Gloom on the horizon for APAC banks' profits in the next few years

Diversification of income streams has yet to yield substantial results.

Structural changes accelerated by the coronavirus outbreak, including reduction in demand and falling oil prices, will keep interest rates low for a long time and drag down Asia Pacific banks’ profits over the next few years, according to a report by Moody’s Investors Service.

Flatter yield curves and forecasted increases in credit costs as asset quality weakens will further squeeze profits. Another key unknown is the timing and pace of the recognition of problem loans.

At the same time, an acceleration towards digital banking services as a result of lockdowns and social distancing measures will push up operating expenses.

The pandemic only further exacerbated the problems in profitability that has plagued many banks in the region since 2014. “Banks' return on assets (ROAs) declined in 12 out of the 17 systems in APAC between 2014 and 2019 due to a decline in net interest income (NII) as a percentage of total assets. The latter is an outcome of net interest margin (NIM) compression and a slowdown in loan growth during the period,” Moody’s analysts Rebecca Tan and Graeme Knowd said in a report on APAC banks.

In the region, NII is a key determinant of banks' profitability because it has accounted for about 70% of total revenue on average since 2008.

Amongst sovereigns, only lenders in Vietnam, South Korea, and Singapore bucked the trend. Profitability of Vietnamese banks improved significantly from 2014-2019 as the banks recovered from the negative asset quality cycle that started in 2011, and as lending increased thanks to the country's robust economic growth and the expansion of the middle class.

Meanwhile, banks in Korea enhanced their ROAs by reducing operating expenses and credit costs, whilst lenders in Singapore kept their ROAs stable as a result of cross-border expansion.

APAC lenders’ portfolio diversification also had yet to yield any substantial results, according to Tan and Knowd.

Banks have been trying to diversify their income streams by expanding into fee generating businesses, such as credit cards, transactional banking and wealth management.

However, only six of the 17 banking systems saw fee income contribute at least 20% to their total revenue in the past decade.

In the remaining markets, fee income growth will take time as banks still need to develop the necessary technical expertise to better compete with more experienced international banks, the analysts said. This will be a difficult hurdle to overcome, particularly at banks with limited resources.

Further, fee income at APAC banks will also come under pressure if disruptions from the coronavirus outbreak, including a slowdown in trade, last for a prolonged period.

In with the old
Banks operating in aging economies also face challenges from both slowing credit growth due to weakening economic activity, as well as changing needs of customers, noted Tan and Knowd.

Amongst the 17 APAC banking systems, Hong Kong, Korea, Taiwan, Japan, Thailand, Singapore and China will see prime age populations, or people aged 25-64, shrink in their domestic markets between 2020 and 2030.

In these economies, competition between lenders will increase as the pool of prime-age customers decreases, thus weighing on profitability.

“Compared to prime-age customers, those older than 64 tend to draw down their savings and are less likely to use more profitable banking products, such as credit cards, mortgages and car loans. In this regard, banks in Japan are the worst positioned, given that less than half of the economy's total population will be in the prime-age category by 2030,” Tan and Knowed said.

“On the upside, older generations in Japan and some other economies have accumulated significant savings, this opens opportunities for banks to increase fee income through low-risk wealth management products.”

Conversely, banks operating in the Philippines, Bangladesh, India, Malaysia and Indonesia will see prime age populations grow in their domestic markets over the next decade.
“Such favorable demographic changes will benefit banks the most when they are accompanied by income growth, with Vietnam being a prime example,” the analysts added.

Technological advances including the ability to offer banking products and services digitally will also allow banks to overcome geographical barriers to reach potential customers, boosting banking penetration. This meant that profitability of APAC banks will depend on their abilities to adapt their business models to changing demographics.

Digital demand will spur costs
Increases in operating expenses are likely to accelerate in the next few years due to investment in technology as the pandemic boosts demand for the digitalisation of banking services, the analysts said. Lockdowns and social distancing measures have spurred growth in online banking transactions. For instance, the largest bank in Singapore, DBS, reported that cashless transactions at the bank nearly doubled in volume in the first three months of 2020 from the same period in the prior year.

“Whilst digitalization will help banks improve efficiency because it significantly lowers costs for acquiring customers and processing transactions, we expect any efficiency gains from digitalization to be limited in the next few years because banks will continue to reinvest cost savings in technology development. The extent of increase in operating expenses will also in part depend on the depreciation policies for such technological investments,” noted Tan and Knowd.

In particular, increases in operating expenses will be steeper in underbanked emerging markets because physical bank branches will remain important in these markets due to less tech-savvy customers, making it difficult for banks to cut costs by closing branches.

Expanding overseas
To reduce their dependence on NII from domestic markets, banks will increasingly seek to develop other sources of revenue or expand overseas whilst continuing to pursue digitisation.

“Laggard banks that lack the vision or resources to adapt their business models to the changing environment will face challenges in maintaining their market share and revenue streams. The gap between agile large and laggard banks in their abilities to tackle profitability challenges means the former will widen their competitive edge,” said Tan and Knowd.

Lenders that fail to change their business models might be acquired by other banks or may have to merge amongst themselves to survive, they added.

Overseas acquisitions by APAC banks will also increase as they seek to expand outside their domestic markets and diversify their income sources.

Large bank in Japan, South Korea, Singapore and Thailand are already active in overseas expansion. Japanese megabanks are prime examples, deriving an average of around 40% of total operating revenue outside Japan.

Amongst the trio, Mitsubishi UFJ Financial Group has the most extensive footprint outside of Japan, owning Bank Danamon Indonesia TBK in Indonesia and Bank of Ayudhya in Thailand  as well as minority stakes in Morgan Stanley in United States, Vietnam JSC Bank for Industry and Trade in Vietnam and Security Bank in the Philippines.

Similarly, South Korea's KEB Hana Bank acquired a 15% stake in Vietnam’s JSC Bank for Investment and Development of Vietnam in 2019, whilst Thailand's Bangkok Bank Public Company acquired an 89.12% stake in Indonesia's PT Bank Permata.

Meanwhile, other banks expanded in foreign markets organically. For example, the three largest Singaporean banks – DBS, OCBC, and UOB – have established significant subsidiaries outside their home market. As a result, their overseas loans accounted for more than 50% of total loans at end-2019.

On the downside, expansion into emerging markets can lead to increases in credit costs because emerging markets tend to have higher asset risks, Tan and Knowd cautioned. The three largest Singapore banks have historically had higher problem loan ratios overseas than in their domestic market.