1H14 was a challenge for the banks in terms of income growth but 2H14 should  see  things turn  around,  aided  by  July’s  25bps OPR  hike.  That said, we believe expectations of stronger earnings growth in 2H14 havelargely been priced in. Meanwhile, August  banking statistics saw stable loans growth but business loan leading indicators improved. We remain NEUTRAL on the sector, with Maybank, AMMB and BIMB as BUYs.

Three  reasons  for  stronger  earnings  in  2H14: 

i)  impact  from OPR hike  to  kick  in.  Looking  ahead  to  2H14,  we  expect  the  earnings momentum  to  pick  up.  July’s  25bps  overnight  policy  rate  (OPR)  hike should  help  provide  a  temporary  reprieve  to  net  interest  margin  (NIM)pressure.  We estimate that a 25bps hike would impact the full-year  net profits  of  the banks under our coverage by  up to +2.5%.  This, however,would be dampened by higher  funding cost resulting from banks raising deposit rates ahead and in anticipation of OPR hikes. 

ii)  Stronger  wholesale  lending.  Despite  1H14’s  weak  wholesale  loan growth, pipelines are generally healthy and the banks  are  optimistic that drawdowns will imp rove ahead.  August loan leading indicators appear to support  the  above,  with  business  loan  applications  and  approvals enjoying an uptick during the month.

Iii) Better  non-interest income.  A  pickup in loan growth in 2H should bode  well  for lending-related  fee  income.  Banks  with  larger  investment banking  (IB)  franchises  also  guided  for  healthy  IB  pipelines,  while increased  market  volatility,  which  was  unusually  low  in  1H14,  should help lift markets-related income.

System loans  base  rose  8.6% y-o-y  in August.  August  statistics saw m-o-m loan growth momentum improve to +0.7%, vs flat m -o-m in July. This  was  due  to  a  combination  of  stronger  disbursements  and  lower repayments,  both  from  the  business  segment.  Y-o-y,  however,  system loan growth was stable at 8.6%. Loans to businesses expanded by 5.1% y-o-y (July: +5% y-o-y) while household loan growth eased to 11.3% y-oy (July: +11.5% y-o-y). Annualised loan growth stood at 7% but  we keepour  9%-10%  expectations  for  now  on  the  back  of  stronger  business lending momentum ahead.

Business loan leading indicators  improved  in August.  Loan leading indicators  improved m-o-m and y-o-y. In the meantime, total applications rose 5% m-o-m/9% y-o-y while approvals increased by 4% m-o-m or 6%y-o-y,  mainly  due  to  the  business  segment.  Business  loan  demand  in August grew 10% m-o-m and 19% y-o-y, and was rather broad-based.  Investment  case.  We  remain  NEUTRAL  on  the  sector  with  Maybank, AMMB and BIMB as our Top Picks (see table below).

Better 2H14 Expected But Priced InUnexciting 2QCY14 results quarter

The recent 2QCY14 reporting period was unexciting. While we expect stronger earnings momentum in 2H14, we think this has been priced in

Business loan growth was subdued and outpaced by household lending thus far, butthe outlook appears to be the reverse for 2H14

We expect 2014 sector NIM to compress by a high single-digit – a slight improvement fromthe estimated 14bps contraction in 2013

Non-interest income capital markets have been quiet but should improve in 2H

Asset quality is holding up well so far but there are lingering concerns, especially with respect to the lower income group

Aug banking statistics – system loan growth stable at 8.6% y-o-y but business loan applications and approvals picked up, suggesting stronger business lending activities ahead

The recent 2QCY14 reporting period was unexciting as operating income was weak. Both net interest income and non-interest income had a subdued quarter due to soft loan growth, NIM  compression and muted treasury and markets-related income. On the  flip  side,  overheads  were  tightly-controlled  while  credit  costs  remained  benign. Looking  ahead  to  2H14,  we  expect  the  earnings momentum to  pick  up.  The  OPRhike  in  July  should  help  provide  a  temporary  reprieve  to  the  NIM  pressure  while business  lending  and  markets-related  income  are  expected  to  improve.  As  we believe these  have been largely priced in,  we are retaining our NEUTRAL stance on the sector.

