we had anticipated from a medium term decline in yields has been exacerbated by a sudden acceleration in August while anticipated capital gains to banks holding these bonds could be capped by the heightened participation of foreign investors in the recent bond rally, and reclassification of most of the long term investment holdings to HTM buckets in the light of recent IFRS adoption within the industry.

Figure 1: QTD Yields for selected government securities


Constrained revenue growth, overall

Also, the MPC’s decision in July to increase the surcharge on deposits by a further 50% through its CRR hike effectively reduces the amount of possible asset creation per unit of deposit growth. We believe  this will have a direct impact on the creation of  risk assets, particularly as the relatively low yield pick up on corporate lending becomes even less attractive even as the lack of robust retail lending platforms for most banks limits its value as an alternative channel for asset creation in the near to medium term. 

Combined with increased saturation in the corporate space, with credit to private sector (CPS) rising an anemic 3.6% YTD compared to 46% in 2011, this could accentuate slowdown in loan volumes. Admittedly, reform initiatives in the power and infrastructure sectors could provide potential outlets for lending, but we believe the nature of the businesses involved implies an inherent funding mismatch for Nigerian banks which at this point have only developed limited capacity to term funding and we discounted the impact of this on lending volumes in the near to medium term.

Furthermore, recent history indicates that even with significantly tighter liquidity conditions, banks lack the pricing power to effectively re-price the corporate loans which dominate their loan books. Pricing on banks loans’ to the corporate sector remain stuck in the 11%-13% band since before the current tightening cycle in September 2010 while CBN data indicates prime lending rates rose <100bps, in spite of the cumulative 600bps increase in MPR. In addition, increased retail lending will likely have a muted impact on total revenue for all but the smallest banks given limited scope to grow assets in this arena.

Overall, looking at lower volume growth in risk assets and falling yields in government securities, we expect lower revenue growth for the sector in H2 2012.

Figure 2: Credit to private sector


Heightened pressures on industry funding costs

In H1 2012, funding costs increased an average of 150bps and we expect the still tight conditions with direct targeting of bank liquidity to perpetuate the trend. The sequestration of a further 4% of sector deposits in July will no doubt worsen already tight liquidity conditions. Monetary aggregates highlight the stunted growth in demand deposits even as deposit rates in H1 2012 averaged 120bps higher than in Q4 2011, amid tightening of monetary policy during period.

Clearly, higher interest rates on deposit funds for which an even smaller portion becomes available for on-lending will put upward pressure on implied cost of funds as a rising portion of banks deposits are sequestered. We expect the new cost burdens to cut across the industry and we expect average funding costs could rise a further 30bps from the already elevated H1 2012 levels by FY 2012.  However favorable perception of the larger banks appears to have conferred distinct advantages in deposits gathering, and we expect funding costs to diverge between the larger and smaller banks amid the overall uptick.

For instance, larger banks witnessed an average 86bps rise in funding costs, much lower than the industry average and widening the gap in average levels of funding costs. Figure 3 clearly shows that larger bank—as well as Diamond—have generally maintained much lower funding costs in spite of the general uptick from competition for deposits. With the exception of Access, this category also clearly showed more moderate rises in Q2 indicating they adjusted more quickly to the initial shock of higher deposit rates, which further underscores their advantage. The value of scale as a driver of low WACF was also evident from the M&A angle: acquirers Access and FCMB were the only two banks to record lower WACF in Q1 while ETI saw similar benefits delayed into Q2. 

However the larger banks still had a clear advantage and smaller acquisitions were hardly transformational for funding costs. Access which was comparable to Skye and worse than Fidelity, Sterling and FCMB (the latter two also acquirers) as at FY2011 was significantly better off by H1 2012. Nonetheless, compared to the performance of non-acquirers especially in the tighter Q2 environment, it is clear that the mergers still afforded some protection from funding cost pressures. For instance, the net 22bps increase in funding costs for FCMB through H1 was relatively muted whilst the H1 increase for Sterling was eclipsed by bigger rises in WACF for Fidelity and IBTC, leading their cost of funds higher by H1 2012. We expect these patterns across various categories of banks to persist into H1 2012.

Figure 3: Trend in funding costs

More dollar-borrowing expected

The impact on cost of deposits-based funding means banks’ interest in alternative funding sources that are free of the surcharge on deposits, imposed by a sharply higher CRR YoY, will likely increase. In our view, deteriorating prospects for cheaper whole sale funding from much higher interbank rates--and a still hardly-existent corporate bond market--suggest and upsurge of renewed interest in dollar-based funding will likely take hold over the next few quarters. This  accentuates a trend which we had already anticipated based on mounting competitive pressures amongst banks which are apparently facing constraints on the domestic deposit pool after the apparent sputtering, thus far in 2012, of 24% post-crisis rise in demand deposit liabilities in 2011 (see Figure 3).

Figure 4: Demand Deposits (N’million)

Already in 2012, we have had one new Eurobond issue and two expressions of interest in addition to a few banks re-tapping existing lines for multilateral funding. In our view, the smaller banks might be better served by this strategy, especially as issuer characteristics appears to have had limited impact on the strong appetite for EM bonds in recent months, going by the broad-based yield moderation across various credits in 2012.

For most banks that have utilized these lines, multilateral funding is currently priced at LIBOR +500-600bps, which puts current rates around 5.5%-6.5%. Considering average funding costs of 3.2% in H1 2012 for larger banks with Eurobonds (higher for smaller peers), multilateral funding appears competitive especially as CBN posture appears to significantly moderate currency risk. In addition, with no constraints imposed on the lending of these funds (compared to 12% reserve for deposits) these funds are implicitly competitive to reasonable downside currency risks and may become increasingly attractive for  smaller banks facing sharp increases in borrowing costs.

