New Dark Clouds Are Gathering Over Polish Banks

(infographics Darek Gaszczyk)

The effects of interest rates decrease, the reduction of interchange fees and other regulatory changes have already had a negative impact on the financial results of Polish banks.

The most worrying signals are weakening economic growth and the crash on international markets which will have further repercussions on banks. The portfolios of Swiss franc-denominated mortgage loans are the biggest direct long-term threat. Let us set this issue aside, however, as the parliamentary work is still underway and its final effect, and consequently the possibility of estimating its cost, is difficult to predict. The risk associated with the loans in Swiss francs can be realized in a different way – as a result of destabilization of the markets.

The current decrease in profitability and increased risk of the Swiss franc denominated loans resulted in a strong markdown of the bank stocks and a decline of the WIG-Banks index by 18.7% in a year. The return on assets in the banking sector fell to 0.96% at the end of the H1’15, whereas at the end of the Q1’15 it reached 1.04%. Since the end of 2012, when the ROA was 1.22%, assets profitability has decreased by one-fifth, and the stock market valuation of the banks has remained almost unchanged.

Interest income has stopped falling

Let’s take a look at the results, and then at the threats. At the end of the Q1 the interest income decreased by 6.1%. After May it was worse than last year’s result by 8.7%, and after the first half of the year – by 8.2%. Some banks are claiming that they have already halted the decline in their interest income, but this is not yet certain for the sector as a whole. The largest Polish bank, PKO BP, reported that its interest income had already entered a growth path. The bank’s net profit in the first six months decreased by 18.6% year-on-year, but in the second quarter it increased by 8.6% compared with the first quarter. The interest result was 0.8% higher. “In the second quarter we managed to stop the decline in interest income. Our results should improve with each subsequent quarter,” said the bank’s CEO, Zbigniew Jagiełło, at a press conference.

ING BŚK is also expecting an improvement in the interest result, but arising from an increase in credit volumes. An even deeper drop in interest margin is expected. During the year, it decreased by 26 basis points (bp) to 2.47%. “We’re assuming that the interest margin will continue to drop. The low point will be reached in the Q4’15 and in the Q1’16. The interest result had been decreasing in the previous quarters, and there was a rebound in the second quarter. We were able to improve it thanks to the increase in volumes,” said the Vice President of ING BŚK, Mirosław Boda, at a press conference.

In their analysis on the burdens of the Polish banking sector, Mieczysław Groszek, the Vice President of the Polish Banks Association, and Marek Radzikowski from the Polish Banks Association, write that a decrease in the interest rates by 100 basis points causes a drop in the annual interest result across the sector by PLN1.5bn. This is approx. 4% of the result obtained by the banks in recent years, on average. For now, it seems that compared to last year’s record (more than PLN37bn), the interest result will decline more sharply, but it will not be significantly worse than in the years 2011-2013, when it ranged between PLN34.6-35.5 billion.

Negative effects of the reduction in interchange fees

The decrease in the fee and commission income seems less painful for banks, at least for the time being, even though in this case pressure came from many directions at once. The reduction of the interchange fee to 0.2% for debit cards and to 0.3% for credit cards has been in effect since the end of January. Recommendation U has been in effect since the beginning of the second quarter of the year and some banks have been unable to implement it. Crisis on the Shanghai stock exchange began in mid-June and August brought another crash. This could have far-reaching consequences not only for the brokerage fees and fees for the sales of investment funds that banks used to rescue their non-interest income.

Banks have more room for maneuver in covering the losses in commission income. It is already clear that they are trying to introduce commission in all areas of services, and especially to increase the fees and commission associated with the granting of loans, as well as changing their price lists. It is possible that the margin of possible action is almost exhausted, which will be driven by market competition. Only convincing the customers to self-service could bring more far-reaching results. The increase in the volumes of credit card turnover also has its limits.

“The mere increase in the number of (card) transactions has a limited effect. In light of a decrease (in income from interchange fees) from PLN200 to 20 million per year, even a 50% increase in transaction volumes over two years changes little,” said the CEO of BZ WBK (owned by Santander), Mateusz Morawiecki, at a press conference.

