Sustainable versus unsustainable growth: An analyst’s view towards the state of the banking sector

Disclosure: The article was written on Sunday, February 20, 2011 at 8:48pm. It reflects the writer's personal opinions based on own analysis. The writer is not responsible for decisions taken on the basis of this article. Send your views at kh.asif@gmail.com.


Background

The first time I studied economics in school I learned that there is an opportunity cost for everything in this world. This extends even to highly desired things like “growth”. The examples of unsustainable growth are probably all around us. The prime example is probably the USA. In an attempt to boost the economy it had (and still is) been on a path of continuous monetary expansion, first by lowering interest rates and then by what they call “quantitative easing”. However, right now, I would like to focus on the banking sector in Bangladesh. Please note that by banking sector I am limiting myself to the private commercial banks.

The banking sector in Bangladesh is considered to be a real success story by many people, particularly stock market investors. The 3 year (2008-10) CAGR profit growth for the private commercial banks as a sector was 88%. This is a ridiculously high number specially because we are talking about a sector and not a specific bank (if this was a distressed bank coming out of recovery this might have been realistic). The real question that remains is whether this growth is sustainable and whether we can expect adverse consequences for such growth in earnings and assets/deposits.

The growth in assets and deposits

A big driver of banking sector profits is loan growth. The real problem is that when a bank tries to grow too fast there is a risk of asset quality deterioration which creates more damage than benefits. As per BB data, YoY loan growth for November 2010 was around 28% while deposit growth was 23%. Just like 88% profit growth is abnormal so is 28% loan growth for the sector.

Was there a real reason for such loan growth?

I can off course argue that Bangladesh is a developing country with huge growth potential and there is a justification for large loan growth. However even If we use a top down approach we can see that nominal GDP growth has been around 13-14% and there is a clear mismatch with loan growth numbers (given that Loan to deposit ratios were not very low in the first place). We can also do some sort of bottom up analysis to identify where the loan growth actually happened by breaking up the loan portfolio into corporate, SME and retail. Since data is not available in this format I need to rely on anecdotal evidence to draw conclusions.

Before proceeding further, let us remind ourselves that in the last 9 years we have probably added around 1,100 MW of electricity. However net addition is lower than that because some old plants went out of operation. If this is the case, then there is no reason to expect huge demand for loans. In reality also, if we look at the early part of 2010, demand for loans were low and the banking sector had a huge amount of excess liquidity. Somehow, suddenly everything changed and by the end of 2010 the huge excess liquidity situation reversed to that of severe liquidity shortage.

Let us now go back to the potential loan growth sources. SME is a relatively new product in Bangladesh and because of that some banks have already seen asset quality problems by trying to grow too fast in this area. I would guess that the gross NPL ratio for SME lending is no less than 12%. So while it might be the case that most of the growth happened in SME there is a risk of asset quality deterioration. On corporate side I have already mentioned that chances of ‘true’ loan demand is low because we still have huge shortage of electricity. This leaves us with only retail loans.

Condition of the reported stock market exposure

Forgetting the diverted loans (which I will discuss later) we can take a look at the declared stock market exposure of the banks. A substantial portion of the banking sectors excess liquidity went to the capital market in the form of both proprietary investments as well as margin lending. In 2010 the capital market showed a tremendous performance with the index growing close to 100% which boosted the banking sector earnings.

Now let me bring your attention to something called financial leverage. I calculated the equity/assets ratio of 22 private commercial banks (using 3Q2010 numbers). The number comes to 8.28%!!!! This means that for every 100 taka of assets the bank has only 8.28 taka as equity while 91.72 taka is in the form of liabilities. Leverage magnifies both positive and negative events and since the equity investments grew significantly profits were magnified.

Now comes the interesting part. As per Bangladesh Bank rule, the maximum stock market exposure that banks can have is limited to 10% of liabilities. If we are to believe media reports then a number of banks exceeded this limit. However, even if I assume that the exposure was 5% of liabilities then we find that stock market exposure is 55% of equity. For a number of banks, the capital market exposure is greater than the equity base. Given that in 2011 the market has fallen by around 30+% it is clear that a significant portion of the equity can get wiped out just because of the proprietary portfolio performance. There is also a circularity issue since there is cross holding of stocks within the financial sector’s portfolio investments. If the first quarter earnings are unsatisfactory (which is the base case scenario at the moment) to investors then we would see a further wave of price fall in the stock market.

