Indonesian banks - Sector outlook

Manageable risk
Regulatory risks have overshadowed the Indonesian banks. While Bank Indonesia (BI) has discussed measures on normalizing spreads, we believe implementation will be challenging. During our talks with BI, it became clear that their goalis to create higher efficiency in the banking system. Intensive discussionsbetween BI and banks arebeing carried out and we expect banks tohave time and room to maintain profitability. We maintain our view that contraction in marginswill be minimal and reiterate our BUYcall on BBRI.
Lower spreads, not lower profitability
q Even though BI considers loan rates too high, BI is not seeking to limit profitability (ROA) of banks.
q Spread will decline for Indo banks in the future, but this will be driven by lower overhead costs and lower risk premiums.
q NIMs may decline, but this will be offset by lower operating expenses. Thus profitability will likely be maintained.

Implementation remains challenging
q BI has carried out intensive discussions with Indo banks, scrutinizing their business plans. A quarterly meeting is conducted to monitor their progress.
q A regulated lending rate will be challenging because Indo banks have different structure and are in different stages of their business cycle.
q Only large banks will be able to absorb the losses if the central bank imposes a cap on lending rates, because these banks have sufficient economies of scale.

Limited NIM contraction
q We maintain our view that NIM contraction of up to 40bps is likely, mainly driven by competition and lower yields on earning assets (due to lower BI rates).
q A further 25bps NIM squeeze (most likely downside case) sees EPS fall by ~5-13%.
q We also expect banks to be able to increase fee based income and improve efficiency to maintain strong profitability.

Regulatory overhang to remain
q Regulatory overhang will likely remain as negative news keeps flooding the market. This has created negative sentiment in the sector.
q We maintain our buy call on BBRI. We believe BBRI will be one of the survivors due to its strong micro franchise.
q BBNI is our second top pick because of its current attractive valuation, while BMRI will have its NIMs contract more than expected because of recent low bond yields.

Lower spreads, not lower profitability
In our previous noteRationalizing regulatory risks, we mentioned the result of our meeting with one of Bank Indonesia’s most senior executives. The meeting basically highlighted the central bank’s intention to reduce spreadsbetween lending anddeposit rates in a bid to improve the sector’s efficiencyand improve implementation of monetary policy.

Spread according tothecentral bank consistsof 3elements:
(1) Overhead cost. BI is aiming to reduce the overhead cost in the Indonesian banking sectorthrough several measures, includingencouragingbanks to share theirATM networks(BBCA and BMRIinterconnectedtheir ATMs at the beginning of this year). BI is alsoaskingbanks to stop offering cash back or giftsto depositors.


(2) Risk premium.BI will encourage banks to price their risk more accuratelybyallocating adequate provisioning/impairment expenses (not providing provisioning excessively).

(3) Profit margin.So far there is no talk on capping theprofit margin enjoyed by banks.
By having lower overhead costs, abank’s spread will decline. Yet, it doesn’t mean that the bank’s profitability will fallbecause the push factor for such lower spreadsis higher efficiency. In other words, lower operating expenses will likely compensate for the decline in net interest margin.
In addition, BI also plans to bring down the cost of funds. BI is in active discussionswith State Owned Enterprises (SOEs)to lowertheirnegotiated deposit rates. This is critical as these are currently expensive at 5.5-6.0%. BI is also in discussionswith the deposit guarantee institution (LPS)in regard tothe maximum rate guaranteed byLPS as large depositors tend to use this LPS rate (currently at 6.5%for commercial banks and 9.5% for rural banks) as abenchmark for the return of their deposits.

Implementation remains challenging
We met with some banks to understand the implementation of BI's planand below arethe highlights:
(1) A thorough discussion indeed occurredbetween BI and banks.Banks have already submitted their detailed business plansin November 2011. Some banks said that they hadincorporated the loanrate cut in their business plan, but had not appliedthe cutsto all loan segments. Lots of discussion on efficiencyoccuredin an effort to bring down overhead cost.


(2) A regulated lending rate will be challenging. This isbecause of the different structuresand business cyclesamong banks. Should there be a cap for the micro lending rate, for instance, banks whose microsegmentsare still in anexpansion phasemight stop disbursing micro loans. This would happen because themicro segment incurs high overhead costs. The survivalof thesebanks(and rural banks) is importantto supportthe welfare ofthe lower income population.

Limited NIM contraction
We maintain our view that NIM contraction of up to 40bps is likelythis year, mainly driven by competition and lower yields on earning assets (due to lower BI rates).Should the NIM contraction be higher than our estimate, the most likely scenario would beanadditional 25 bps cut in NIMs forIndonesian banks.

