What’s next for the Singapore financial sector and value of bank stocks?

What’s next for the Singapore financial sector? When we published our thoughts on how to value bank stocks back at the start of October 2020, we opined that the Singapore banks were undervalued then, and could reward investors with 30% or more in returns over the next year. 20% coming from the increase in the Price-to-Book ratio (the main metric for bank stock valuation) back to the historical average, and 10% from dividends.

What a difference the past 2 months has made! Despite the rollercoaster volatility in the financial markets around the American Presidential elections in early November 2020, Singapore bank stocks held firm (validating their undervaluation), and subsequently have gained some 25%. This sharp move brings the value of bank stocks back in line with the historical average, and there are still dividends to look forward to. So while there is vindication for our view on the value of banks stocks (so far!), we certainly did not anticipate how fast and furious these gains have come!

So the question that is probably on everyone’s minds is, what’s next?

What’s next for the value of Singapore bank stocks?

Within a very short period of less than 2 months, the markets have recognised the undervaluation of Singapore banks stocks, and have rebounded by some 25%.

Singapore banks share price performance Oct – Dec 2020

But this only means that the banks are now valued at their historical averages in terms of their Price-to-Book ratios. This also means that with the introduction of the vaccines for COVID-19, valuations can continue to climb back to their pre-COVID-19 levels. This implies, perhaps, a further 10% upside in capital gains from the current levels.

And let’s not forget about the dividends. Pre-COVID-19, bank stocks were among the stocks with the highest dividend yields. In what we believe was an overly cautious move, the MAS restricted banks from paying more than 60% of their previous dividends for this fiscal year, in order to increase their capital levels. This was a misguided move, because the same regulatory outcome could have been accomplished with less angst for the shareholders if the MAS had simply mandated the banks to pay at least 40% of their dividends as scrip. This way, the capital of the bank would have been increased, and yet the shareholders who preferred to receive their dividends in cash could simply sell their scrip dividends in the stock market. But alas, we cannot expect too much forward-thinking from our bureaucrats, it appears.

Banks are among the stocks with the highest dividend yields

So if there are no more dividend restrictions on banks, we can expect 5% to 6% dividend yields once again. And maybe even a special dividend to boot. After all, the Singapore banks remain well capitalised at a regulatory capital ratio of 14%, way above the 10% regulatory minimum. Which in turn is higher than the 8% standard for global banks).

But can we really be so optimistic? Isn’t the Singapore financial sector still facing headwinds and possible loan defaults and losses?

What’s next for the Singapore financial sector?

Despite the optimism of the stock market, there is still quite a bit of doom and gloom about the economy. But this is the same pattern as we have seen in earlier downturns. We do not know the exact turning point until after the fact. Remember the hostility and scepticism in the face of Ben Bernanke’s “green shoots” remarks back in March 2009? This is not to say that the current economic data is not terrible. For example the Non-Oil Domestic Exports (NODX) figure, a commonly used barometer of economic health showed a decline from a year ago in October 2020, bearing in mind October 2019 was also a decline from October 2018, so a decline for 2 years in a row!

But not everything in the Singapore financial sector is looking as bleak as exports. Let’s take a look at how some of the key factors driving bank valuations are faring, and will fare:

Net Interest Margin

The outlook for the net interest margin (NIM) for the Singapore banks remains uniformly poor at around 1.50% across all analysts. Bt this seems rather pessimistic! Now, the pricing of most loans in Singapore is as a spread above some interest rate, like the 3 month SIBOR. This means that when interest rates go up or down, the spread remains, and hence the interest margin does not change.

But that’s only the theory. In practice, the local banks hardly even fund their loans using SIBOR, since they have more than enough deposits. Since these deposits have interest rates which are not tied to SIBOR, when the loan rates come down due to SIBOR, there is going to be some margin compression. However, that is being dealt with, as banks are all cutting the interest rates on their High Yield Savings Accounts, which have already served their purpose of bringing in new account information and usage data from the millennials who have been bank hopping in search of the highest interest rates.

Furthermore, remember that part of the cause of lowered NIMs was because of the flight to safety when the markets crashed in March, as investors puled money from financial markets and put them into deposits. Also, the cap on dividends imposed by the MAS meant that banks had more funds than they knew what to do with. So al these excess funds ended up in low yielding Singapore Government Securities. Now that these actions are being unwound due to the pick up in the financial markets, banks will start getting rid of these low yielding assets, and hence NIMs should start to recover.

Loan Growth

And another reason why NIMs will start to recover is because loan growth will start roaring back next year. Loan growth in Singapore is historically twice the rate of GDP growth, but this year is exceptional in that despite GDP growth being forecast at -6%, loan growth is essentially flat at around 0%! When GDP growth comes back next year, forecast at 5.5%, we should see loan growth at around 10%! And this loan growth, will increase the book value of the banks, and the value of their shares.

