Rising bank confidence disguises weak retail market

Ernst & Young Financial Services Index Q2 2009

The 2nd quarter Bank confidence index results, released today, indicate a slight improvement in sector confidence. However, a breakdown by category illustrates that retail bank’ prospects remain weak, whilst investment banks have seen an upsurge in sentiment, largely driven by business fundamentals.

Retail banking confidence fell from 32 points in the 1st quarter of 2009 to a slightly weaker 28 points in the 2nd quarter, while investment banking confidence rose quite sharply, from 32 to 50.
This is the 30th quarterly survey conducted to measure confidence in the banking industry, and the research is conducted by the Bureau for Economic Research in Stellenbosch.

Says Emilio Pera, the lead Financial Services Director at Ernst & Young, ‘ We have been hearing a lot about the appearance of early signs of a recovery (green shoots) in the last four to six weeks. In the case of investment banks, this appears to be more pronounced. Interestingly the business fundamentals are not entirely different between retail and investment banks. Both segments of banking are experiencing continued and protracted profit contractions, caused by flat or reduced income growth, and continued high growth in non-performing loans.

Nevertheless, investment banks are benefiting from a client base that was more resilient to interest rate increases over the last two years, although corporate entities were starting to feel the impact towards the end of the interest rate tightening cycle. This is illustrated in the graphic below, where investment banking interest income has remained more buoyant than that of retail banks.

(Click on image to enlarge)



(Click on image to enlarge)

A more fundamental reason for the return of confidence in investment banking is a turnaround in resource companies. All the major resource producers have gained from rebounding commodity prices, which in turn has led to a resumption in corporate M&A activity and re-looking projects that in the latter half of 2008 were mothballed. These developments tend to be beneficial for investment banks. As a result, interest income growth continues to be sturdier for investment banks, although declining fee income did negatively impact them.

Continues Pera, ‘ It may well be that the current weak credit growth trends will be turned around by growing corporate demand. The household demand for credit remains weak, and this in turn is hurting retail banking’s bottom-line resulting in lower confidence levels’.

Whilst demand for credit remains weak, banks themselves are maintaining stringent credit standards, particularly in the retail market. Investment banks, on the other hand, saw a noticeable relaxation of credit standards in the 2nd quarter. Comments Pera again, ‘ Retail banks remain wary of granting credit in an environment where the ability of over-extended households to repay secured and unsecured debts continues to be a concern. Credit cards, mortgages and installment finance are all either reflecting negative or flat growth in the year to April. It is understandable why banks are more cautious in their credit granting processes at this point in time. Banks have a fiduciary duty to provide credit responsibly and not in a reckless fashion. The National Credit Act, for one, provides a framework within which the banking sector must abide. There is also a duty to shareholders and to clients, both depositors and borrowers’.

In this tough environment, it has been difficult for the banking sector to improve efficiencies, particularly retail banks. Says Pera, ‘Although banks have had success in reducing cost growth, efficiency ratios have worsened due to sharply declining or flat revenue growth. Investment banks have been far more flexible in shedding costs as their revenues declined, whilst retail banks have more extensive infrastructure which is not as easily discarded. However, both segments of the banking sector have seen a contraction in headcount, as they size down to a more suitable size to fit the current economic environment.’

Concludes Pera, ‘ Typically, it takes at least six – twelve months for interest rate reductions to feed through the economy, and result in increased consumer expenditure. Thus far, the lower interest rate environment has not filtered through to the retail banking sector, and in addition, there is concern that the current recession is far from over. Growing unemployment may offset any of the benefits of lower interest rates for retail banks. However, on the investment banking side, there appears to be better prospects for growth, even if profits are contracting at present. The corporate sector of the economy may well lead the economic recovery, in which case the investment banking market is likely to continue benefiting in the immediate quarters ahead.