SINGAPORE (Oct 26): DBS Group Holdings, Oversea-Chinese Banking Corp and United Overseas Bank, arguably the most closely followed stocks within the finance sector, did not come out tops in any of the three metrics by which the Billion Dollar Club companies are measured. Instead, local bourse operator Singapore Exchange chalked up the highest return on equity (ROE) and pretax profit growth over the three years to 2015. It also had the second-highest stock return over the period, behind insurer Great Eastern Holdings. That easily gave SGX the highest overall score in the category.

Still, DBS and UOB managed relatively high scores in terms of stock return and pre-tax profit growth to be placed second and third overall, respectively. OCBC did better than its two local bank peers in terms of ROE, but trailed them on stock return and pre-tax profit growth. Its overall score was second from the bottom.

To be fair, the last three years have not been the best of times for the banks. Their net interest margins have been squeezed by low interest rates, loan growth has been soft, operating costs have been rising, and, recently, there have been more instances of loans turning bad. On top of that, as a linchpin of the economy, banks are heavily regulated and have to comply with increasingly tough capital and liquidity requirements. In fact, there is talk of the weights on risk assets being raised beyond the current Basel III standard. Among the assets that could see higher risk weights are a bank’s trading book, mortgage loans and uncommitted banking lines.

None of the three local banks are in any danger of failing to comply with the tougher standards. For instance, all three of them currently have Core Equity Tier 1 capital adequacy ratios of more than 12%. The minimum CET1 ratio laid down by the Basel Committee on Banking Supervision is only 4.5% and the minimum CET1 required by the Monetary Authority of Singapore is 6.5%. Yet, failing to maintain capital adequacy and liquidity ratios that are significantly above the minimum standard could affect the banks’ high credit ratings. For instance, DBS and UOB have been able to issue covered bonds that have yields lower than their fixed deposit rates.

Provisions and technology
Against this backdrop, profitability at the banks is likely to be determined by two important factors. In the near term, analysts are concerned about provisions for losses, allowances and rising credit costs. For its 2QFY2016, DBS took a S$400 million charge of specific provisions for a single company, Swiber Holdings. Of this, $250 million was drawn from its general provisions. So, for 2QFY2016, DBS made a net charge of S$150 million against its earnings for its exposure to Swiber.

As oil and gas companies face further stress and lower cash flows, banks are likely to be under pressure to renegotiate loan tenures and covenants, leading to a rise in their provisioning levels, analysts say. Among the three local banks, UOB is seen as having the most conservative provisioning policy, and having driven up its general provisions in recent years. According to Maybank Kim Eng, the bank now has a bigger general-provision buffer (general provisions/total loans) of 1.5%, versus 1% at OCBC and DBS. UOB also has the highest provision coverage of 125.6% versus 112.8% for DBS and 100% for OCBC.

In the longer term, the investments that the banks are making in fields such as blockchain, artificial intelligence and biometrics could be important in bringing costs down and accelerating their expansion into new markets and services. This past year, all three banks have announced significant fintech initiatives. Yet, these initiatives are more likely to raise costs at the banks in the short term rather than lower them. For instance, UOB has said that its cost-to-income ratio is likely to rise by another two to three percentage points over the next two years. All three banks currently have cost-to-income ratios in the mid-40s.

Derivatives driving SGX
SGX has been subject to similar trends as the banks. Its core securities trading business has suffered in recent years, amid a chorus of complaints from local brokers about reduced trading interest by their traditional clients and even corporate governance standards. In fact, much of its growth in recent years has been fuelled by growing trading volume in derivative contracts by institutions. On Aug 22, SGX announced the acquisition of Baltic Exchange for £87 million (S$147.5 million), which its officials say will enable it to boost its commodity derivatives business.

Analysts expect derivatives to remain an important driver of SGX’s growth for a long time to come. “Derivatives will continue to be the main growth driver until SGX is able to monetise initiatives to improve the securities market microstructure. We believe the results of these priorities would only be visible in the medium to long term. SGX is also working on the regulatory front to further enhance the corporate governance of SGX,” notes a recent report by DBS Research.

Meanwhile, operating costs have been rising. And, investments in technology have become more important as it struggles to reposition itself. The trend is for exchanges to become integrated platforms where a broad range of products are easily listed and traded, including products traditionally traded over the counter. SGX is also looking at becoming a clearing house for a wider range of assets and is moving towards a standards- based application programming interface, which would enable it to provide access to other markets and minimise the likelihood of customers switching to its competitors.

Interestingly, SGX is also subject to stiffening regulation by global bodies such as the Bank of International Settlements. Notably, it was one of the first exchanges to adopt the Principles for Financial Market Infrastructure introduced by the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions , both under the BIS. The new standards are designed to ensure that the essential infrastructure supporting global financial markets is better placed to withstand financial shocks than the current system. They contain principles pertaining to systemically important payment systems, central securities depositories, securities settlement systems, central counterparties and trade repositories.

Another important regulation is to incentivise trading on exchanges and clearing by central counterparties while imposing higher capital requirements on non-centrally cleared contracts. SGX is certified as a Qualifying Counterparty under the Basel III framework. “While the ultimate goal of the regulators is the establishment of sustainable and stable markets, the pace of introduction of the many new and previously untested regulations may cause unintended consequences in the markets in the near term,” SGX’s letter to shareholders says.

Nevertheless, the nature of SGX’s business enables it to generate an ROE that is almost three times that of the banks, despite having an ungeared balance sheet. It also has a track record of paying out most of its earnings as dividends, providing investors with a high certainty of return. For its FY2016 ended June 30, SGX’s dividend payout ratio was 85.9%. By comparison, the banks typically have dividend payout ratios that are well under 50%.

The Edge Singapore has started giving the largest locally listed companies special coverage and recognition under The Billion Dollar Club.Membership to the BDC is not by invitation but by eligibility. To qualify, a company must have a minimum market capitalisation of S$1 billion. At the cut-off date of June 30, 2016, there were 101 companies that qualified for the BDC. To see the full list, get your Issue 751 of The Edge Singapore which is out now