Banking sector RoE makes about turn giving fresh hopes for investors

Banking sector return on equity (RoE), a key ratio that is used to gauge the attractiveness of the sector by investors, made an about turn in 2020 as the sector delivered robust earnings defying the pandemic-induced challenges. 

Banking sector RoEs, which were hovering near 20 percent in 2017 started to gradually decline as banks were forced to shore up its capital base, both as a result of the additional capital buffers required under BASEL III rules and the enhanced minimum core capital requirements mandated by the Central Bank. 

According to the latest available data, the banking sector RoE climbed to 11.3 percent in 2020, the highest in two years after sector earnings reached a record high on the back of emerging credit growth despite the higher credit costs on account of possible bad loans. 

With the higher capital buffers required under new BASEL III rules, banks were required to set aside a higher amount of their capital equivalent to their loans and other assets, risk weighted based on their credit, market and operational risks. 

This was done with the purpose of improving banks’ shock absorption capacity in times of economic crises in the scale of 2008 global financial crisis and the pandemic induced economic shock in 2020. 

In strict compliance with what is referred to as the capital adequacy ratio (CAR), banks were unable to lend over and above this minimum threshold, unless they added new capital, which provides more wiggle room for new lending. 

As BASEL III rules set a higher threshold since mid-2017 through January 2019 in a phased approach, banks had to leave a higher amount of capital idle to satisfy regulatory mandated CAR, which otherwise would have used for lending to make more money. 

Exacerbating the pressure on RoE, the private sector loan growth also decelerated since 2018 before slumping to just 4.0 percent in 2019 due to slowdown in the economy, dealing a blow on the ability to generate higher earnings. 

Private credit growth accelerated to 6.5 percent in 2020 despite the virus snag, and the authorities now plan to expand it by as much as 14 percent in 2021, making a windfall in profits for the banking sector.

The banking sector on average now targets to expand their asset bases by between 10 to 15 percent 
in 2021.  

With record level of excess liquidity in the banking sector and the stable capital levels, the banking sector is now poised to return to their earlier glory days delivering near 20 percent RoEs for their investors.