Welcome to Standard Chartered's update for the third quarter of 2018. Today's call is being hosted by Andy Halford, Group Chief Financial Officer, and Bill Winters, Group Chief Executive. Once the opening remarks are finished, there will be an opportunity for questions and answers. At this point, I'd like to hand over to Andy to begin.
Thank you very much, Sharon, and good morning or good afternoon to everybody, depending upon where you're dialed in from. Hopefully, you've had a chance to have a quick look at the quarterly statement. At a headline level, I think it shows the following. Income growing 5% year-on-year, with every client segment up between 5% and 8%. On a risk-adjusted basis, actually the income after credit impairment is up 11%. Costs well under control, cumulatively on a constant currency basis, growing slightly less fast than income on a cumulative basis. In the third quarter itself, actually income up 4% and costs flat. Credit impairment halving again year-on-year, having halved the previous year and remaining stable in the quarter. Importantly, profit up 25% and return on equity rising a further 150 basis points to over 6%.
The statement focuses primarily on the year-on-year comparison, I'll spend a bit more time covering some of the more recent quarterly trends, then touch briefly on costs and investments, credit quality, capital, et cetera. Then hand over to Bill to conclude so that we have plenty of time for Q&A. Stepping back, a bit of context, starting with the macro picture, by reiterating our belief that despite the background geopolitical noise, we continue to see potential to grow high-quality income from areas where our clients tell us we are the most differentiated. We said at the interim stage that we were cautiously optimistic on global economic growth, and that very much remains the case.
At the interim stage, we also said that uncertainties resulting from escalating trade frictions and geopolitical risks were emerging, and we have seen the indirect effects of that to some extent in the second half in the form of lower investor sentiment in some of our markets. At an operating level, that most obviously affected our wealth management business and parts of financial markets, where we are seeing some clients transacting less, deleveraging, and generally adopting a slightly risk-off attitude. Sentiment in wealth management tends to be cyclical, however, and we remain confident that this will be a core growth driver and area of strength for us in the medium term, particularly given the successful shift we have been making into the more affluent segments in our markets, where at our core, we have always had a strong value proposition.
On the financial market side, although client activity has been a little more subdued since the strong start to the year, the return of market volatility usually creates profitable growth opportunities for us. The final macro theme I wanted to touch on is US dollar liquidity, which in our market remains, for now, reasonably elevated. Meaning that volume growth in trade and corporate finance across most of our dollar-denominated lending businesses in the third quarter continues to be more or less offset by margin pressure. As dollar liquidity reduces, however, the more challenging conditions for some of our local regional competitors may create interesting opportunities for us to deploy our strong capital and liquidity to support our clients and drive profitable growth. If we don't see good opportunities at the right return, then we have always been very clear that we won't jeopardize our hard-won foundations.
We are committed to grow shareholder value and our 5%-7% medium-term income growth guidance reflects our belief that we can continue to do that without pursuing low-quality income for income's sake. Stepping back, our recent performance shows just how much more resilient we have become as a group in the last three years in the face of uncertainty such as these. We grew income year to date within the range that we indicated at the start of the year. Although the rate of growth slowed down slightly in Q3, it was within a percentage point of the year-on-year increase we saw in Q2, with the difference being the softer third quarter performance in financial markets that I mentioned, and particularly challenging conditions in Africa and the Middle East. The rest of our businesses performed pretty steadily in the third quarter.
In Africa and the Middle East, income was down about $90 million in Q3 to $600 million, having delivered just under $700 million each quarter consistently over the last year and a half. From a product perspective, about half the reduction in the quarter was from financial markets, but that in turn was driven mainly by macroeconomic and geopolitical conditions that remain pretty challenging in most markets across the region, and to some extent, our own de-risking actions as a consequence. The region remains a key focus for us, and we are maintaining our ambitious plans to roll out the digital bank platform that we developed in the Côte d'Ivoire over the coming year or so. Our improved performance over the last year also reflects our focus on generating better returns on our risk-weighted assets and balance sheet generally.
The net interest margin was five basis points higher year-on-year, net interest income grew strongly, which is offsetting the headwinds that I just mentioned affecting some of the fee-oriented businesses in wealth and financial markets. Our liability-oriented cash management deposits businesses, for example, continue to benefit from our efforts over the last couple of years to improve the quality of our deposit mix in a rising interest rate environment. You can see that in the consistently strong quarterly trends in the product table near the back of the statement. On the asset side of the balance sheet. Strong competition has meant it has not always been possible to reprice in full. This is particularly evident in the third quarter in slightly lower income from mortgages, for example. As we look forward, we expect rising rates should continue to benefit us as monetary policies normalize.
