Interest rates and inflation are two key global trends that could impact local banks as economies emerge from the pandemic. Rising inflation has caused the US Federal Reserve to communicate the end of its bond-buying programme and the start of an interest rate hike cycle.
The US reported its highest inflation rate in 40 years while Singapore also saw inflation at the highest in a decade. Inflation is partially due to disrupted supply chains and the rising price of oil and gas that is a side effect of the focus on sustainability and a shift away from fossil fuels, especially coal.
Banks have broad businesses. They get fee income by offering a wide range of services including wealth management, bancassurance as well as those involving loans, credit cards, markets and treasury.
Yet, despite diversifying income sources, net interest income contributed 60% and 65% to FY2021 total income for DBS Group Holdings and United Overseas Bank (UOB) respectively. DBS’s net interest income (NII) in FY2021 fell 1% y-o-y to $8.44 billion.
Bear in mind that FY2020 was the first year of the pandemic. Any firmness in interest rates is likely to be more than a tailwind for DBS. CEO Piyush Gupta of DBS says the bank’s opportunity cost during the aggressive easing by the US Federal Reserve since 2019 is somewhere between $2.8 billion and $3 billion. “From a financial and business standpoint, [FY2021] is the best performance we’ve had in the last decade, notwithstanding the collapse in interest rates between 2019 and now, where we lost $3 billion,” Gupta said on Feb 14.
What would happen if the Fed raises interest rates by 25 basis points (bps) four times in a year? This is moot. The Fed has communicated that it will wind down its quantitative easing programme in March and begin a rate hiking cycle. But some market watchers believe the Fed could hike as much as 50bps in March given inflationary pressures.
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According to Gupta, DBS would record an $18 million to $20 million rise in net interest income for every 1bp rise in rates. A 100 bps hike in 12 months would mean a $2 billion increase in DBS’s net interest income. On a pro forma basis, that would mean an NII of $10.44 billion, an alltime high.
No surprise then that DBS’s share price has risen to new all-time highs despite concerns over inflation. In a manner of speaking, the biggest economic problem for households and governments is a tailwind for DBS. One way to invest in a proxy for inflation would be to invest in DBS shares. On the other hand, although DBS’s NAV rose more than $1 to $21.47, its P/B ratio is at the highest level in more than five years (see chart 1).
At UOB, CFO Lee Wai Fai points out that firmer interest rates are generally positive for banks. According to him, every 25bps hike by the Fed adds about 4bps to UOB’s net interest margins (NIM) and between $150 million and $200 million to NII or around $600 million to $800 million for every 100bps hike. Lee reveals that UOB’s in-house assumptions are for five rate hikes this year.
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Credit costs, expenses
How does inflation figure in the macroeconomic variable (MEV) model of banks? Under current financial reporting standards (FRS), MEV models guide general provisioning or expected credit loss (ECL) levels 1 and 2 that banks must set aside for their loans. The FRS makes provisioning somewhat pro-cyclical. Hence, when the banks entered the pandemic, general provisioning levels shot up sharply, suddenly.
One way to lessen the volatility is to put aside management overlays, which is over and above what banks need to place in their general provisioning. DBS has some $1.5 billion in management overlays while UOB had some $1.2 billion in management overlays at the end of 2021.
“FRS is too pro-cyclical and there is not enough we set aside during good times, hence we have the management overlay concept,” Lee explains.
UOB’s credit costs assumptions are for overall credit costs to normalise to the 25bps level in 2022–2023. Unlike DBS, UOB has a regional business. In FY2021, the regional business, which comprises Malaysia, Thailand, Indonesia, Vietnam and North Asia, contributed 42% to operating profit. DBS’s earnings outside of Singapore are mainly from Hong Kong.
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“For credit costs, do I add to general provisions or management overlay? If the macro-economic environment improves significantly, we will look at the countries’ overlay themselves and we will debate whether the outlook is sufficiently positive to see some reversal. Our view is to wait a bit longer because in 1H2022, the region will need to stabilise,” Lee says.