PKO BP renegotiated its agreements with Visa and MasterCard operators, as a result of which a greater part of the commission will constitute the bank’s income. According to Mieczysław Groszek, the reduction in the interchange fees to the current level from about 1.6% in 2012 resulted in a decline in the banks’ non-interest income by approx. PLN1.2bn. Assuming fixed costs, which amount to approx. PLN4bn per year, this would result in a decrease of 9% in a year.

Although for the time being such a sharp decline is not expected, according to NBP’s analysis of the effects of the reduction of interchange fees, the negative effects “far outweigh” the positive ones (such as the increase in the number of transactions), and the biggest beneficiaries of the reductions are the largest card-accepting merchants, and not the consumers. Another thing is that such a reduction would enter into force this December anyway, along with the EU law.

Other profits are shrinking

This year, both the profits in the first quarter and the second quarter were “made” by other results, such as trading and investment activity, including the sale of Treasury bonds and one-off income. BZ WBK’s sale of a block of shares of the Aviva insurance companies to their parent company for more than PLN460m was the largest item in the latter category. Should we subtract this transaction from the PLN4.16bn earned by the sector in the Q1, the profit would shrink to less than PLN3.7bn.

The results of the second quarter are always “inflated” by the dividends. This year they are reaching the pockets of their owners at a roughly analogous pace as last year and their amounts are also very similar. The dividends received by the banks in the second quarter amounted to well over PLN600m. If we were to remove both seasonal events and the most spectacular one-offs from the result of the second quarter, the profit of the entire sector would amount to less than PLN3.2bn.

In the second quarter of 2014, banks pocketed nearly PLN800m in dividends. “Clearing” the results in such a way reveals one thing: in the second quarter of this year banks earned approx. PLN700m less on their core activity than in the same period last year. Such a comparison shows a year-on-year drop in quarterly profits by approx. 18%. The roughly cleared profit for the entire first half of the year would be worse by more than 13%.

In the subsequent months of the first half of the year, the trend of the banks’ deteriorating results was also caused by the gradual weakening of the other operating income from banking activities. While after the first quarter (including the BZ WBK transaction) it was 70% better than after the first quarter of 2014, following the first six months this difference dwindled to 16.6%. In nominal terms this is almost exactly as much as the BZ WBK transaction was worth. Perhaps there will be some one-offs in the second half of the year, but the trends are indicating that the quarterly results of the sector in the second half of the year will be closer to PLN3 rather than 3.5 billion.

What banks are afraid of

The previously existing negative factors, such as interest rate cuts, reduction of the interchange fees, the increase of the fee for the Bank Guarantee Fund and the effects of Recommendation U, have already had an effect and will probably not allow for a clear “rebound” of the financial results before the end of the year, and perhaps even in the next year. So far, however, their effect has been less acute than many pessimistic expectations suggested. After six months, the sector’s net profit amounted to nearly PLN8bn and was only 8.2% lower than last year’s.

Meanwhile, the number of factors that in one way or another make it more difficult for banks to earn money is increasing. The decision of the Constitutional Tribunal on the abolition of bank enforcement titles, the new bankruptcy rules in force since the beginning of the year, the new reorganization law entering into force in the next year – all this raises concerns that profitability could shrink. What the consequences will be – it’s too early to tell.

It is certain that all this will force banks to be more cautious in granting loans and to better assess customer risk. However, it can also result in reduced lending activity. The changing legislative solutions constitute major steps on the road to a more civilized economic system and are certainly worth their price, even if they result in temporary perturbations. Such perturbations, however, are bound to occur.