As we've indicated before, the sensitivity is likely to reduce as clients increasingly expect banks to pass through rate rises. It's important to note the rate of sensitivity will vary by market. In our largest market, Hong Kong, for example, despite escalating trade tensions and strong competition for deposits, we maintained double-digit income growth with a good performance across all client segments, driven by cash, wealth, and retail deposits. Our balance sheet there remains highly liquid, with an advances to deposits ratio of around 60% compared to a market average of 75%, and a cash to total deposit ratio of 74% compared to a market average of 54%. The recent prime and savings rate increase had a slightly negative impact given we hold more Hong Kong dollar cash deposits than prime-based mortgage assets.
Overall, we stand to benefit from further rises in HIBOR, while on mortgages, which incidentally make up less than 5% of income in Hong Kong, margins were lower, but volume and pricing remained steady. The franchise strength in Hong Kong has shown its worth recently, with our cost of funding there increasing to slower rates than the published Hong Kong dollar composite benchmark, resulting in the net interest margin in Hong Kong increasing both year-on-year as well as in the third quarter. Putting this all together, as I said, we generated just over 5% top-line growth year-on-year, whilst at the same time reducing risk-weighted assets from credit impairments and keeping costs in the third quarter below the second quarter at only a touch higher than they were in the last year. Indeed, they were flat, if you adjust for currency variations.
The group's return on equity, our primary focus, continued to grow nicely in the period, whilst our return on tangible equity in Q3 increased by nearly two percentage points compared to last year. Despite this progress, we know we need to continue to drive returns higher, and we are developing plans to do exactly that, which Bill will come to shortly. Moving now to costs. We take the view that if an investment will fundamentally improve the franchise, then we will be disciplined in creating the capacity to go ahead and do it. I'll just give you a couple of live examples of where we have invested and the benefits we are seeing. First one is in India. Robotic processing is taking information from client onboarding applications to populate our back office systems automatically.
This eliminates manual processing, saving around 18,000 hours annually, increases accuracy, enables inbuilt exception reporting, and reduces the risk of incorrect routing. Secondly, our new wealth management portal that we launched in Singapore in the first half is one of the first digital advisory platforms in Asia. Since launch, 44% of fund transactions now take place on the platform, and it is being rolled out Taiwan first, then to Hong Kong, then to other markets. This offers a seamless digital experience that increases convenience for our clients whilst reducing our sales cost. Creating capacity for investments in a bank as complex and highly regulated as ours is not easy, and usually requires tough decisions as well as frequent adjustments through the course of the year to ensure we stay in line with our commitments.
We have tightened discretionary operating expenses in several respects in the second half of the year to ensure we can maintain the pace of investment whilst keeping costs in the second half overall, excluding the U.K. bank levy, similar to those in the first half. Moving now to asset quality, where as you know we have made considerable progress over the last few years. The credit impairment charge in the third quarter was one-third of the level it was a year ago and has remained low year to date, with most indicators continuing to go in the right direction. Given the increased uncertainties I mentioned earlier, we are, as you can imagine, scanning the horizon for signs of credit stress emerging in our markets. As of today, though, we have not seen any significant evidence of that reflected. In fact, credit impairment only ticked up slightly in the third quarter.
Clearly, given the historically low cost of risk currently, Bill and I are monitoring the situation with Mark Smith, our Chief Risk Officer, frequently and carefully. The final point from me before I hand over to Bill is on capital, where our CET1 ratio rose another 28 basis points in the quarter to 14.5%. This is the highest it has been since the concept of CET1 was introduced, meaning we are substantially above the 12%-13% target range that we set out back in 2015 and positions us well given the increased macro uncertainty. On that positive note, let me hand over to Bill.
Great. Thanks, Andy, and good morning, good afternoon, everybody. Thanks for joining us. It's been almost exactly three years since Andy and I launched our Refresh strategy back in November 2015. I thought it would be useful to spend a very short period of time reflecting on what we've achieved over the three-year period. More importantly, talk about how we approach the coming years, both in terms of the evolution of our business and our strategy, but also in the context of obviously a changing market environment or potentially changing depending on how things that are in play right now turn out. Broadly, we're very happy with the progress that we've made. When we reflect on what we set out to accomplish in 2015 in terms of securing our foundations, getting lean and focused and investing for growth and innovation.