However, this strategy introduces new risks for banks in our view. The trend of accessing multilateral dollar funding has been supportive of risk appetite especially in light of partial guarantees sometimes provided by the multilateral agencies. However, the principal drivers of currency stability which is the main source of risk could easily reverse. Indeed the CBN during last week’s MPC highlighted the extant risks to oil prices and the traditional flighty nature of foreign portfolio inflows – which between them account for almost all the reserve accretion – and opted to discount these in its policy considerations. Considering that hard economic data continues to belie the impact of stimulus by major central banks and the combination of slowing global demand and increasing supply’ from some major oil producers poses increasing threats to oil price equilibrium even as possible likelihood of a crisis with global implications emerges from strained conditions in both developed and emerging markets with the passage of time, we see increased “event risk” to foreign currency liabilities of Nigerian banks. Accordingly, we will reflect these risks in our discount rates as banks increase exposure to foreign currency lines, which may have considerable valuation impact for some.

How will the cards fall?

For the industry, we believe the combined impact on revenues and funding costs will serve to further contract already narrowing NIMs. The effect could persist over the medium term and should lead to some benefit for banks who already have some headstart in the retail lending space – FBN and UBA for larger lenders and Diamond and Fidelity for mid-tier banks. In addition, we believe these developments place a greater premium on cash liquidity and an additional burden on banks which are already flirting with the regulatory limits on liquidity and/or capital adequacy. For this class of lenders, this will impose significantly greater constraints on asset growth (and, consequently revenues) and funding costs.

Figure 5: Adjusted Liquidity ratios*

Broadly speaking, we continue to expect the top tier banks to fare better than smaller peers, on both revenue growth and funding costs, and we envisage the budding discrepancy in net interest margins and overall profitability could widen at the expense of smaller banks with the exception of a few names, principally Diamond and to a lesser extent FCMB and Fidelity. For Fidelity, our concerns about its sharply higher cost of funds in H1 2012 are mitigated by its sizeable capital which reduces reliance on new deposits to sustain risk asset growth. Thus we expect its significant earnings growth to be sustained through 2012.

Among the mid-tier banks, Diamond still maintains funding costs at tier 1 bank levels and so far in Q2 2012 has reported the smallest uptick (2bps) in WACF, same as GTB. Fidelity and FCMB both have excess capital—CAR of 29% and 26%, respectively—sufficient to drive significant near-to-medium term asset growth. In addition, FCMB has a more diversified asset base while Fidelity’s retail lending efforts could help offset some of the squeeze on margins. Nevertheless, their protection against rising funding costs is more limited compared to Diamond. For the rest of the smaller space, the rising funding costs, exacerbated by revenue constraints, will likely constitute a further drag on margins.

Yield declines as a ticking bomb under nascent recovery:

Nevertheless, the rapid decline in bond yields gives us cause for concern. Coupled with the rise in funding costs, this appears set to drastically reduce smaller banks’ competitiveness and potential for revenue growth. Imminent liquidity pressures in the face of erosion in their deposits generation capacity is complicated by the falling yields on securities’ holding which bulk has been lumped in HTM category under recently adopted IFRS reporting. For most banks, this strategy was the easiest way to manage previous accumulation of securities at yields that were much lower than current levels, while relying on sustained deposit growth to take advantage of a sharp uptick in yields which helped support earnings recovery. The substantial mark-to-market losses that could ensue if liquidity pressures precipitate wholesale re-classification will only exacerbate an already dire picture and such a systemic event will likely spread to the healthier larger banks via the interbank market. This scenario could cause a repeat of the rapid but (thankfully) brief spikes in interbank rates into the ~40%region in the immediate aftermath of the July CRR hike—which is perhaps the clearest evidence yet that pressure points still exist within the industry—but the extent and duration of such an event is certainly one that should give monetary authorities pause.

Figure 6: 2012 changes in cost of funds


We estimate FY2012 YoY revenue growth of ~30% for the sector down from 42% as at H1 2012, to capture the risks to revenue accretion we have identified. Expectedly this is skewed to smaller banks for which subset we expect YoY revenue growth to slow from 55% in H1 to 31% by FY 2012 while for the larger banks we posit a mild 1ppt increase from H1 to 30% YoY by FY2012. This largely reflects the contribution from larger acquirers which we believe have more leeway for growth. In line with foregoing views, we also estimate a milder 10bps increase in WACF for larger banks compared to 40bps for the smaller banks. As an offshoot of the outlined trends, we expect an average 110bps expansion in NIMs for the larger banks while we believe we could see as much as a 120bps contraction on average for smaller banks.

Accordingly, we broadly favour larger banks over smaller peers under the current environment with our views reflected in much faster earnings growth expectations, though there are exceptions among smaller banks. In our view, the discount embedded in smaller peers compared to larger banks (P/B: 0.6x vs 1.1x; PE; 7x vs 11x), at least, partly embodies the challenges they could face in coming quarters. FBN (TP: N17.4), GTB (TP: N26) and Zenith (TP: N16.18) command our attention among the larger banks and we expect earnings growth and profitability from these to remain resilient, riding on sustained revenue and lower-than-average operating costs even among tier 1 peers. As previously highlighted, Diamond (TP: N6.4), FCMB (TP: N7.6) and Fidelity (TP: N3.01) each have unique characteristics which should provide support under the current environment and are our top stakes for relative out-performance.

Table 1: Summary of FYE 12 Forecasts (N’ mln) and Assumptions


Table 2: Summary of FYE 12 Ratios and Recommendation



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