Moreover, loan growth has been slow this year because banks became much more cautious lending to SMEs and corporates. Nobody knew who would be the next Hin Leong or Robinsons! But much of that uncertainty is going away now, and it will become clear that the survivors of the past year are really very creditworthy borrowers to whom banks can lend to.

Provisions for bad loans

What about bad loans? Well, the banks seem to have put aside enough provisions for those. In fact, the losses are unlikely to reach their initial forecasts of 130 bp of loans. After all, following Hin Leong and ZenRock, do you recall which other big Oil and Gas company has collapsed? Well, I don’t either, because the outlook is better now, and it is becoming clearer that those failures are really victims of fraud more than poor business.

For OCBC and UOB, there was concern that their Malaysian loans will sour, especially after the loan repayment moratorium ends. But that ended in September, and no Malaysian bank has experienced waves and waves of defaults. So that fear appears to have passed as well. There are, of course, rumbles of corporate defaults in China, which will hit DBS and OCBC hard. But corporate, especially State-Owned-Enterprise (SOE) defaults have been a common story in China for the past decade or more, and none of them have ended in an economic crash in China. So, those fears seem overblown as well.

Better outlook ahead!

Net, previous concerns about NIMs, loan growth and bad loans in the Singapore financial sector have not panned out. Which means that the financial sector is in good shape to ride the recovery which is just around the corner. After all, this COVID-19 downturn was never due to the financial sector in the first place, and the lessons from more than 10 years ago have been put to good use.

What about the new Digital Banks?

The latest news in the Singapore financial sector is the award for the 4 new digital bank licenses. The Grab-Singtel joint venture, and SEA have snagged the Digital Full Bank licenses, while Ant and the Greenland Consortium have landed the Digital Wholesale Bank licenses. So, what about them, and what sort of an existentialist threat will they pose to the local banks?

The newly minted digital banks in Singapore

Let’s not put the cart in front of the horse, for a start. Firstly, the award of the digital bank licenses does not mean that they will be operational quickly. The Grab-Singtel consortium, which has hired an ex-Citibanker to lead the JV are only launching in 2022 at the earliest. After all there is quite a bit of work to do to get up and running. Secondly, a criteria emphasised by the MAS in selecting digital banks is:

Provides clear value proposition, incorporating the innovative use of technology to serve customer needs and reach under-served segments of the Singapore market

Monetary Authority of Singapore

Hence the digital banks will not necessarily be competing directly with the existing local banks. Rather, they will be tapping the customers which the large banks currently deem too risky, or uneconomical to serve. Such as micro businesses, or gig economy workers.

So what exactly will the digital banks be doing?

So let me put on my speculative hat for now and peer ahead into the murky future. After all, Yogi Berra said: “It’s tough to make predictions, especially about the future“.

At the end of the day, a bank makes money by either lending to you, or selling something to you. Things that fintechs do well, such as payments, actually does not make much money. Also, it’s always a race to be the cheapest, and most unprofitable. Which is why the established banks have been reluctant followers in payment solutions, as it is neither profitable, nor beneficial to their existing card payments and wire transfer businesses. Also, any large scale funds transfer will ultimately have to be cleared by a bank at the backend, unless it is for tax evasion or money laundering, so the existing banks already have a finger in that pie.

Lending means that they need to have the funds to lend out. So, the Digital Full Banks will have to get deposits with higher interest rates. The Digital Wholesale Banks will tap the interbank money markets for their funds. Raising funds this way will be expensive, but can still be worthwhile for these digital banks if they go after higher risk borrowers, like micro businesses and gig workers. This is an area where the Grab-Singtel bank will do well, since they have many small vendors and merchants based locally needing financing to grow and survive.

Ant and SEA seem to be in a trickier situation. While they have many vendors and merchants in their internet shopping networks, many are not based in Singapore. Hence, as a Singapore digital bank, they are not going to be able to lend to them effectively. Perhaps they might target the buyers based in Singapore instead, providing interest free financing for their purchases. SEA might use this as a stepping stone to launch an Indonesian digital bank, since that is where Shopee’s business is largest.

Selling financial products is a tougher proposition, simply because you do not need a bank license to do that. Hence the existing competition, from robo-advisors, to funds platforms, to financial advisors and capital market firms, will be intense! But they may have something up their sleeve, since they have submitted a feasible to the MAS to win their licenses.

Conclusions

There are not many conclusions to make this time around. The bank stocks do look fairly valued now, but there is substantial growth potential remaining as the world comes out of the COVID-19 coma.

And as for the digital banks, the near term prospects look clearer for the Grab-Singtel JV. A bit less so for SEA and Ant. And it is anybody’s guess for the Greenland Financial Consortium.

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