The coming Fed pivot will likely crimp return ratios for Singapore banks. S&P Global Ratings forecasts net-interest margins and return on assets may get a touch slimmer after a record earnings year in 2024. On the bright side, lower policy rates should boost appetites for loans.

In the past year, weak borrowing has been the only sore spot for Singapore banks. High interest rates rapidly boosted interest incomes even as the cost of funds was slow to catch up. Meanwhile, credit conditions remained benign with asset quality supported by strong household balance sheets, full employment conditions, and resilient corporate financial buffers.

This year the stars may not be quite so well aligned. A likely easing by the U.S. Federal Reserve, combined with impending Basel III reforms, will lead to shift in dynamics. This has important implications for bank profitability, loan growth, and capitalization trends. Overall, however, the Singapore banks remain in good shape.

Dynamics Could Change After Record Profitability

Profitability for Singapore banks will likely compress after surging to near historical highs. The return on assets reached 1.3% in 2023, notably better than 2020 lows of 0.8%, and above pre-COVID levels of around 1.1%.

The interest-rate hike cycle has been hugely beneficial. The majority of floating rate loans quickly repriced upward, while the banks' funding costs remained contained thanks to ample liquidity and low-cost customer deposits. This led to consecutive quarters of sizable interest margin gains, fueling interest income growth from the banks' core lending business.

The negative side effect was near-zero loan growth for several quarters as interest margins surged. Companies have become more cautious about taking on new loans as borrowing costs have gone up, with some cash rich borrowers paying down their obligations to manage their financing costs.

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The Way Forward: More Loan Growth, Less NIM

We believe the fed funds rate peaked at 5.375% and anticipate a series of rate cuts beginning in June 2024, landing at 4.625% by year-end. We forecast the cycle will push the policy rate to 2.9% by early 2026 ("U.S. Economic Forecast Update: A Sturdy Job Market Keeps Growth Going," published on RatingsDirect on Feb. 21, 2024).

Given the nature of Singapore's monetary policy, the Fed pivot will likely result in a similar downward trend in domestic rates. This will crimp net interest margins (NIMs), which we see moderating to about 2% for 2024 and 1.8% in 2025, from 2.2% in 2023.

Banks are already selectively accumulating longer-duration investments to lock in yields, predominantly in the form of fixed-rate government securities. In our opinion, this pre-emptive rebalancing will mitigate, but not completely offset, the inevitable NIM decline.

On the flipside, borrowing appetite could be reignited as interest rates decline. Given that interest rates are coming off historically high levels, the pick-up will be gradual initially, likely around low single digits of 1%-3% in 2024. By 2025, we expect a return to the long-run average of roughly 3%-5% annual loan growth. This would represent a shift in dynamics from high interest rates with flat loan growth that characterized most of 2022 and 2023.

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Higher Rates Are Not Hurting Asset Quality

Interest rates in Singapore are the highest they have been for two decades. The benchmark three-month Singapore overnight rate average (SORA) is hovering above 3.5%, a stark contrast to the near zero levels during 2020. Even pre-COVID levels rarely exceeded 1.5%.

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Higher interest rates could lead asset quality to deteriorate, as reflected in higher credit costs and nonperforming loan (NPL) ratios. Banks have even set aside meaningful management overlays for general provisions to buffer against this potential deterioration.

Yet while correlation between high interest rates and rising NPLs is seemingly intuitive, it has not played out thus far. Quite the opposite. Benign credit conditions and low delinquency have pushed reported NPLs to even lower levels.

We attribute this to the broad-based economic recovery across Southeast Asia. The bulk of Singapore bank's exposures are to stable economies. The main market of Singapore is a high-income and well-diversified economy, with strong household and corporate balance sheets.

Corporates with strong fundamentals have been paying down their loans to manage their financing costs amid high interest rates; an illustration of their financial strength and financing flexibility. Indeed, the credit strength of these borrowers is a double-edged sword, given the low loan growth.

In our view, the financial strength of corporate borrowers is a net positive for banks' financial profile. Banks' profitability has not suffered despite flat loan growth. On the contrary, they are reporting record earnings due to wide interest margins. Meanwhile, low loan growth combined with good retained earnings is highly supportive of their capital position.

In our base case of a Fed pivot in mid-2024, asset quality will hold up as borrowers rely on their balance sheet strength and buffers to withstand elevated interest rates. We forecast that Singapore banks will maintain some of the lowest credit costs among regional peers.

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Downside Risks Include A Delayed Pivot

In a "higher for longer" scenario where rates remain sticky, we believe asset quality issues would start showing up. Loans to small and midsized enterprises and unsecured consumer portfolios would be most vulnerable.

In our opinion, pockets of weakness in the commercial real estate sector will not have a material impact on Singapore banks. By our estimates, commercial real estate office loans account for about 10%-15% of the banks' total loans.

Most of these exposures are to grade-A office space in Asia, particularly Singapore, where the average loan-to-value ratio is around 50%. Singapore's commercial real estate sector has proved resilient as occupancy rates remain high. The banks' exposure to U.S. commercial real estate are insignificant, which we estimate to be less than 1% of total loans.

A slower-than-expected property recovery in China, or worsening geopolitical tensions, could have negative knock-on effects through the region. We believe this potential stressor is one of the reasons why banks have maintained their management overlay on general provisions from the pandemic period.

Active Capital Management In Play Post Basel Reforms

The final implementation of Basel III reforms will see a capital uplift to the tune of 1.5%-2% on "day one," July 1, 2024. We think this will gradually erode, as the capital output floors are phased in over five years, resulting in no net uplift to regulatory capital adequacy ratios (CAR) by 2029. In the meantime, we believe some stakeholders may pressure Singapore banks to deploy or more actively management excess capital.

The capital uplift is due to notable reductions in risk weighted asset calculations, particularly for corporate exposures. We attribute this mainly to the removal of the 1.06x credit scaling factor under an internal rating-based approach, and reduction in loss given default for corporate exposures.

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The manner is which Singapore banks manage their capital will be a function of several interrelated factors. In our base case, an interest rate pivot resulting in a meaningful pick-up in new loans will increase risk-weighted assets and hence use up regulatory capital.

This will partly alleviate the need for capital intervention. In the absence of that--which could play out in a "higher for longer" interest rate scenario--we believe banks will look to increase dividend payouts or consider one-off special dividends to return capital to shareholders.

Having a war chest of capital could also spur Singapore banks to hunt for overseas acquisitions with greater vigor. Singapore banks are no stranger to bite sized, bolt-on acquisitions, having made a string of these in recent years to strengthen their regional footprint. For example, Oversea-Chinese Banking Corp. Ltd. has recently acquired Bank Commonwealth PT to augment its Indonesian franchise.

In our opinion, such options will remain opportunistic in nature, and will only happen if the pricing and fit is correct. We believe Singapore banks are unlikely to chase acquisitions for the sake of it.

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