We've done pretty much everything we said we were going to do. We feel that we've demonstrated that we are able to take some pretty complicated problems and work them through into a foundation for good, solid growth for many years to come. At the same time, though, we fully reflect and recognize that we are not covering our cost of capital as yet, that we have more to do, both ourselves, even relative to our own sense of progress, but also relative to the market's understanding of the actual potential of this franchise and what this team can deliver against that franchise. We have spent a chunk of time this year, and will continue to between now and the end of the year, reflecting on those questions that we asked back in 2015, affirming that the areas that we focused on were the correct ones.
Broadly, we're very comfortable with our focus on growth in Africa. Obviously, recognizing the comments that Andy just made about the sluggishness in parts of this year. We believe fundamentally that that's a differentiating strength for our bank and that we will continue to invest there. About the opening up in China, where we've made great strides, and as recently as this week, recognized as the first foreign bank to receive a local custody license in the People's Republic, which is a basis for real growth for us in the years to come. The focus on affluent, which we've come back to regularly, which continues to be a core strength for us. That affluent client segment and the associated products in wealth management and related products, deposits in particular, have been growing at a very healthy pace, together with our GCNA business, as Andy just called out.
We're getting the mid to high double-digit growth rates in those areas that will allow us to achieve our financial objectives over the medium to long term. These are the things that we set out in 2015. We think that they're still core to our strategy, but we recognize that there are things that we'll have to do differently as well. Both the mindset and the actions that we take when we're in transformation mode are different than the actions and mindsets that we'll take when we're really in growth mode and return optimization.
We've agreed to continue to just take a step back, appropriately, I think, and quite normally after three years of, excuse me, an initial plan, and lay out for all of you when we announce our February full-year results, how we intend to tweak our plan, adjustments that we expect to make or are making or have made, in order to hit a 10% plus return over the medium term. That being as good a proxy as I think anybody can have for cost of capital. Fully recognize a few of the areas that Andy called out in terms of either storm clouds potentially on the horizon. They haven't materially impacted the business that we've seen over the past six months, but we know that there are uncertainties around geopolitics and trade. We call that our relative insensitivity to the specific U.S.-China trade corridor.
Of course, as trade tensions rise, if they rise further, we can expect some second-order consequences that would impact parts of our business. We've seen a genuine economic slowdown in many of our African markets and across the Middle East, despite higher commodity prices. We've all witnessed the pressure on emerging markets, in particular, countries that are running deficits in current account or budget. That has affected sentiment across emerging markets to some degree. Of course, this has translated through to currency weakness in a number of our markets, and a broader sense of malaise in emerging markets. We've not lost faith at all in the emerging market asset class or our position in it, but we recognize that there could be some headwinds, and we're watching those very carefully.
As Andy pointed out, we think we've navigated the bit of challenge that we've seen so far quite well, and we have every bit of optimism that we'll continue to do so. I also wanted to comment very quickly on the ongoing investigations in the U.S. and in the U.K. We've seen, and obviously you've seen, a considerable amount of speculation recently about the outstanding investigation, and relating back to activities that we first disclosed or investigations that we first disclosed in 2014, and that Andy and I have called out at pretty much every opportunity since as an open item. We are determined to play a leading role in fighting financial crime. Since 2012, we've transformed our approach to financial crime controls and risk management, bringing in new leadership, investing significantly more into systems and training, promoting a culture of conducting business with the highest integrity.
In addition to these internal efforts, we're also forging public-private partnerships with regulators, financial intelligence units, enforcement agencies, and other banks around the world to disrupt illicit financial flows. We recognize that there's more work to do, but U.S. authorities share our view that we've made substantial progress. You will understand that we can't say much more on this topic, but we are engaged in constructive discussions with relevant authorities to reach a fair and appropriate resolution as soon as practical, and of course, as soon as we have something that we can say, we will do so.
Aside from these few external challenges and the reference to ongoing investigations, there's plenty of good stuff going on that we could put into the tailwind category. As much as we're concerned about the trade tension between the U.S. and China, other trade disputes seem to be resolvable, and the intra-regional trade within our markets, within Asia, between Asia, South Asia, Middle East, Africa, will be picking up.
