Egyptian banks emerge as net winners post-25 January Revolution

Financial Times—Egyptian banks emerged as net winners after the 25 January Revolution in 2011 on significant net interest margin (NIM) expansion, supported by record-high treasury yields over 2012-2016. For the past six years, banks have been channeling excess liquidity to treasury investments. As such, banks’ treasury investments reached circa 45% of assets as of mid-2016 versus circa 30% in 2010 on a system-wide level. High treasury yields compensated years of slow credit growth (2011-2013). Sector-wide average margins have improved from an average of 2.5% in 2010 to 4.0% in 2016, while major private sector banks’ NIMs have been hovering around 450-500 bps for the past three years. What aided banks’ margin expansion is the significant momentum in customer deposits, especially between 2013-2015, growing at an average 20-25% year-on-year (y-o-y). Low-cost demand/saving deposits contributed a big chunk of deposit growth, especially for the large private sector players (accounting for circa 50% of deposits), and thus supporting NIMs further. NIM expansion has reflected positively on the sector’s overall profitability, with the return-on-equity reaching 24% in the first half of 2016, up from 14% in 2010.

Credit growth, on the other hand, has seen a gradual recovery starting 2015, growing at circa 20% y-o-y, powered by both corporate (capex lending recovery) and retail lending, with the latter standing at 23% of total system credit. In 2016, however, the heightened foreign exchange shortage took its toll on trade finance activities and companies’ expansion plans. Nonetheless, system-wide lending growth continued to look resilient during the first nine months in 2016 (9M2016), partially fueled by public sector lending growth, which has accelerated above its average growth levels, comprising circa 50% of net loan additions year-to-date (YTD), supporting lending growth in light of the slowdown in private sector and foreign currency lending during the year. Household lending, on the other hand, has relatively slowed down recently following caps imposed by the Central Bank of Egypt (CBE), which revised debt exposure limits for single retail clients to 35% of monthly salary from circa 50-60%.

Against all odds, sector-wide asset quality has been consistently improving post-revolution, with the sector’s non-performing loans (NPLs) ratio falling from 13.6% in December 2010 to 5.9% in June 2016, as a number of banks have been writing off some of their legacy NPLs. Provision coverage ratios have also been improving system wide, with provisions coverage at 99% in June 2016.

Key private sector players should absorb repercussion of Egyptian pound flotation

On a system-wide level, the CBE’s numbers have been demonstrating a widening net liability position ($6bn as of end September 2016), which we believe could largely be attributed to public banks and smaller private sector players. That said, the CBE has extended EGP 31bn in direct loans to support the capital bases of state-owned banks in August 2016.

The large private players, on the other hand, are shielded from foreign currency losses as their foreign currency assets and liabilities are perfectly matched. Moreover, most of the key private sector players operate at comfortable capital adequacy ratio (CAR) levels (average CAR at 14%) that should allow them to absorb the higher values of foreign currency risk-weighted assets (20%-30% of balance sheet size) as they get translated into higher Egyptian pound terms. Accordingly at a an exchange rate of EGP16 to $1, main private sector banks will likely continue to have CARs above the CBE’s minimum requirement of 10.625%. Nonetheless, we believe that smaller players, on the other hand, could suffer a shortage of capital.

We expect banks equity losses to be contained post flotation, at least for the key banks. Over the past 2-3 quarters, amid treasury yields’ surge, large private sector banks have been reclassifying a significant portion of their available-for-sale (AFS) bond investments to held-to-maturity (HTM). As such, we have seen AFS revaluation reserves narrowing on banks’ September 2016 statements versus the preceding quarters. Last month, the CBE gave clear instructions for all banks to reclassify their AFS bond investments to HTM.

Flotation improves outlook, amid monetary tightening expectations

The long-anticipated Egyptian pound flotation, overall, improves the outlook for 2017 and onwards. As noted earlier, loan growth and trade finance activity have been slowing down in 2016 due to the FCY shortage, and thus has been pressuring banks’ fees and commissions. Accordingly, with the re-channeling of FCY liquidity back to the banking system (estimated at circa $20bn), should revive banks’ balance sheet growth and ultimately recover fees and commissions growth. That said, we don’t rule out asset quality issues to emerge in 2017, and accordingly higher provisioning levels in the fourth quarter of 2016 and first half of 2017.

