‘Holdco Gives Banks Avenue to Explore Earnings Growth Outside the Sector’

The Senior Analyst at Coronation Asset Management, Ope Ani and the company’s Head of Research, Guy Czartoryski, in this interview analysts activities in the banking sector. Obinna Chima provides the excerpts:

What is your assessment of the performance of the Nigerian economy in the first half of 2021?

The encouraging thing is that growth returned to the economy as early as the fourth quarter of last year, with 0.11 per cent year-on-year growth, and this continued with 0.51 per cent year-on-year growth in the first quarter of this year. The slightly discouraging thing was the fact that non-oil growth was 1.69 per cent year-on-year in the fourth quarter but only 0.79 per cent year-on-year in the first quarter of this year. It was pretty easy to see what was going on. Oil is generally sold from between three to six months forward, so the benefits of rising oil prices impact the oil and gas sector of the economy with a significant time lag. The large and fast-growing telecom sector may have been held back by the restrictions on registrations of new SIM cards during the first quarter of the year. So, there are two sectors where development was being held back but where the potential to grow is strong. At the same time, it was encouraging to see the manufacturing and real estate sectors return to growth. This bodes well for the economy.

In the banking industry, we have seen increased adoption of the holding company structure. What do you think is driving that?

Amidst the strict regulatory environment and other challenges within the banking sector, the Holdco route gives banks an avenue to explore earnings growth outside of the sector (potentially in fast-growing sectors) as well as room to explore cross-selling opportunities across things like banking, asset management, wealth management and insurance. It will also help to create new value for shareholders in areas where the path to meaningful scale is clear. One of the key developments in the years ahead will be cross-selling of insurance products and asset management products across banking grounds. In the past, there have been regulatory obstacles to banks selling insurance products, and this was a contributory factor to Nigeria being unable to develop a bancassurance industry, such as we find in Europe. But the insurance industry lacked critical mass, and capital, to develop on its own, and our own study, ‘From the Lagoon to the Ocean’ (September 9, 2020), showed that it had not really grown in inflation-adjusted terms over 10 years. So, rather than replicate a bank’s sales force itself, it makes sense to cross-sell across banks, insurance companies and asset management. It is not essential to have a Holdco to achieve this because other structures can be adopted, but a Holdco structure can undoubtedly help.

Can you take us through the major findings in your latest banking sector report?

We looked at the banks’ Net Interest Margins and spreads over the long term and found a remarkable degree of resilience through several interest rate cycles. This suggests that investors have little to fear when it comes to current fluctuations in interest rates, while the banks themselves state that they are confident they can re-price deposits and loans advantageously this year. We took as our sample: Zenith Bank; Guaranty Trust; Access Bank; United Bank for Africa; FBNH Holdings; and Stanbic IBTC. Second, we looked at the growth record of the banks and found that, with one notable exception, balance sheet growth has been elusive, something that became clear when we re-stated key metrics for the effects of inflation over time. The exception is Access Bank, which has been growing both organically and through mergers and acquisitions, notably through its 2019 merger with Diamond Bank. The importance of looking at growth as a source of value addition is that, without a growth trend across the board, investors need to look to improvements in profitability for their returns. Third, we looked at profitability in terms of the Return on Average Equity (RoAE, or more simply RoE) and the Return on Average Assets (RoAA, or RoA) of the banks over 10 years. Again, we made a note of the gradual improvement and convergence in RoAEs over this period. This is highly encouraging because it shows that – at least among the leading group of listed banks featured in our report – lessons about excessive risk concentration and lessons about the importance of relentless cost reduction have been learned. In fact, we expect underlying profitability to continue to rise. Finally, we found that, in terms of valuations, and despite a significant rally in share prices over the past year, Nigerian bank stocks look remarkably cheap, both in relation to other Sub-Saharan African banks and in relation to their own valuation history. This implies there is meaningful value in Nigerian banks for today’s investors, in our view. One anecdote from the production of the report tells the story here. We plotted the banks’ valuations on a chart, and we had saved that template from 2016, which had a space for a group of entries for price/earnings multiples of five times earnings. We had hardly any entries there, and the bulk of our entries were at two-and-a-half times earnings, half the level we had been looking at five years ago. So, we actually had to adjust the scales on our chart. At this point, you realise that the valuations have become very cheap.

One issue you highlighted in the report was the relationship between banks’ NIMs and naira interest rates. Can you shed some light on this area?