Business lending – pickup expected in 2H14

Business  loans  growth  has  been  subdued  thus  far  and  outpaced  by  household lending (see  figures below for  Aug  2014  statistics). That said,  banks  that are more exposed  to  the  corporate  segment  had guided  for  healthy  wholesale  pipelines  and stronger drawdowns ahead. Conversely, banks that enjoyed relatively more resilient loan  growth  in  1H14,  ie  retail-focused  banks,  have  guided  for  a  slowdown  in consumer lending activities in 2H as the impact from the various property tightening measures  announced  in  the  2014  Budget  and  Bank  Negara’s  measures  to  rein  in housing  debt  become  more  pronounced.  August  loan  leading  indicators  appear  to support the above with business loan applications and approvals enjoying an uptick during  the  month,  which  suggests  stronger  business  loan  growth  ahead,  while household loan leading indicators were more muted.

NIMs under pressure from funding cost but OPR hike to provide relief2QCY14 sector NIM fell 9bps y-o-y and 4bps q-o-q, although the rate of compression eased  slightly  compared  with  1QCY14  levels  (NIM:  -10bps  y-o-y,  -6bps  q-o-q). However,  unlike  previous  quarters,  2Q’s  NIM  compression  was  driven  by  rising funding costs (+5bps y-o-y and q-o-q), whereas average asset yields rose 2bps q-o-q (-5bps  y-o-y).  The  rise  in  funding  costs  was  likely  due  to:  i)  banks  offering  higher deposit rates ahead of the OPR increase to lock in their funding costs.  This nudges up funding costs in the near term but should be compensated when the Central Bank raises rates and lending yields are re-priced upwards, and ii) competitive pressures.As for asset yields, lending yields have been rather stable for the past few quarters and  we  note  that  the  compression  in  average  asset  yields  in  2QCY14  was significantly lower than the 19bps y-o-y decline in 2013.

Looking  ahead,  July’s  OPR  hike  should  help  provide  temporary  relief  to  NIM pressure, although the impact on earnings is not expected to be too significant. Theimpact  on  bottomlines  would  be  further  dampened  given  that  banks  had  raised deposit  rates  ahead  of  July’s  OPR  hike.  We  understand  that  deposit  rates  were raised  again  leading  up  to  September’s  monetary  policy  committee  meeting.  This was in anticipation of another hike in the OPR, which did not materialise.

We believe the Central Bank is likely to keep the OPR unchanged at 3.25% for the rest  of  the  year,  given  moderating  headline  inflation,  among  others.  That  said,  webelieve  a  25bps  hike  could  be  in  the  cards  in  1Q15,  depending  on  the  country’s economic performance as the year progresses.Non-interest income still soft, but should improve in 2H14

Capital  markets-related  as  well  as  treasury  income  saw  a  soft  1H14,  reflecting weakness.  This is  also  consistent  with the  soft  demand for  credit from  businesses thus far. As mentioed above, our loan growth projection implies a picku in lending activities ahead and this may also help improve lending fee-related income. Banks with larger IB  franchises also guided for healthy IB pipelines while increased market volatility, which was unusually low in 1H14, should also bode well for markets-related income ahead.

Stable asset quality helps keep credit cost in check 
As asset quality has remained stable thus far, 2QCY14 sector credit cost was kept low at 17bps while credit costs for individual   banks trended below guidance. Going forward,  the  banks  remained  mindful  of  rising  inflation  levels  and  the  impact  this would  have  on  the  lower  income  group  on  the  domestic  front.  However,  at  this juncture,  no  systemic  deterioration  was  noted.  Banks  with  regional  operations  are also keeping a close watch on developments in countries such as Indonesia. The low credit cost in 1H14, however, should provide some headroom for a potential rise in credit cost ahead, without adversely impacting full-year guidances.

