Falling loan loss coverage the consequence of lower-than-expected provisioning. Recent 2Q09 banks’ earnings were generally above our expectations, with lower-than-expected provisioning being a critical contributing factor. However, with NPLs on the rise, this has led to the three banks registering sharply lower loan loss coverage ratios – DBS fell the most to 80.5%, from 114.2% at Dec 08. Whilst the improving economy will be positive for banks’ earnings going ahead, we remain cautious that a slow economic recovery could lead to banks having to make more provisions ahead to maintain their loan loss coverage. We are NEUTRAL the banking sector. For investors keen on Singapore banks, UOB (NEUTRAL) is our preferred as its asset quality is seen to be the best amongst its peers.

DBS’ NIM remains narrower than peers. DBS was the outperformer in net interest income, as it recorded a 3.3% sequential growth. The other two players had lower gapping income during the quarter. However, DBS’ NIM of 2.01% remains sharply lower than OCBC’s 2.29% and UOB’s 2.35%, due to its low loan-deposit ratio in the current low SIBOR environment. We expect this difference in NIM to persist through 2H09.

Trading and investment gains contributed to non-interest income growth. The strength of noninterest income was mainly due to trading and investment gains, on the back of the rise in equity markets. We do not believe this is sustainable in subsequent quarters, and have assumed lower gains for 2H09.

All three banks had higher NPL ratios, with the 0.8 ppt QoQ rise for DBS being the highest. Manufacturing loans’ asset quality deteriorated more during the quarter, and all three banks cut their manufacturing loans, ranging from 7.6% decline for UOB to 11.4% cut for OCBC. We believe manufacturing loans have the highest risk. DBS has been most aggressive growing its manufacturing loans over the past few years, and manufacturing loans also account for a larger share of DBS loan than its peers. Hence, we will watch DBS asset quality more closely. Following the results, we raised the target price for all three banks – we peg the target price to 2010 book. We believe the P/B discount for DBS versus peers will be wider than the historical norm of 0.2x given the risk for manufacturing loans and DBS’ lower loan loss coverage. Amongst the banks, UOB (NEUTRAL) is our best pick.