Net interest margin (NIM) is a measurement comparing the net interest income a bank generates from credit products like loans with the outgoing interest it pays holders of savings accounts and fixed deposits, divided by its interest-earning assets. Interest rate fluctuations directly impact NIMs. Looking at long-term historical trends, we have found that banks NIMs and spreads have not been adversely affected by fluctuations in interest rates, as banks have been able to adapt quickly and consistently to interest rate changes. So, in times of declining interest rates, such as 2020, banks are quick to re-price their deposits but typically delay before re-pricing their loans. Of course, there is competitive pressure, but generally, the banks in 2020 were able to stagger the changes in interest rates on deposits and loans in such a way as to maintain their spreads and, therefore, their NIMs. In some cases, we say banks increase their spreads and NIMs: in other cases, we saw banks misunderstand the trend in the early part of the year but correct later in the year. In 2021, of course, we have seen the opposite happen as Nigerian Treasury Bill rates have moved from just over half a per cent at the beginning of the year to around ten per cent now. In these circumstances, banks could generally afford not to move their deposit rate upwards for several months but adjust their lending rates fairly quickly. This way, they could increase their spreads. Most banks were already re-pricing loans in March. However, they had to be disciplined about doing this because the overall liquidity of money in the system soon became quite scarce, so some of them were soon offering very good rates of fixed-term deposits. Changes in the interest rate environment soon catch up with you.

One of the findings is that gross loans remain less impressive despite various measures adopted by the regulator. So, what can be done to encourage more lending by banks?

Loan growth in this climate is quite challenging as it increases risk pressure and asset quality concerns for banks. An improvement in structural issues and the overall macro environment will help assuage these concerns and spur loan growth. Recent developments around credit infrastructure (collateral registries, credit bureaus) have certainly been positive with respect to driving risk asset creation. So, there is a foundation for banks to increase their loan books going forward. However, loan growth also needs to be looked at in the context of capital. The distribution of capital across the banks featured in the report is unequal in terms of the percentage of total capital to assets (or, more technically, interest-earning assets). We have seen some banks held back by not wanting to increase capital and actually changing their strategy to maximise the returns from the loan portfolios that they already have. The problem with this strategy is that it is essentially defeatist, in our view, because growth is an essential component of maintaining profitability. So, a bank following this strategy has problems increasing its profits and its capital. By contrast, some banks will hold on to profits and fight shy of paying good dividends in order to retain earnings and bolster their capital bases so that they can keep on expanding. This is the explanation for some of the dividend disappointments experienced earlier this year. So, for loan growth to take place, and because it requires capital, it is necessary to achieve and maintain a certain level of profitability. Of course, the regulator’s response, in the middle of 2019, was to impose the loan-to-deposit ratio (LDR) regime that requires banks to make customer loans equivalent to 65 per cent of their deposits. This worked very well in 2019, with overall gross loans rising sharply. However, once most banks were compliant with it, the effects of the policy were not as strong during 2020.

How much of a threat are the fintechs to the traditional banks?

They are a significant threat in the long term. Innovation from the fintechs has been disruptive as they have targeted the lower end of the market. These banking platforms are attractive to millennials and other tech-literate customers and require little or no physical banking presence. The obvious advantage they have over conventional commercial banks is low cost. The race for market share will heat up as they continue to expand their product offerings and reduce reliance on traditional banks for their operations. So traditional banks are doing a lot to keep pace with these developments. Those that do not keep pace risk losing market share.

But I disagree with your submission in the report that most of the traditional banks are not concerned about the threat from fintechs. In my view, there have been lots of innovations from the traditional banks and a lot of them investing in technology to enable them to remain competitive. What more do you expect from them?

We wrote in the report that the banks featured did not think that fintech companies will surpass them but that they consider fintech enough of a threat to adapt to the challenge. A few banks are making great efforts to invest in technology, make interactions with customers more effortless, and therefore, compete head-on with fintechs. A standard retail offering from the traditional banks these days includes many mobile banking and digital banking features, and customers now expect these as standard. However, we think that some of the traditional banks have not yet reached the level of customer service of the fintechs. Many processes still require going into branches, and product offerings on mobile apps are not extensive as those available from fintechs. The point here is about the mentality of the supplier as well as the experience of the customer. The traditional bank can add fintech-like services to its platform. However, it may do this without fully understanding the potential of the services when they are put together, partly because of the barriers created by its own departmental structures. And it may not understand what its offering looks like to the customer. This is where genuine fintechs have the advantage, in our view.

What are your expectations for the economy for the rest of the year?

Nigeria’s recovery this year will be smaller than most due to its large informal sector. Household consumption has not recovered from the previous recession in 2016, and Nigeria is experiencing rising unemployment, wage arrears and COVID-19 induced changes to the economy. With a modest fiscal stimulus and targeted private investment, we expect growth this year, but it will be fragile.

Inflation has remained at double-digit. What is your take on that?

Inflationary pressure is mainly due to legacy structural factors across the economy. Food inflation remains the primary driver behind the double-digit headline inflation rate. In addition to supply-side constraints triggered by the pandemic, the worsening insecurity in the country (particularly in food-producing areas) is limiting expected outcomes and further fuelling food inflation. Our view is that the headline inflation rate will remain far above the CBN’s reference range of between 6– 9 per cent year-on-year due to sticky food price inflation. We expect the headline inflation rate to remain double digits this year.