Earnings of commercial banks to swell in 2011

Earnings of commercial banks which are high this year are set to further increase in 2011, a top stock broker has forecast. “Earnings growth at banks will be more pronounced for 2011 with the tax reductions taking effect while Return on Equity based on normalised earnings which previously ranged between 13% -16% for the banks covered in the review would now move towards 16% to 19% going forward on the back of stronger loan growth and lower taxes,” John Keells Stock Brokers (JKSB) said in a recent report. Following are excerpts from the report:

The seven listed commercial banks highlighted in this review reported a cumulative yoy earnings growth of 22% for the first nine months of the current financial year.

In line with our expectations of more robust loan growth in the second half, net loans and advances increased sharply in the 3Q rising by 14% for the nine month period for the seven commercial banks reviewed.

Consumer loans and in particular pawning advances continued to grow along with an increase in corporate lending. Loans and advances for trading, tourism, fisheries and agriculture all recorded significant growth in the last quarter.

Net interest margins declined marginally as spreads narrowed given the relatively lower interest rate regime the sector now operates in. The decline in interest rates has placed greater emphasis on the management of the asset and liability mix in order to retain healthier margins.

With economic momentum gathering pace following a slower pick up after the end of the war, our early estimates in 2011 onwards the next two to three years now appears very likely NPL ratios at the banks continue to decline, reflective of a lower credit default risk in the market while provision cover continues to improve.

A mandatory 1% general provision has been brought down to 0.5% for 2011 at a rate of 0.1% per quarter for the next five quarters. However the positive earnings impact of this is to a great extent compensated for by the requirement of banks to contribute towards a mandatory deposit insurance scheme with a premium on eligible deposits ranging from 0.10% to 0.15% per annum depending on the strength of the institutions capital adequacy.

The sector continues to witness a steady shift towards low cost savings deposits as a result of the lower rate differential against the term deposit. Inflationary increases in operating expense have been contained while cost to income ratios of most banks seeing little change despite modest branch expansion across the sector during the year.

The Budget proposals delivered on expectations of a reduction in financial VAT on the banking sector as well as a reduction in corporate tax. We estimate the downward revision in taxes to result in effective taxation on banks declining from 60% to 45%, effective from 1 April 2011.

The goal of doubling of per capita GDP by 2016 effectively requires the financial system to double credit flow into the economy in that period. The reduction in taxes gives banks a significant boost to ROE and permits greater capital accumulation to fund this required loan growth.

Budget proposals indicated that 13% of PBT would have to be allocated for a period of 3 years toward lending for development projects at concessionary rates with a longer tenure. Whilst details are yet to be defined, given the fact that the interest income arising from this would be income tax free, we do not see this as a significant impediment for the sector.

The banks continue to carry excess liquidity and despite expectations of loan growth of approximately 20% for the sector in 2011, we do not expect any of the banks covered in the review to require a fresh capital infusion at least up until the 4Q 2011.

Earnings growth at banks will be more pronounced for 2011 with the tax reductions taking effect while ROE based on normalised earnings which previously ranged between 13%-16% for the banks covered in the review would now move toward 16% to 19% going forward on the back of stronger loan growth and lower taxes.