There's a clear focus from a policy perspective, but also a practical economic perspective on picking up those intra-regional links, which play much more to our strengths than the specific weakness that could develop in U.S.-China trade. We feel very good about the progress we've made in our digital agenda, and we feel great about the opportunities that we have to take the digital lead that we've opened up in a number of our markets and really drive that through to earnings growth over a period of time. Of course, the early-stage investments in digital don't produce an impact on the bottom line, but we're convinced that in the medium-term they will. We think our network continues to be extremely valuable. It's strong and it's differentiated. And in many ways, it's unique. We are driving strong growth in our client franchise, in our non-financing income, in our network income.
That is leveraging this network strength, and we look forward to sharing more details from quarter to quarter and half year to half year on how that's manifesting itself in bottom-line results. The capital strength, as Andy mentioned, is a great opportunity for us. A number of the markets where we operate either are or will go through some stress. We're very well-positioned in those markets, having taken our medicine early on. It maintained a high level of discipline, and there could be every possibility of opportunities for us to invest some of our surplus capital into interesting markets, should things get a little bit tougher. On that note, I think I'd say broadly, we've got a balanced and pragmatic approach. We feel very good about the current environment, very good about our prospects, fully recognize the challenges that could present themselves to all of us.
We're prepared for those. We're refreshing our strategy as I think is appropriate, three years after having initially launched. We'll have some more to say about that in February. In the meantime, we'll open it up to questions. Sharon, perhaps you could moderate that process.
Thank you, ladies and gentlemen. As a reminder, if you wish to ask a question, please press star one on your telephone and wait for your name to be announced. If you wish to cancel your request, please press the hash key. Once again, please press star and one if you wish to ask a question. Your first question comes from the line of Ronit Ghose from Citigroup. Please go ahead.
Great. Thank you. It's Ronit from Citi. I had three areas of questions, please. First of all, big picture one, ROE north of 10%. Can we quantify this in terms of timeline? Is this three years, five years, a stretch target or a realistic target? Secondly, margins. Standalone third quarter looks like margins are down three basis points. Andy, can you just give us some more color around how much, if I looked at just Hong Kong standalone versus the rest of the group, what the trends are and what your expectations are for next year? I'm guessing most people have margins up next year in their thinking. Given what's happened in the third quarter, do we need to revisit that assumption?
Thirdly, by region, your standout weakness was Africa and the Middle East, and it looks much worse than what we've seen from some of the regional banks, at least in the Middle East. I'm just wondering how much of this is linked to business mix changes or given the oil prices you alluded to, some of the bigger government-related business streams seem to have picked up in the Middle East. It looks like you're doing worse than some of the local peers. I don't know if that's correct or not. Appreciate any comments or color on those three questions. Thank you for taking my questions.
Thanks, Ronit. On the ROE point, we've always had the ambition of exceeding a 10% return on equity, having moved through the initial milestone of 8%. As we approach 8%, it's appropriate to shift our focus to the next set of steps and actions that we'll take to clearly pass through our cost of capital and obviously continue to grow from there. We'll give you some more detail on exactly how we want to do that when we are together at the full year. Really, this is a repetition of the ambition that we've had and a recognition of the progress that we've made towards that from a negative ROE three years ago when we stood up to set out our targets in the first place through to today, where we're obviously much closer to that intermediate 8% milestone. I'll hand over to Andy for the margin point.
Ronit, let me take margins and then the Africa, Middle East question. Yes, you're right, the margin's slightly down in the third quarter. As ever with so many markets, quite a sort of complicated story there. Bottom line is it does not deter us from the belief that over time, we should be getting the margins to be moving forwards and upwards. There are a couple of factors in here. One is that in the second quarter, we did see a little bit more movement of money from the current account savings accounts into time deposits. That slightly pushed up the liability mix. In the third quarter, we actually saw that trend settling down. Whilst we can't rule out more of it happening, I think there is sort of a flow-through of a slight correction there as we went up the interest rate curve.
That I hope would moderate as we move forwards. By geography, Hong Kong actually slightly improved margin. We saw margin pressure a bit more in India and in China. The Hong Kong story, quite a complex one because you've got the effect of the increased interest rates on mortgages, many of which have then got a cap on them and the prime rate moving in the period. Conversely, we have a significant amount of customer deposits in HKD in Hong Kong. Overall, we were sort of slightly up on margin quarter-on-quarter in Hong Kong, and definitely up year-on-year. I think I'd say, great on margins, but things do move around from quarter to quarter at slightly higher liability costs because of the time deposit mix change. That we saw settling down in the third quarter.