August banking statistics
Meanwhile,  August  statistics  saw  the  m-o-m  loan  growth  momentum  improve  to +0.7% compared with July, which was flat m-o-m. This was due to a combination of stronger  disbursements  (August:  MYR90.3bn  vs  July:  MYR84.6bn)  and  lower repayments  (August:  MYR81.4bn  vs  July:  MYR87.3bn),  both  from  the  business segment.  Y-o-y,  however,  system  loan  growth  was  stable  at  8.6%.  Loans  to businesses  expanded by 5.1% y-o-y (July:  +5% y-o-y) while household loan growth eased to 11.3% y-o-y (July:  +11.5% y-o-y).  As mentioned above, wholesale lending is  expected  pick  up in  2H14.  Thus,  while  annualised  loan growth  stood  at  7%,  we keep our 9%-10% projection for now.

August loan leading indicators improved m-o-m and y-o-y. Total applications rose 5% m-o-m or 9% y-o-y,  while approvals increased by  4% m-o-m or 6%  y-o-y mainly due to the business segment. Business loan demand in Aug was up 10% m-o-m and 19% y-o-y,  and rather broad-based. Meanwhile, business loan  approvals  rose 12% m-om/6% y-o-y  with the m-o-m rise led by construction sector,  while the y-o-y increase was mainly due to loans approved for the manufacturing sector. On the other hand, loan  applications  and approvals  from  households  were  flat  m-o-m  while  y-o-y, applications  and  approvals  rose  by  2%  and  6%  respectively.  Applications  and approvals for residential mortgages remained stable.System asset quality improved further with absolute gross impaired loans down 0.3% m-o-m and 5% y-o-y respectively. However, gross and net impaired loan ratios were relatively  unchanged  from  July,  at  1.75%  and  1.26%  respectively,  given  the  weak loan growth. System loan loss coverage remained healthy at 104.8%.System deposits inched down  0.4% m-o-m (+6% y-o-y)  and hence,  system loan-todeposit ratio was up 80bps m-o-m to 86.3%, as at end-August.  That said, we beliee that with  the hike in  the OPR in July, depositors would   now receive a higher rate of return on their deposits and this may help improve deposit-gathering activities ahead. The average base lending rate (BLR)  was stable  m-o-m  at  6.79%  but the average lending rate of banks rose by 8bps m-o-m to 4.69%. We believe this was a reflection of the time lag in repricing up lending rates.

Forecasts
No change to our earnings forecasts.

Risks

The  risks  include:  i)  slower-than-expected  loan  growth,  ii)  weaker-than-expected NIMs,  iii)  a deterioration in asset quality,  and  iv) changes in market conditions that may adversely affect the investment portfolio.

Valuations and recommendations
Despite  expectations  of  stronger  earnings  growth  in  2H14,  we  believe  these  have largely been priced in.  Hence, we maintain our  NEUTRAL call on the sector. For bigcap  exposure,  our  pick  is  Malayan  Banking  (Maybank)  (MAY  MK,  BUY,  FV: MYR11.00). In our view, it is  an all-rounder that is well-positioned to benefit from the resilience  in  domestic private  investment  and  consumer  spending,  and  a  pickup in capital  market  activities.  Dividends  are  attractive,  too,  while  valuations  appear decent. Among the mid-sized banks, we like AMMB (AMM MK, BUY, FV: MYR8.00) for  its  focus  on  profitable  and  viable  segments,  healthy  current  account  savings account (CASA)  growth and efforts to grow recurring  non-interest income. Our smallcap pick among the banks is BIMB (BIMB MK, BUY, FV: MYR5.05), which we see as a proxy to the growth in Islamic finance.

Source: RHB