Banks’ NIMs should, in theory, benefit from November’s 300 bps hike, which has consequently reflected on treasury yields. In a higher interest rate environment, banks should capture higher yields on T-bill holdings and higher yields on corporate loans (80% for banks’ book) are primarily short-term and priced on corridor rates, and also reprice quickly after a rate hike. Moreover, the pass-on effect on deposits usually takes longer to materialise as these are not benchmarked to a particular rate. However, we have to note that, this time, the benefit would vary from one bank to the other based on the ability to control cost of funds. Egypt’s key public sector banks, National Bank of Egypt (NBE) and Banque Misr, led the sector by offering exceptionally high earning certificates of deposits—1.5-year certificates of deposits at 20% and raising 3-year certificates of deposits rate to 16%. Such a move has been followed by private sector players in a faster-than-expected fashion, to preserve deposit market share. Accordingly, banks which are rich in low-cost deposits will likely benefit more, at least over the short-term.

Going forward, to complement fiscal prudence measures, we foresee a shift in monetary policy towards a more tightening manner to reduce the pressure on the Egyptian pound. As such, we anticipate slower deposit growth across the system, amid a gradual recovery in credit activity. Weaker deposit growth will likely push banks’ cost of funds upwards over the short-term to medium-term. Moreover, we believe that carry trade revival should push treasury yields downwards starting in the second half of 2017. Accordingly, we anticipate banks’ NIMs to witness a gradual compression towards the end of 2017 or starting 2018.

A glimpse on recent mergers and acquisitions in the sector

Most recent bank merger and acquisition activity has been small in terms of bank size, with the exception of the QNB/NSGB deal in late 2012. However, there has been an obvious post-revolution discount to all the recent acquisitions, with QNB/NSGB at a price-to-book ratio (P/B) of 1.9x, ENBD/Paribas at 1.6x, and Al Ahli Bank of Kuwait/Piraeus at 1.4x and Attijariwafa/Barclays-Egypt estimated at 1.7-1.8x versus a P/B of 6.0x in SanPaolo/Bank of Alexandria (BOA) back in 2006 and a 4.0x book for the deal that was never completed of Banque du Caire in 2007.

Banks up for sale

The CBE is set to offload stakes in three state-owned banks either through public offering or selling to strategic investors as part of a package of fiscal/monetary reforms underway. The CBE is reportedly planning to offer around 20-49% of its stake in Banque du Caire and a 40% stake in Arab African International Bank (AAIB) through a capital increase, while it also plans to sell 100% of United Bank of Egypt (UBE) to a strategic investor. The aforementioned stake selling/listing to be finalised before the end of fiscal year (FY) 2016/17, ie June 2017, which could be a determining factor in valuation rerating for the whole banking sector, noting that there’s still a few banking players that qualify as takeover targets, such as Crédit Agricole-Egypt and Egyptian Gulf Bank (EGB), in our view.

Banque du Caire—the smallest of the three key public sector banks—is mostly retail-focused, whereby the retail segment encompasses 61% of the bank’s loan book and 72% of deposits. The bank is also a pioneer in small- and medium-sized enterprises lending, an under-served segment. Banque du Caire has doubled its loan book over the past five years, growing at a compound annual growth rate of 20%, which accordingly has pushed the bank’s loan market share from 3.6% in 2011 to 4.5% in 2015. Banque du Caire’s profitability has also significantly improved throughout 2012-2015, as the bank has undergone restructuring following a challenging FY2011 (in which the bank booked hefty investment losses), with return on average equity (RoAE) averaging 26% over the past four years.

AAIB, on the other hand, is a prominent private sector player with a solid track record and management team. AAIB is considered a head-to-head competitor with the key private sector players (i.e. Commercial International Bank and QNBA), mostly corporate focused (87% of loan book and 65% of total deposits). AAIB’s performance has been largely stable over the past few years, maintaining an RoAE of around 16%-17% each year, despite a relatively slower-than-peers loan growth (at an average of 7%), as the bank has been directing much of its solid deposit growth (20% average growth per annum) to treasury investments, which stood at circa 37% of assets as of the end of FY 2015. AAIB’s asset quality metrics are solid with an NPL ratio 3.8% and provisions coverage at 149%, as of December 2015, moreover, the bank’s CAR at 17%.