Hopefully it won't be a feature going forward. On Africa and Middle East. Listen, I think we have got quite a number of different political and geopolitical situations going on there, and the mix of countries in which we operate in is clearly a bit different to those that others operate. We were a little bit softer in the Middle East than we were in Africa. We were actually quite strong in East Africa. By product, about half the drop overall was in the financial markets area. Some of that was reduced activity. Some of it was actually a conscious decision that we weren't going to participate in some of the activity, and we were just taking a view on risk management. I would look at Africa and Middle East as being something where there's quite a lot of things going on simultaneously.
Over periods of time, things do tend to even out. We have been thoughtful. We're not going to take risk on where we're not comfortable with it. That, in part, was a conscious decision we made during the period. As Bill said, clearly it is an area where we see long-term still very considerable potential, and we will continue to focus upon it, even if it was a slightly weaker quarter.
Great. Thanks for that, Andy. Just to circle back and pin down the margin point. Some of the negative in the third quarter on margin is due to a mix shift in the second quarter, because obviously you're calling out the CASA going up 70 basis points from the third quarter. This is like the negative mix shift in the second quarter hitting you in the third quarter. I'm just wondering, looking to the fourth quarter, because it's clearly quite a trend shift. I don't want to over-exaggerate, but just isolated quarter, you're down three basis points and one of your big local peers in Hong Kong just reported up for Hong Kong and Asia Q and Q.
I'm just wondering whether, again, mixes are not exactly the same, but I'm just wondering whether this three basis point down is the start of something for the second half, a negative trend for the second half.
No, I don't think you should look at it like that. As I say, taking individual quarters in isolation, it was quite difficult to extrapolate from it. Our view remains that over time, we should be able to continue to get the margin up. Interest rate increases are beneficial, albeit the further one goes up the curve, then the less that is the case. Nonetheless, we still see upward potential there. I wouldn't get too worried about this as we look forward. There were some factors in there which were a flow-through from the previous quarter. Equally, we're doing a lot of work on the mix of deposits and trying to get more current accounts clearly across the overall franchise. We continue to focus upon that, and it's something that over time we see increasing.
Okay, great. Thanks, guys.
Thank you. We will now take our next question, and the question comes from the line of Jason Napier, UBS. Please go ahead.
Good morning. Thank you for taking my questions. Three, please. Just beginning with loan losses, obviously very low in the quarter, and consensus for next year is about 50% above your current run rate. I just wanted to check whether you might give us some color on any role of IFRS 9 assumption changes, perhaps recovery levels at present. Perhaps you could tell us sort of what the run rate gross charge is at the moment, because it doesn't feel like there's anything in your early alerts or credit quality data now that suggests that loan losses will be at that sort of level, as uncertain as the environment is. Secondly, just looking at the net interest margin outlook. In the first half, you posted very strong growth in government secured wealth and FI related lending.
I just wondered whether there was a significant role of mix in the kind of margin numbers that you're posting, and whether that actually leads to lower loan losses down the track, whether that's something that might be temporary, and just what role you think that might be playing. Thirdly, this is a simple question. I'm afraid the product income disclosures, I find them endlessly fascinating and useful. In trying to understand the very significant quarter-to-quarter sensitivity that the credit side revenues in retail have to rates. Mortgage income's down 27% in the quarter, and credit cards and personal loans is down seven. I just wonder how does you calculate this and sort of how you interpret that kind of data? Because presumably if rates keep going up, these numbers are going to keep going down. Thanks very much.
Okay, Jason, let's take those in order. It's clearly difficult to know how loan loss provisioning would have been operating if we had not had IFRS 9. On the other hand, we do have IFRS 9. It is much more sophisticated. It is more forward-looking than the previous. Yet we are seeing a very low level of credit impairment. That is very consistent with what we are seeing in terms of forward indicators. The non-performing loans The category 12, the ones that are performing but sort of fragile, the early alerts, et cetera, have all been heading in a pretty good direction. I think that you should look at this as not being particularly inflated by recoveries. We have not had a particularly unusual level of recovery during the third quarter. Clearly, IFRS 9, with the forward-looking element, has got more sensitivity to changes in macroeconomic outlook.
Albeit, at this point in time, we are not seeing any significant change coming off the back of that. On the other hand, if you go through the cycle, you would obviously observe that it is below average cycle numbers that we have got at the moment, and clearly one can take a view just as to where we are in the cycle, where we're going to be. I think our main takeaway, however, is that the medicine we applied from 2015 onwards to get the quality of the loan book into a much better position has really been paying off, and I think the quality of the balance sheet now is a huge amount better. Where we have provisioning decisions, they tend to be, in quantum terms, much, much lesser than was the case a while ago.