That is not the end of the story because the margin loans are also under risk as “trigger sales” have virtually been banned by the regulators.

Story of diverted loans

This is not a new story as the newspapers have highlighted this issue already. Just for the unaware readers, let me recap a bit. A good amount of loans disbursed in the form of corporate, SME and retail actually found its way into the capital market. There is no number on the extent of this but as per my discussion with bankers I am inclined to believe that this is quite a substantial amount.

What is even more fascinating is how people used credit cards to invest in the stock market. As no interest has to be paid on credit card loans for 40 days (probably varies a bit), credit card holders used cheques issued against cards to invest in the stock market. In 2010 there has been a massive increase in the number of credit card issuances. As per a banker I talked with, around 80% of the credit cards issued in 2010 were for this purpose and very soon we are going to see credit card defaults going up.

Asset quality and provisioning

Given that my hypothesis is true, we are likely to see a dramatic decline in the banking sector asset quality. Since the majority of the stock market crash happened in 2011 the non-performing loans (NPL) numbers reported for 2010 will probably not reflect the true situation. As a result the provisioning that was required would also fall short of the required amount. I also have my reasons to believe that banks have a tendency to under report NPL numbers.

It might be a good idea to check interest earnings on accounting basis and cash flow basis to see whether there are any significant deviations. That can be done once annual numbers are out.

Capital Adequacy and BASEL II

I have already mentioned that the leverage is huge and provisioning has been inadequate so far. The final thing to check is whether banks have enough cushions to withstand a shock. The decision to implement the BASEL II guidelines was taken quite some time ago and the initial deadline was 2009. This deadline was off course broken. As a result the Bangladesh Bank gave additional time to the banks to adapt to the BASEL II requirements. One of the major requirements was to have a Capital adequacy ratio of 10% (calculated as Capital/Risk Weighted Assets).

As per Bangladesh Bank data (as quoted by newspapers) the CAR for the private commercial banks at the end of June 2010 stood at 8.69% which not only falls much below international standards but also below BASEL II requirement. Now given that assets have continued to grow and that equity investments have not done very well it is much more likely that current CAR figures are even lower.

I believe that Bangladesh Bank has done some stress tests on the banking sector. Therefore they are well aware of what the outcome will be in the case of different scenarios. It would be interesting to know what the results of those tests were.

Conclusion

In conclusion we can list down the 4 major reasons which caused the profit figures to grow so much

1.High loan growth, a significant portion of which got diverted

2.Large exposure to the stock market through proprietary investments

3.Huge leverage that magnified the return from the stock market

4.Under reporting of non-performing loans and hence lower provisioning so far

It is quite clear that this situation is not sustainable in any way. In fact, the wind is now blowing in the opposite direction. Given the tight monetary situation, stock market crash and high leverage the outlook indeed looks gloomy. Whatever “accounting earnings” the banks earned in the last year are probably going to vanish due to the asset quality problems. Asset quality is something that can be kept hidden on a temporary basis but sooner or later it comes out of the box. Usually that is time when the economy can least afford a banking sector problem.

Unfortunately, I cannot quantify the magnitude of the problem due to inadequate data. Even if the problems evolve in the manner I am expecting this is a problem that could be contained by prudent guidance by the central bank and proper decision by the commercial banks as well. I have seen banks come of out much worse situations (e.g. Kazakhstan where banks used wholesale funding from other countries to increase loans and loan-to-deposit ratios went up to 200%).

Given the present situation I can recommend a number of things that the banks ought to do

1.The most important thing is to understand the magnitude of the problem. An external analyst like me does not have access to enough data to make specific conclusions. However bank managements can pinpoint their problem and identify a plan to get out of it.

2.Secondly, they need to stop thinking about growth for the next 12-18 months. Loan disbursements must be very strict. If necessary banks can even think about lowering their balance sheet sizes which has happened many countries of the world.

3.Instead of growth, the focus must be put towards asset quality. The immediate priority should be the recovery of the diverted loans because they are the riskiest. The next target should be lowering the size of the proprietary portfolios. Interest rates on margin loans should be allowed to increase because it is actually a risky product contrary to what people think.

4.Capital adequacy must be improved. A CAR of 8% is really not acceptable when most banks around the world have CAR ranging from 15%-18%.

5.Often times when stock markets crash investors have a tendency of ‘averaging’. This must be avoided by banks at any cost because they really cannot afford to increase their capital market exposure.

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