The dark clouds are not coming, they are here
By Sameer Sharma
As the global economic recovery begins to plateau in the last quarter of the year, the divergence in terms of relative performance between listed bank stocks which are more digital (think operational efficiency and margin control), have more investment banking or/and wealth management sourced revenues vs. the more traditional banks continues to increase.
With interest rates low, yield curves globally flatter and default risk remaining very much in the limelight bank stocks in general have been under-performing in the wider market globally. US banks have made significant progress when it comes to their capital buffers since the last Great Financial Crisis and are in much better shape when it comes to absorbing such shocks when compared to their European counterparts.
“Comparing MCB and SBM in terms of performance and management quality is a non-starter since the former group is significantly ahead of the latter given how majority state-owned banks are run and credit risk is managed. When we look at the annualized latest quarter’s impairment charges as a percentage of risk weighted assets, the figures which include expected credit losses are more likely than not to have a lot of upside to them but remain suppressed given the moratoriums and other BoM measures…”
When it comes to impairment charges, it has been publicly reported that models which relied heavily on the historical link between the US unemployment rate, associated higher frequency data and credit defaults could not account for the relative success of the America Cares Act and the associated Payroll Protection Program leading to a moderate degree of over-conservatism across the industry when it comes to making such provisions.
Others have seen the advantage of masking increased trading profits with more provisions. No one wants to show increased or stable profits when millions are suffering. Accounting for expected credit losses in uncertain times can indeed be a tricky affair requiring a combination of quantitative skills and expert judgement.
The Mauritian economy on its part continues to struggle despite the commitment of the monetary authorities to inject more than a third of the country’s GDP in terms of liquidity into the system on top of ultra low rates and moratoriums on capital and interest payments given that borders are still quasi shut, the still nascent reopening strategy, the European Union blacklisting and the way the stimulus programs from the Mauritius Investment Corporation Ltd (MIC) and other stimulus programs have been structured and implemented so far. In fact, the Mauritian stock market is still near its March lows in Rupee terms and in Dollar terms. the local market is one of the worst performing in the world from March 2020 till today.
Before one understands the current Covid-19 induced credit conditions on the island, it is important to have a better historical understanding about the health and structure of private sector balance sheets when coming into this crisis.
When it comes to non financial corporates, an overly passive equity investor base locally, the relatively closed nature of equity ownership and the small size of the country (not many foreign companies are interested in coming and competing for such a small pie) have always created quite the bubble for local players and a skewed capital structure where debt has been overly relied upon by all too many players even when returns on capital employed have been below the cost of debt and debt to free cash flow has been below par for sustained periods. An extended period of excess liquidity in the system and the phenomena of many banks chasing the same lot of corporate clients have made it a large corporate borrower’s market. Over time the low yields which excess liquidity brought about also brought along both institutional and retail investors who readily bought corporate bonds and structured notes which were issuer biased and not always well priced in terms of the credit risk the investor was actually taking on. The relatively concentrated nature of the corporate landscape also meant relatively concentrated corporate credit exposures for Mauritian banks when compared to their global peers too with limited diversification potential locally.
A simple pre Covid-19 credit analysis of all listed non-bank companies on the SEM and DEM will in fact showcase that there were many borderline Zombie companies (needing debt to stay alive) in Mauritius. Over the past decade, these strained balance sheets meant that there was limited capacity in terms of capital expenditure which translated itself into weak private sector investment.
Mauritian non financial corporates on average entered this crisis with little in terms of buffers and with skewed capital structures, not exactly what you need to face the crisis and the new normal to come. This was why unconventional ideas such as the need to provide capital backstops to systematically important but viable corporates in a timely fashion in the form of capital that was needed in order to prevent economic stagnation was pushed forward. For smaller sized but deemed viable companies, long term debt rescheduling which is a form of soft defaults and central bank guarantees on a securitized pool of loan portfolios to be rescheduled should be considered actively given rising default risks.
To be fair, the Bank of Mauritius initially started very well in March with the moratoriums on capital and interest payments for at risk corporates and this has allowed both bank CEOs and Chief Risk Officers and policy makers to push the can of rising defaults down the road a bit further. The Bank of Mauritius has in this spirit provided regulatory support to deal with impairments. The problem is that these necessary measures cannot offset the difficult 2021 ahead.
