Having a Long-Term View

Banking is generally a highly regulated industry, and government restrictions on financial services by banks have varied over time and location. Banks face a number of risks in order to conduct their business, and how well these risks are managed and understood is a key driver behind their profitability, and how much capital a bank is required to hold. Banks are susceptible to many forms of risk which in the past have triggered occasional systemic crises. These include liquidity risk (where many depositors may request withdrawals in excess of available funds), credit risk (the chance that those who owe money to the bank will not repay it), and interest rate risk (the possibility that the bank will become unprofitable, if rising interest rates force it to pay relatively more on its deposits than it receives on its loans).

ABSA, South Africa’s largest bank by customer numbers, kicked off the banking reporting season this week with results that reflect the tough times bankers have endured. Banks can either increase income or decrease costs. Income is in the form of loan and advances to customers. Advances growth has been muted due to a lack of credit demand and increased risk aversion. Investors would use various financial ratios to determine the health and growth prospects of a particular company. One such number is the credit impairment, which looks at the consistent late repayment of debt obligations on the part of the debtor or borrower. Impairment losses at ABSA declined significantly by 33% mainly due to lower impairment losses at the Retail Banking division. This division reported a 36% decrease in impairment losses driven by improvements at the Card, Personal Loans and Home Loans segments. Following on from the credit impairments is the credit loss ratio, which in ABSA’s case improved from 1.74% to 1.2%.

One of the other important financial ratios to look at is the cost-to-income ratio. The cost/income ratio is calculated by dividing the operating expenses by the operating income. It is an efficiency measure similar to the operating margin. Unlike the operating margin, however, lower is better. The cost income ratio is most commonly used in the financial sector, especially the banks. It is useful to measure how costs are changing compared to income. For example, if a bank's interest income is rising but costs are rising at a higher rate, then looking at changes in this ratio will highlight the fact. Interesting to note that operating expenses increased by 15%, driven by increases in IT costs and staff costs of 19% and 16% respectively. The increase in staff costs reflected wage settlements and higher incentives. As a result, the cost-to-income ratio at ABSA increased from 49.6% to 56.2%. ABSA said that they are not worried as they are investing for the future. The jury will remain out on this as long as the economic outlook remains uncertain. In contrast, Standard Bank’s announced the shock decision to retrench staff and slash budgets for everything from expansion to sponsorships.

In spite of challenging operating conditions, ABSA delivered a solid set of results for the year ended December 2010 due to improved interest margins and lower impairment losses. The group's headline earnings grew by 6% and diluted HEPS rose by 4%, while the final dividend was up by 2%. Banking conditions are likely to remain subdued with muted advances growth in the short term. Impairment charges are expected to improve further, albeit at a slower pace than that of 2010. The gradual economic recovery, together with the group's diversified earnings streams and high proportion of, more defensive, transactional revenue should continue to support its performance in the period ahead. However, cost containment is imperative for the group. Trading on a historical PE of 11.8 times and at 1.7 times NAV, we feel the share is fairly valued and would recommend investors to hold their shares. The chart of ABSA shows that it is trading below its short-term moving averages, as well as its long-term 200-day moving average. Although the trend is bearish, as are most of the other banking shares, it is oversold and could bounce higher from here. The share price of Standard Bank, however, may still drop lower as it is not yet as oversold.