The basic business of banking hasn’t changed a lot since the 18th century BC… when gold stored for safekeeping in temples of Babylon was loaned out by priests.
Today, depositors give banks their money, and banks pay interest to depositors. In turn, banks lend most of those deposits at a higher rate of interest. A bank’s profits are the difference between these two.
So the higher percentage of its deposits that a bank can lend out, the bigger the profits.
However, central banks generally require that banks set aside a certain portion of their deposits as reserve. That reserve is often placed with the central bank, earning a very low rate of interest.
Additionally, a bank has to keep some cash for depositors who want to withdraw their cash. If a bank lent out US$100 million and only had US$2 million of capital on its books, all it would take for the bank to go under is for 2 percent of those loans to go sour… or for depositors to demand just US$2 million back. Then the bank would need to ask the central bank to help them out.
Depending on the banking system, commercial banks are required to keep anywhere between 3 percent and 10 percent of their deposits (called the reserve requirement ratio) in the central bank safe, to account for potential bad loans, or depositors who want their money returned.
In addition, they have to maintain capital equivalent to about 15 percent of their assets.
That means that out of deposits of (say) US$100 million, banks actually only have about US$85 million to lend out and make money from.
This means that how efficient banks are at managing costs is a big driver of profitability.
The pressure for banks to innovate is enormous
When prevailing interest rates are high, as set by each country’s central bank, banks are happy.
A bank that pays out depositors 2 percent (which is what I’ve gotten used to seeing over my lifetime) is happy when they can lend out at 8 percent.
But when interest rates come crashing down, as they have been over the past eight years, banks’ margins dwindle.
The piddling 0.05 percent you’ve been earning in your savings account also means that your bank is lending out at only 4 percent.
They’ve lost around 2 percent of interest margin, because they just about hit the floor in terms of interest paid on deposits.
So as interest rates fall, banks compete against each other for loans. They are forced to be more efficient. They have to come up with new ways to make money from their customers. And their profits get squeezed like a lemon.
That’s where innovation matters.
Now if you want to see an example of banks that are slow to innovate, I’m sure many of you will agree with me that U.S. banks definitely qualify.
For example, for many U.S. banks, including Bank of America, it still takes two or three full days for cheques to clear. Electronic transfers are equally slow.
That’s because many U.S. banks still rely on decades-old infrastructure for their backroom operations. They either haven’t gotten around to upgrading their systems, or simply won’t spend the money.
Now, I’ve been all over the Asia region, and I keep accounts with banks in Singapore, Hong Kong and the Philippines.
And based on my experience – and following the sector – I can say that Singapore is home to the most innovative and profitable banks in the region, if not the entire world.
The innovation of Singaporean banks
In Singapore, technology allows your bank to clear a cheque within 24 hours, as long as you deposit it before the cutoff time. Overseas transfers are just as fast.
Meanwhile, payments and transfers using online bank accounts to local companies are instantaneous.
Singapore’s top three banks are DBS Group, Oversea-Chinese Banking Corporation (OCBC), and United Overseas Bank (UOB).
They have a combined market capitalisation of US$135 billion – which is less than half the size of Bank of America.
They’re still minnows in terms of market capitalisation when compared with U.S. banks, but they’re more profitable. The return on equity of Singapore’s banks is far higher than that of the biggest U.S. banks.
Not surprisingly, they’re also way ahead in terms of efficiency, as measured by their cost-to-income ratio. This is basically the bank’s operating expenses divided by its operating income. The three big Singapore banks spend about US$4 for every US$10 in income; for the biggest American banks, it’s between US$5 and US$6.
Singapore’s banks are entering a new phase of profitability
During the lows of the interest-rate cycle sometime in 2016, Singapore’s three biggest banks were lending out between 85 percent and 90 percent of their deposits.
That compares with a loan-to-deposit ratio of between 65 percent and 85 percent for the five largest banks in the U.S. That means that the rest of the money from depositors – from 15-35 percent in the U.S. – isn’t generating revenues for the banks… compared to just 10-15 percent in Singapore.
But that doesn’t come at the expense of safety. The average capital reserves of these Singaporean banks was 16 percent – double the 8 percent required by the Monetary Authority of Singapore.
Meanwhile, Singapore’s banks maintained one of the lowest non-performing loan ratios (the ratio of delinquent loans to total loans) in the global banking industry.
So Singapore’s biggest banks are extremely well capitalised. They’re also very efficient in lending out their deposits when the interest rate- cycle goes down. Recent earnings for Singapore’s biggest banks have also been strong, reflecting higher interest rates – as well as Singapore’s economic strength, and low unemployment.
Singapore banks are also embracing blockchain
Right now, the overall sentiment in the U.S. banking industry towards blockchain and cryptocurrencies is one of fear.
Some of the biggest financial institutions and investors in the U.S. have come out openly to chastise and lament blockchain and cryptocurrencies.
JP Morgan Chase CEO, Jamie Dimon, famously said “If you’re stupid enough to buy it [bitcoin], you’ll pay the price for it one day.”
Robert Shiller, Nobel laureate and the namesake of one of the most widely cited stock market valuation measures, thinks bitcoin will “totally collapse.”
But in Singapore, the attitude towards blockchain and cryptocurrencies is very different.
Their biggest banks, as well as the central bank, see it becoming an important and indispensable technology and tool for enhancing efficiency in banking and a host of other industries.
For example, OCBC has been using blockchain technology for local and cross-border payment funds transfer services. I’ve used it… It’s fast, easy and efficient.
And Singapore has become a hotbed for blockchain and cryptocurrency startups. It’s home to CoinGecko, one of the world’s biggest cryptocurrency data providers, as well as DigixGlobal, which allows users to exchange cryptocurrency into physical gold on demand.
But the most obvious beneficiaries – and the most accessible to ordinary investors – of the acceptance of blockchain and cryptos right now are Singapore’s biggest and most innovative banks.
While banks in other markets see blockchain and cryptocurrencies as threats to their traditional business model, Singapore’s banks are pouring billions of dollars into developing new services to exploit the time and cost savings of blockchain.
A great way to invest in Singapore’s three banks is through shares of the SPDR Straits Times Index ETF (Exchange: SGX; ticker: ES3).
Its top three holdings, comprising 41.5 percent of its total assets, are Singapore’s three largest banks. The ETF also pays a 2.9 percent dividend yield.
Another way to gain exposure is through the iShares MSCI Singapore ETF (NYSE; ticker: EWS).
It also counts Singapore’s three largest banks as its three largest holdings, with a 42.3 percent total weighting.
Editor, Stansberry Churchouse Research