Gupta says DBS’s credit outlook continues to be very good and asset quality continues to be resilient. DBS’s non-performing assets fell because of a recovery of two significant non-performing loans in the transportation, storage & communications sector in Singapore in 4Q2021. The NPL ratio declined from 1.6% to 1.3% y-o-y. In 4Q2021, DBS’s specific provisions hit $67 million.
Gupta is now guiding for total allowances to be at the same level as 2021. For the full year, DBS had specific provisions of $499 million and wrote back $447 million of general provisioning. “Specific provisions might creep up a bit. We have the belief we can release some general provisions,” he says.
On the funding front, DBS is fortunate that some 76% of its deposits are low-cost CASA (current account savings account). In Singapore, DBS has the largest market share in CASA.
UOB’s CASA ratio was at a new high of 56%. Malaysia, Thailand and Indonesia are self-funding. “Our regional businesses are self-funding because of the foreign currency impact. Where we are looking for domestic supply chain growth, we have plans to roll out Infinity for wholesale banking that helps the supply chain. We are also trying to increase our retail portfolio which we can tap into,” Lee says. UOB Infinity is a digital banking platform for businesses.
“We invested quite a bit in cash management and activity picked up by 20% in 2021. We are seeing growth in our working capital cash mandate so our CASA balances should pick up,” he adds.
On the operational expenditure front, UOB is expecting technology spending to continue to rise. “Our staff cost was up 4% y-o-y [in 2021] and we expect staff cost to be higher [this year], closer to 9%–10% now that there is a lot of competition for talent. We are guiding for stable costto-income ratio. Internally, we run our operations on a business-as-usual basis without assuming margin improvement from rising rates,” Lee says.
Gupta says DBS’s expense growth will be higher. He is factoring in 6%– 7% expense growth on the back of higher wage growth. “We probably could have mildly negative jaws. [But] if we get a quarterly rate hike this year, we could wind up with flat to neutral jaws,” he adds.
Capital and growth
Of the two banks, DBS’s management sounded more positive on outlook. Gupta guided on high single-digit loan growth because of an extensive pipeline. In addition, he expects $500 million to be added to DBS’s bottom line by 2023. This would come from the acquisitions of Lakshmi Vilas Bank, Shenzhen Rural Commercial Bank and Citigroup’s Taiwan business.
Moreover, DBS’s common equity tier-one (CET1) ratio of 14.4% is expected to remain high despite the Citi acquisition and an operational risk capital charge by the Monetary Authority of Singapore. “On the conservative assumption that the operational risk charge for the digital disruption is not lifted before the consolidation of Citi group’s Taiwan consumer business and there is no further capital accretion, CET1 would be 13.3%, which is at the upper end of the group’s target operating range and well above regulatory requirements,” says DBS’s group CFO Chng Sok Hui.
UOB’s CET1 is likely to fall to 12.8% following its acquisition of Citi’s retail businenesses in Malaysia, Thailand, Indonesia and Vietnam. In addition, UOB is likely to take a one-time charge of $700 million for the acquisition.
Further out, CFO Lee expects return on risk-weighted assets (RoRWA) to rise to 2.2% by 2026 from 1.68% as at end Dec 2021, if all of UOB’s stars are aligned.
Wee Ee Cheong, whose family has owned UOB since the 1930s, is casting his eye beyond the horizon. “We see significant upside in Southeast Asia, though the pace of recovery may vary by country. Our confidence in the region is underscored by our continued efforts to deepen our customer franchise and to build scale through organic growth and acquisition.
“The opportunity to acquire Citigroup’s consumer business in Indonesia, Malaysia, Thailand and Vietnam came at the right time, with the right strategic fit. Subject to regulatory approval, the acquisition will double our retail customer base across these four markets. At the same time, we continue to invest in capabilities such as supply chain, sustainability and digitalisation to tap the structural trends propelling our region’s growth,” he says.