NIM contraction will be detrimental to our banks because most of the bank’s earnings are generated from net interest income (NII contributed 65-75% of total gross revenue).
However, we don’t think significant NIM contraction will occur in the short term due to the following factors (1) Indonesian banks still need to build up their capital to anticipate Basel 3 implementation (2) There is always a transition period for new rulings to be implemented. The latest credit card regulation will only be effective in 2013.
We believe that NIM contraction will happen gradually.Acap on Base Lending Rate componentswould be difficult to implement, particularly considering the significant number of banks in Indonesia.

Furthermore, there are avenues to help protectthe banks’NIMs, including(1) improving asset mix (more loans versus holding gov’t securities), (2) increasing proportion of higher yield loans (more micro) and (3) lowering costs of funds.
Apart from NIMs, banks also have an ability to improve profitability by growing their fee based income.

Regulatory overhang to remain
However, the regulatory overhang will likely remain, particularly as unfavourablenews keepsflooding the market. Thiscreatesnegative sentiment in the sector and may causebanks’ share performance to underperform the market.
At this juncture, we maintain our buy call onBBRI because we believe the bank is best positioned to withstand theuncertainties in the market. The bank’s extensiveexperiencein the micro segment will allow themto absorb any losses should the central bank come up with a regulated micro lending rate (while other smaller banks will likely be driven out). From a fundamental point of view, we like the bank’s aggressiveness to penetrate into the traditional market while at the same time continuously strengthen its funding composition. BBRI is employing a differentiated marketing strategy for deposit taking according toeach regionthat they serve in.
BBNI is our second pick because of its current attractive valuations. While execution risk seems to be a concern, we are actually seeing better coordination and communication within the bank.
Meanwhile, we have concerns on BMRI due to the trend of declining 3 month T-bills (SPNs). The 3-month SPN is used as a benchmark for the variable-rate bonds held by BMRI, which totalled Rp76tn as of Sep11. The latest auction on 7 February 2012 resulted in an SPN yield of 1.69%. With another auction will be held on 21 February, we have to be cautious on the possible decline in the yield. We estimate that a 100 bps decline in 3-month SPNs will lead to a NIM contraction of 16bps, ceteris paribus. BMRI highlighted the possibility of lowering its saving rate to slightly compensate for a decline in bond yield.

Appendix
Regulated rates in Malaysia (discussion with Chee Wei Loong, Head of Research in Malaysia)
Malaysia hadadoptedaregulated Base Lending Rate (BLR)previously. There was a set formula to work out the BLR,and all banks used the same rate. In determining BLR, there were three components:
(1) Cost of funds.Whereas 3-month interbank rate was used as a benchmark policy rate previously, theintervention rate determined by the central bankwas used since 1998.
(2) Operating expense.The central bank determined thefixed operating expenses based on industry data.
(3) Profit margin.The central bank determinedthe margin enjoyed by banks.

Since 3-5 years ago, there wasa de-regulationto allow banks to set their own BLR. However, most banks tend to follow the big banks like Maybank and CIMB. Some banks may vary the rateby 5-10bps from the norm.
When pricing their loans,banks will apply a certain margin on the BLR, called an interest spread. This interest spread basically reflectstherisk premium attached to the loans. It used to be a "positive" margin 8-10 years ago for residential and commercial property loans but competition has driven it to a "negative" margin currently. Currently a typical mortgage is priced at BLR -2.4%. To give an example,if the Overnight Policy Rate (OPR)is now at 3%(OPR was introduced in recent years after BLR was deregulated), and the BLR is at 6.6%, the effectivemortgage rate will be4.2%. Unsecured loans to small and medium enterprisesthat are more risky are likely to be charged a “positive” margin above BLR.
The Malaysian central bank uses moral suasion to ensure interest margins are neithertoo high nor too low for retail loans. Interest marginsused to be regulated during the Asian financial crisis, but aregenerally unregulated currently.
Malaysia currently has 8 commercial banks from c 39pre-Asian crisis.

Rates from market forces in thePhilippines(discussion with Alfred Dy –Head of Research in the Philippines)
There is no regulated lending rate inthe Philippines.Rates aremore driven by market forces. The decline in NIMs seen in the Philippines wasmainlydue to competition and price cutting by some banks. HSBC for instance, cut its pricing in the home mortgage marketlast year.
Another reason for such low NIMs in the Philippinesis the relatively low LDR in the system, leaving significant excess liquidity.

The Philippinescurrently has 38 commercialand universal banks.

source: CLSA dated 9 February 2012