Take Hong Kong retail mortgages as an example. At the end of 2014 STAN had retail mortgage lending in Hong Kong of HK$174bn ($22bn), supported by just HK$5m of loan loss provisions! In other words, the implication is that the entire HK mortgage book has near to zero risk of loss. The bank might argue that asset prices of Hong Kong real estate have risen strongly providing comfort in collateral values and there are no customers defaulting: so they don’t need to take provisions for bad loans. But this ignores the inherent cyclicality in lending money and the risk that the future might not look like the recent past. Failure to provide for the risk that good loans might turn sour in the future means not only that historic profitability was over-stated but that STAN’s future prospects will be weighed down by the need to make amends for these past failings.
As we can see, the bank went from having Loan Loss Provisions on its balance sheet equating to 3% of its loan book in 2000, which was similar to Eurozone peers, to LLP’s equivalent to just 1.5% of its loan book for most of the last decade, significantly below the 3-5% eurozone peer group. So whilst the industry in Europe accepted that not all loans were going to be fully repaid, STAN’s management appeared to believe that the Asian and EM credit cycle was dead. Whilst we think we are beginning a new credit cycle in Europe with shareholders in European domestic banks acutely aware that money lending is a cyclical industry, as the Asian credit cycle turns down, will this cyclicality come as news to Standard Chartered and its investors?
Of course it could be argued that we are comparing EM apples with EZ pears and that STAN’s provisioning should be compared with Asian peers. It should also be noted that new management would seem to have begun to recognise that a more conservative accounting policy is needed for provision charges, with an increase in the banks’ corporate loan non-performing loan (NPL) coverage ratio from 47% to 52% in yesterday’s numbers. We would point out that this still leaves STAN’s coverage ratio meaningfully below its Asian peer group. Indeed, we would argue that after a robust period of economic growth during which bad loans should be infrequent, it is appropriate for all banks to run coverage ratios of above 100%, so that there is a safety buffer of risk absorbing capital when the credit cycle turns. STAN have argued that each of their loans is assessed on an individual basis and that their confidence in collateral values does not require higher coverage. This is nonsense. Every other Asian bank could also argue this but have chosen instead to adopt counter cyclical provisioning policies with coverage ratios above 100%. Either STAN has to take a proper multi-billion clean up charge for provisioning or it will require a structurally higher cost of risk in its P&L which will continue to weigh on profits for years to come. Either way its shareholders will lose.