21 October 2016
An oil refinery looms over the horizon in the US. Oil producers are struggling to repay loans and they have to ramp up output in order to generate cash flow. Photo: Bloomberg
An oil refinery looms over the horizon in the US. Oil producers are struggling to repay loans and they have to ramp up output in order to generate cash flow. Photo: Bloomberg

This is where investors in bank stocks should put their faith

Several major Hong Kong banks have released their annual earnings reports for last year and all posted unsatisfactory growth.

Some banks performed better than others, partly due to their respective focus on different regions and segments.

For example, Bank of East Asia, which is focused on the domestic market, posted a profit, albeit at a slower pace.

By contrast, Standard Chartered reported its first annual loss in more than 25 years thanks to its widely spread business.

In fact, banks are struggling on global stock markets.

The NYSE financial index is down 13.6 percent this year compared with a 5.6 percent drop in the S&P 500.

In Europe, the Euro STOXX banking index is off 26 percent.

Japan’s TOPIX banking stocks have lost 30 percent since the start of the year.

Banks that have substantial cross-national business are grappling with rising bad loans from energy companies, deteriorating asset quality in emerging markets and depressed interest income amid low or negative interest rates and tightening regulation.

Several US banks have said they have limited exposure to the energy sector.

However, JPMorgan Chase & Co., the biggest US bank, said it would need to boost reserves for impaired energy loans by US$500 million, 60 percent of its total impairment.

Meanwhile, HSBC said its loan impairment loss increased to US$1.6 billion in fourth last year from US$1 billion in the third quarter on energy loans in North America.

That means the bank’s receivables could come in below book value.

Why are energy loans suddenly attracting attention?

There is no simple answer but many big banks went on a lending spree to the rapidly expanding shale gas sector after the 2008 financial crisis.

Massive capital has been flowing into shale gas companies. Nobody expected that oil prices would crash.

Some banks even used leverage to finance their energy lending.

Now oil producers are struggling to repay loans and they have to ramp up output in order to generate cash flow.

That has put more pressure on oil prices this year.

The exact size of energy loans worldwide is not known.

What is certain is that concern over such loans will weigh on banking stocks unless oil prices rebound to US$40 to US$50 per barrel.

Standard Chartered is the best example of how slowing emerging economies have dampened corporate earnings.

In the past few years, the bank has been tapping into emerging markets in Southeast Asia, the Middle East and Africa.

The strategy worked after the financial crisis when developed markets were mired in gloom.

By contrast, emerging markets showed robust growth as a result of US monetary easing.

Standard Chartered has been too aggressive in developing new markets in recent years and paid insufficient attention to asset quality.

It’s paying a heavy price as emerging markets struggle.

Low interest rates are likely to stay for the foreseeable future.

The Bank of Japan has introduced negative interest rates, one of four major central banks that have adopted negative interest rates to fight deflation.

The Federal Reserve said it once considered a negative interest rate, a signal that the US central bank might adopt the strategy if the economy slips into recession.

That would make things even worse for banks, which are already grappling with regulatory fines and tightening oversight on proprietary trading.

Banks would prefer to lend to big companies or state enterprises rather than high-risk companies.

However, traditional companies may not generate new growth engines for the economy while only a handful of startups could drive future growth.

If banks become more averse to bad loans, they will create a drag on economic growth or recovery.

Investors should put their faith in banks such as Bank of East Asia or Hang Seng Bank, which have stringent on asset quality standards and have full-fledged business coverage in the mainland.

Multinationals such as Standard Chartered are less favorable due to poor risk management.

This article appeared in the Hong Kong Economic Journal on Feb. 26.

Translation by Julie Zhu

[Chinese version 中文版]

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Founder and Managing Director of Pegasus Fund Managers Ltd.

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