Does Money Grow On Trees?

Investing in Asia’s Garden of Eden

Investing in Asia’s Garden of Eden

If you’re not invested in Asia’s banking sector, you are missing out.

But with so many state-owned banks in the region, how do you know which banks make good investments? In this article, we’ll tell you where Asia’s banks are headed and three things to watch out for when investing your hard earned cash.  

If you’re thinking about adding Asian stocks to your portfolio, this article is a must read.

Traditional sources of revenue declining in Asia

Normally, banks get most of their revenue from receiving deposits and granting loans. The wider the margin between the lending rate and deposit rate, the more money banks can earn.

If you’ll remember from our previous piece, it’s hard for banks to keep wide margins without capital controls (controlling the money going in and out of the country).

Currently, Asian banks have wide interest rate margins relative to western countries because their economies are more disconnected from the global financial system. But as they “open” interest rate margins will shrink and as a result, banks will make less revenue from deposits and lending.

Growth in alternative banking services 

To make up for the reduction in margin, banks are trying to diversify their income streams. Security services, trading fees and wealth management options offer banks alternative sources of income outside of deposits and lending.

In the West, most banks have fully exploited these services.

But Asian banks are still reliant on deposits and lending. So as this becomes less lucrative they will have to provide other services.

And they’re already getting started…

As you can see in the graph below, from 2010 to 2015 banking revenues rose worldwide – significantly increasing in the Asia Pacific region. And within the region, services outside of deposits and lending, like security services and trade fees increased as well.

Most Asian countries (excluding Japan) have large, young populations and rising annual incomes, meaning non-traditional banking services (and profits from those activities) will increase, too.

So we know banking is growing in Asia, but how do we know which banks to invest in? 

Follow the money: how to evaluate the cash flow of banks

For normal businesses, the indication of success is based on how much money they can accumulate. The more cash generated, the more valuable the company becomes.

Banks are slightly different, they are still judged on their profitability, but they can use money as a commodity to create revenue. The value of that commodity, money, changes too. Banks buy money at a lower price from depositors and sell it at a higher price for borrowers.

So evaluating the profitability and efficiency of a bank can be difficult.

But there are a few indicators that will help you find good investment opportunities in Asia’s banking sector.

Measuring profit

To make a profit, a business needs to achieve a  higher value of output than input.

Remember from earlier, banks get most of their money from the difference between the interest and lending rates, this is called net interest.

So banks with lower costs (less interest paid to depositors) and higher lending rates (interest paid by borrowers to banks) should, in theory, generate more profit.

Banks can also improve profits by lowering operational costs, like replacing expensive employees with technology. One of the simplest ways to compare the profitability of banks is to look at cost to income ratios.

You can see the average cost to income ratios across East Asia in the two graphs below.

In places like South Korea, the deposit rate and operational costs are very high relative to the lending rate. So on average, banks there are less profitable.

China, as you can see, has incredibly low deposit rates and operational costs relative to lending rates, bringing its cost-income ratio down and increasing the competitive advantage of Chinese banks.

For example, Chinese Huishang Bank (Hong Kong Exchange; ticker: 3698) has a net income margin 47.1 percent. That’s a huge margin and makes it one of the most profitable banks listed on the Hong Kong Stock Exchange.

And if you compare ‘emerging’ Asia to developed Asia, banks, on average, in less developed countries, have lower cost to income ratios, as shown below.

But that’s not to say that this status quo will be maintained.

In the last five years, many Asian banks have struggled to improve efficiency.

Increasing regulation, wages and IT investments are driving up labor costs across the region. Declining net interest will also squeeze banking margins. With the added deterioration in growth in emerging markets, intense structural reforms at these institutions will be required to increase future profits.

But profits aren’t the only way to measure a bank’s success. Those profits must be kept safe through responsible lending.

Safe lending in a world of leverage

Banks that apply strong risk management controls on their assets and liabilities, will be more appealing to investors. Let’s look at an example to help us understand why controlling leverage is important.

Let’s say you run your own bank. One day you receive a $500 deposit from your mom. And the next day your cousin wants to borrow $500 to build a fence.

You can think of the deposit from your mom as short-term borrowing. On your bank’s balance sheet, that’s called liability.

You will pay her interest for her deposit and then try to lend her money out to your cousin for a higher rate to generate revenue. This is called leverage. Money is in multiple places at one time.

But your cousin is lazy and it will take him a long time to build the fence.

And what if your mom wants to withdraw before your cousin is done building?

If not done correctly, you will become insolvent as you cannot meet your current liabilities.

To prevent a run, you must structure your liabilities and assets accordingly in order to control the flows of cash in and out of your company. Timing is crucial to managing this correctly. To calculate the profitability of your bank, you’re going to have to have to measure leverage, and how long it will take you to convert leverages back to full face value.

This way, you can keep your mom’s money “safe” while lending to your cousin and making money.

Risk is a cost

Banks that are over leveraged are a much higher risk investment.

What happens if your cousin does not repay the $500? It then becomes a non-performing loan (NPL). That’s bad debt and it’s a cost to your bank.

How much it costs will depend on how much you’ve leveraged your mom’s initial deposit.

If you have a net interest rate margin of less than 2 percent it doesn’t take many bad loans to wipe out a hefty chunk of your profit.

In developed Asia, the ratio of bad debt to good debt has been declining, as shown in the graph below.

But across emerging Asia, it’s a mixed bag. China, India, Indonesia and Thailand are all seeing an increase in NPLs. Whereas the Philippines, Vietnam and Malaysia are seeing lower ratios of bad debt to good debt.

Bad debt is very dangerous for banks. And the threat of bad debt is multiplied if a bank is excessively leveraged.

So going back to your bank. If you leveraged your mom’s $500 deposit 20 times (lending out $500 to 20 different people), your $500 equity would become $10,000. If all goes smoothly, you now have $10,000 in assets.

But as Warren Buffett said, mistakes have been the rule. So it’s very likely that at least one of your loans will be defaulted on.

If just one person defaults, you’ll incur bad debt of 5 percent on your balance sheet. That immediately wipes out all of your equity (your mom’s $500 deposit).

And it’s normal for 5 percent of loans to not perform, especially in emerging Asian markets.

This highlights the importance of equity in banking. Equity is the only robust buffer against losses. And although it costs more to hold onto equity, if you aren’t careful, you’ll wipe out more equity than you actually hold, which can bankrupt your business and crash markets – both terrible things for investors.

For example, the Bank of China (Hong Kong Exchange; ticker: 3988) has an outstanding asset to equity ratio of 12.38. That means it is less leveraged and makes a safer investment than other banks.

By understanding how banks generate revenue, and their unique risks, you can figure out which banks are efficient and profitable.

The ideal bank to invest in has wide interest rate margins and offers diverse and profitable services. It also has fewer “costs” relative to both revenue and equity. Importantly, it also keeps tabs on duration matching between lending and deposit periods.

In an upcoming special report, we’ll tell you which banks in Asia make ideal investments based on these conditions.