Understanding FAB’s Q3 financials

Ioften try to provide alternative ways of looking at issues as a way of adding to the dialogue. Two weeks ago earnings season began and in my first article I looked at the income statement of some banks, and in a subsequent article I examined the balance sheet of a bank. This week I link the income statement to the balance sheet statement.

Two weeks ago I looked at the first banks to report their Q3 financial performance. The main thing that I was looking at was source and quality of profits and the increase in profits. If profits came from core business, which is lending, then I considered this better quality profits. If the source of profits was due to sources that were difficult to repeat or maintain, such as operating expense efficiencies, large increases in investment or fee income, or a large decrease in the impairment charge, then I considered this lower quality profits, even though they might be important.

Last week I took a look at another bank, examining it from my long-running worry that banks might be increasing profits by increasing their loans at a time when the return on assets for some was deteriorating. I was concerned about why some banks might be lending more in a more challenging market. Looking at the balance sheet of the bank that I reviewed, ADCB, it was clear that there was a conscious de-risking of the balance sheet by management followed by a balance sheet optimisation strategy that looked like deploying its balance sheet into stable markets.

This week I look at First Abu Dhabi Bank’s Q3 performance. I’m not trying to make an absolute judgment about performance, but rather to explore ways in which to study the performance. Also keep in mind that FAB completed its merger earlier this year and this will have one-off effects. All numbers are quarterly year-on-year, ie comparing Q3 2017 to Q3 2016.

The income statement stands out with a 5 per cent drop in net interest income. To understand this I look at the components and see that interest revenue dropped slightly by 0.8 per cent, but interest expense increased 9.85 per cent.

What could cause such a big increase in the interest expense? Look at what generates an interest expense, and we do that by going to the balance sheet. The main component of this is customer deposits, which is about flat. Looking at the other entries, there are three large movements of note. Due to banks dropped 34.8 per cent, repurchase agreements (repos) increased 16.3 per cent and commercial paper (CP) increased 56.1 per cent.

Let me explain what repos and CPs are. A repo is when you sell a security, usually bonds, to another party with an agreement to buy them back for a specified price at a specified time. It is a form of borrowing that is relatively low risk, as the collateral is transferred to the ownership of the lender and furthermore the collateral is liquid.

Commercial paper you can think of as similar to a bond with a short tenor, so another form of borrowing. The interbank borrowing (due to banks line item) is usually low cost and extremely short tenor.

The 34.8 per cent drop in cheap, short-term interbank funding was replaced partially with cheap repos, but mostly with longer-term CPs. In absolute terms CPs increased Dh7.7 billion. Can this explain the interest expense increase of Dh130 million?

It can if CPs are more expensive than the interbank borrowings by about 1.7 per cent. Not everything is about revenue and expense. Because commercial paper usually has a far longer tenor than interbank borrowings, the bank’s funding risk has decreased. This needs to be weighed against the expense. And in this market, decreasing risk should be the priority.

Let’s look at what is happening to interest revenue. Just because a number doesn’t change, this doesn’t mean that nothing worthwhile is happening. The first place to look at is again the balance sheet and the loans and advances line item, which shows a drop of 1.84 per cent.

In expansionary economic times, this might be considered a bad thing. But in an economy that is adjusting to the change in oil price, I would argue that this is the smart thing to do. The more important conclusion is that loans and advances, the highest interest earning asset, went down 1.84 per cent but interest income was lower by only 0.80 per cent.

This indicates that FAB increased the rates it charges, but there might be other explanations. The last step is to understand whether the interest increase is because of a risk increase or better marketing. Given FAB’s conservative heritage, I’m leaning towards the latter explanation.

There is much more to FAB’s financials and using some of my ideas you should be able to improve your understanding further. I have not covered the important cash flow statement, since I have run out of space. Perhaps in a future article.