The need for central banks to tame inflation and for governments to bring their finances under control is likely to have the following impact on commercial banking operations:
Margins are likely to widen as interest rates rise (positive).
Operating costs will likely increase due to higher inflation (negative).
Wholesale funding will become tougher to secure as monetary policy tightens (negative).
Credit growth will likely slow due to affordability issues and reduced confidence (negative).
Loan quality will likely deteriorate due to weaker debt servicing capacity and lower collateral values (negative).
We have previously written on items 1 and 2. We believe these are most pertinent in the current environment and explore these issues further below. Items 3-5 will take effect later in the cycle and we will return to these topics in subsequent reports.
The emerging market banks that benefit most from higher interest rates
We present below the results of our previously published analysis, which highlights the banking systems whose margins are most sensitive to higher interest rates.
Based on a structural mismatch of rate-sensitive assets and liabilities, the median impact on the emerging markets banks would lift margins by 15bps for every 100bps rate hike. The effect will likely be felt most by banks in Saudi Arabia, Qatar, Poland and Ukraine; their margins can rise by over 50bps for every 100bps rate hike. In contrast, the margins of banks in Lebanon, Hungary and Colombia would be less impacted by monetary tightening, while banks in Greece could face margin pressure due to an excess of rate-sensitive liabilities versus assets.
The emerging market banks that are most exposed to higher cost inflation
Operating costs consume a median 44% of emerging market banks’ revenues. For the largest emerging market banks, the cost/income ratio is highest in South Africa, the Philippines and Hungary, and lowest in Qatar, Vietnam and Russia.
More pertinently for investors, operating costs are equivalent to c100% (average/median) of pre-tax earnings, meaning that a 1% increase in costs erodes earnings by a similar amount. The bank earnings that are most vulnerable to earnings erosion include those in South Africa, the Philippines, and India.
How investors in the EM banking sector can protect themselves from inflation risks
Combining both these factors (margin and cost sensitivity) allows us to assess those banks that could benefit most from higher margins and be less sensitive to higher cost inflation (top-left quadrant in the chart below) and those that are less favourably positioned along both these metrics (lower right quadrant). Our analysis presents banks in Qatar and Saudi Arabia in a positive light. India, Hungary and Colombia banks could find the current environment to be more challenging.
We repeat this exercise at the entity level below, which highlights Qatar Islamic Bank and Saudi Arabia's Al Rajhi Bank as names that could potentially benefit more from margin expansion than the earnings erosion impact of cost inflation. In contrast, State Bank of India, the Philippines' BPI and South Africa's Standard Bank could find that their earnings are at risk.
Valuations have yet to reflect likely performance differentials
For our sample of around 50 large emerging market banks, current price/book multiples are around 15% below their 5-year average. In the chart below, we compare the current valuation premium/discount (y-axis) versus a composite score that incorporates both potential upside from margin expansion with potential downside from cost inflation.
While the market has priced in a premium for some potential beneficiaries in the current environment (such as Saudi Arabia), there are exceptions (notably Qatar). Similarly, some markets that could likely be hit by higher cost inflation are trading at a discount (eg Hungary). But other poorly placed banks are trading at premiums to history (eg Czechia, Colombia).
Names that could potentially benefit in the current environment, but that are not trading at valuation premia to history, include Qatar’s Masraf Al Rayan and Saudi Arabia’s SNB, In contrast, names that could suffer in the current environment and yet are trading at premia to history include State Bank of India and Bancolombia.