As we look at the recent releases of annual financials for both the Mauritius Commercial Bank and the six-month release for that of the State Bank of Mauritius, the focus should then turn to impairments, whether these banks have adequate capital buffers in order to face a tough first half of 2021 for Mauritius.
Relevant Asset Quality Comparison for Mauritius’ Largest Banks
Source: Financial Releases, Author’s Calculations
Comparing MCB and SBM in terms of performance and management quality is a non-starter since the former group is significantly ahead of the latter given how majority state-owned banks are run and credit risk is managed. When we look at the annualized latest quarter’s impairment charges as a percentage of risk weighted assets, the figures which include expected credit losses are more likely than not to have a lot of upside to them but remain suppressed given the moratoriums and other BoM measures.
We have to understand that most of the companies which applied for such relief did so because their debt service coverage ratios, interest coverage ratios and general credit health have deteriorated significantly with little visibility as to when revenues will pick up again. Mauritius has missed the high season, the real estate sector lacks clients and has inventory overhang and while I expect moratoriums to be pushed out further, these policies will have diminishing returns to scale in H1 2021. Non-performing loans which have remained stable so far have more upside over the next 12 months.
In this respect, despite the expected deterioration in credit conditions, MCB’s move to suspend dividend payments to buffer up its capital which still remains comfortable is welcome but will not be a positive for equity holders in the medium term. Both banks seem to have adequate capital buffers to withstand the current shock in the medium term despite relatively concentrated corporate credit portfolios locally. Lower interest rates has lowered the cost of funds for both banks, which have seen increases in terms of investment securities held on their balance sheets and a more modest growth in the loan books which have allowed them to maintain net interest income at decent levels for now.
Unlike what we are seeing globally, net fee and commission income has declined for MCB given lower contributions from trade finance and MCB Capital markets. With bond yields globally near all-time lows and with the recent spurt in market volatility and given the relative stability of the Mauritian Rupee during the second half of the year, other income for both banks are not likely to repeat the performance witnessed in their latest financials.
It has to be noted here that SBM’s other income was bloated by gains made on the derecognition of financial assets measured at fair value though Other Comprehensive Income. Sixty two percent of MCB’s profits are foreign sourced and over the years its investment grade credit rating has allowed it to maintain a profitable funding strategy in terms of raising dollars relatively cheaply. The EU blacklist and longer term perceptions on the Mauritius jurisdiction, the potential 2021 downgrade of Mauritius by one notch given rising debt to GDP vs. The Baa1 country peer group and a weak growth outlook and/or a deterioration of its credit portfolio locally would likely be at the forefront of the Management’s mind.
The MCB unlike its large peer still maintains an investment grade credit rating. A one notch credit downgrade to non investment grade status would mean raising dollars at a higher cost. From MCB’s perspective, this would likely be why it would be keen to see the MIC succeed at relieving pressure on the credit risk front and for borders to re-open gradually but surely.
In parts of western Europe, the United States and in Canada the increased digitalization of banks especially when it comes to the deployment of machine learning and AI models has enabled banks to bring decent controls on margins. Data architectures are quite advanced and data scientists and data engineers are moving towards scalable unified analytics platforms which allow for the optimal development, deployment and ongoing monitoring of machine learning and AI models (AI models = ensemble models, deep learning models). Mauritius is still nowhere on the map. Branchless banking also helps to control costs.
The outlook for the economy and the banking sector is certainly challenging, especially for smaller more retail focused non-credit rated banks. While deals need to be fair for the country and the private sector, the MIC needs to execute fast and do it well. The longer Mauritius stays in the blacklist rot and the longer local bank captains perceive that Mauritius has lost its competitive edge, the more they are likely to shift businesses elsewhere.
After all in the post EU blacklist world and post many an African country cancelling or reviewing its tax treaty with Mauritius, the African high-net-worth individual would not mind going to a Mauritian bank with a rep office in more accessible Dubai tomorrow than come to do business in Mauritius directly. The dark clouds are not coming, they are here… if we open our eyes to them.
* Published in print edition on 6 October 2020
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