Weak lending activity

The bad news, however, is that the signals from the economy are less favorable than half a year ago. If the slowdown in economic growth were to last, it could weaken lending activity, which has been far below expectations this year anyway. During the first six months of this year, the gross book value of loans to the non-financial sector increased by PLN46.9bn, compared to an increase of PLN35.1bn in the first half of last year. This acceleration of growth is, however, only apparent because the banks “owe” the entire surplus to the rise in the value of mortgage loans denominated in Swiss francs in their balance sheets (by about PLN12.4bn in comparison with the end of 2014). But for that, the growth rate of lending in the first half of the year would have weakened to 3.9% from 4.2% the year before.

In the first six months, banks granted PLN1bn less in mortgage loans denominated in zloty than in the same period last year and PLN2.8bn less in loans to enterprises. The growth rate of lending weakened in the segment of large companies, and slight growth was recorded in the sector of small and medium-sized enterprises. The increase in the value of consumer credit was almost PLN800m higher than in the same period last year. In total, its book value increased by almost PLN3bn, or 2.3%, in the first half of the year.

Despite record low interest rates in borrowing, the banks’ dreams of increased credit volumes have not materialized. In the second quarter GDP growth weakened to 3.3% from 3.6% in the first quarter. Just a few months ago there were still expectations that the economy could grow by 4% this year. And since growth is not accelerating, the very high restraint of households and businesses in taking loans, visible since the beginning of the recovery, is likely to last. All of this does not bode well at least for the first quarters of next year, especially since the possible increase in interest rates could be pushed back further.

The very modest increase in lending is probably caused by demand-side factors, but this does not have to be the only explanation. Perhaps some banks have restricted the supply of credit themselves, in light of the scale of involvement in Swiss franc denominated loans, the political initiatives associated with the issue and the continuous uncertainty as to the final outcome.

Bubble bursting

Another negative impulse is coming from the outside. Analysts and economists are wondering whether the August crash on the Chinese and then the world stock markets foreshadows yet another instalment of the crisis, this time involving the bursting of speculative bubbles inflated through the policy of quantitative easing.

Due to their limited foreign exposures, the situation should not have a direct impact on Polish banks, but the indirect impact is already acute. It is manifested in the fall in the price of the Polish debt, the likely increase in financing costs and the possible devaluation of the Polish zloty.

At least since the beginning of 2012 banks have been realizing profits on sales or “accumulating” the valuation of securities available for sale (AFS) in assets, due to the increase in the prices of Polish Treasury bonds. The expectations of an increase in interest rates in the US and the outflow of capital from emerging markets have caused another fall in the price of the Polish debt, and this is probably the ultimate signal of a trend change.

Now, the valuation of the bonds will have to be adjusted or the AFS securities will have to be reclassified to the held to maturity category (HTM). Both the first and the second action may result in a reduction in capital, and consequently, in solvency ratios.

Citi Handlowy chose a different path and sold off its portfolio of government bonds with fixed rates and long maturities, accepting lower profitability, which affected the decline in the bank’s profit in the first six months by 29% year-on-year. All the banks will have to deal with the interest rate risk in one way or another. What their results will look like in the end obviously depends on the structure of the portfolios. “We made a strategic decision on a reduction of the interest rate risk due to the risk of a trend change. We are confident that the change will occur this year,” said the CEO of Citi Handlowy, Sławomir Sikora, at a press conference.

Another risk associated with the situation on international markets is the increase in the cost of financing. The best time for debt issuance has already passed and now banks will be much more dependent on the domestic market of deposits. These do not necessarily have to be cheap, however, in spite of the low official interest rates. They may officially still remain low, but the long-term interest rates may grow in connection with the situation on international markets. If customers begin to expect higher rates of return, deposits will have to become more expensive. “The costs of deposits are high, a part of the portfolio has negative margins, but it is still cheaper than (debt) financing 120-140 basis points above WIBOR,” said Mateusz Morawiecki.

If the trend of capital outflow from emerging markets deepens, these costs could further increase, which would also make it more difficult to meet the net stable funding ratio (NSFR) requirements in the not too distant future.

The next instalment of the crisis might ultimately pose a threat to big international banks, including some mother companies of the Polish institutions. The list of banks for sale in Poland could unexpectedly grow longer.

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