Overall, we are very pleased with the progress we're making there. The loan losses, credit impairments are a small proportion of our overall income, whereas a while ago, they were eating up quite considerable amounts of the top line. I think behaving well, and we'll continue to focus upon it, and we'll see where the cycle takes us. On the NIMs, probably a little bit repetitive of what I said earlier. It is a combination of multiple products, it is a combination of multiple countries, and there clearly is a weighted effect of all of those when it comes up to the higher level. As I said earlier, I think the direction of travel on that, certainly over the medium term, we do see the opportunity to further improve the NIMs within the business.
The fact that they have gone up generally over the last three quarters but gone down slightly last quarter, I wouldn't read too much into that. We're very focused upon the increases there, and some of that will be product mix change, and some of it will be more by country. The product table at the end, endlessly fascinating. That's a memorable way to describe that table. Again, a lot of moving parts. I think on the mortgage side that one should remember quite a high proportion of our overall mortgage book is in Hong Kong. In Hong Kong, there is quite a high level of capping of rates, and in the period we saw the caps coming in and taking some effect.
What we conversely saw was the benefit on the deposit side, so that actually when you put the two together, net-net, it was a good outcome. We actually, as I said, saw the Hong Kong margin go up slightly quarter-on-quarter and reasonably strongly year-on-year. As ever with these, I think one needs to look at them across the piece, I wouldn't be too worried about looking at the mortgage line alone. There are considerable offsets in other lines and in particular in our very biggest market. As I say, it's been a net positive, not a net negative.
Thank you. Just to follow up on that in terms of the way that the caps work and so on. If the consensus view of Fed funds is right for next year and we might get three or four movements over the next 12 months, does that naturally feed through into a number that could trend to zero in mortgages and auto?
I would look at it more this way, particularly Hong Kong, the biggest mortgage market, we're reasonably balanced in terms of the deposits from customers and the mortgages we have got out there. Therefore, actually changes are fairly neutral on an overall basis across the two different product group income streams.
Thank you.
Thank you. Our next question comes from the line of Joseph Dickerson from Jefferies. Please go ahead.
Hi, good morning, guys. Thank you for taking my question. I guess just a couple of questions echoing similar themes that have already been asked. Just not to hark upon it too much, but the mortgage and auto line, could you discuss what was the underlying asset growth associated with mortgages and auto? Number one. Number two, you've referenced liquidity a couple of times. It'd be helpful to understand in the Hong Kong market in particular, what you're seeing amongst your customer base in terms of liquidity preference in terms of different products on the liability side, i.e. deposits versus floating rate notes, et cetera. Some color there would be very helpful. Many thanks.
Yeah. Okay. Overall, the mortgage asset book was fairly flat period on period. It was something where we were quite happy to take share of market but not push it too much. Overall mortgage sort of fairly flat. In terms of the liability side of things, as I said earlier, we saw a little bit of movement towards time deposits and away from current accounts in the end of the second quarter. That actually flattened out during the third quarter. Obviously it is possible as we go further up interest rates that we could see more of that. The recent experience actually was that that transference moderated.
Yeah
Thank you. We will now take our next question. The question comes from the line of Manus Costello from Autonomous. Please go ahead.
Good morning. I've got a couple of questions, please, one general and one a bit more specific. The general one is you have had some good news on capital, various bits of good news on capital today, and are running, as you say, well above your target. You're talking about investing that next year. Is it possible that you might consider returning some of that excess to shareholders during the course of the next three-year plan, if you can't find opportunities for it? My specific question was about your other impairment line. You were talking about some transport assets taking a hit there. I wonder if you could explain that a bit more, and more broadly, talk about your transport asset financing business and how it fits within the group. Is that something which you're comfortable with or which you might think about restructuring in the future? Thanks.
Okay. Thanks, Manus. Obviously, self-evidently, we have got the capital ratio now up to a much higher level than we have had before and a level above where we had targeted. I think encouragingly, a number of things have come into play that have been helpful. We had a possible downward pressure on the CET1 and upward pressure on the RWAs on some loss-given default issues. Those have now actually been resolved. Those did not have an adverse consequence, which is good. We've been doing a lot of work in the business on the returns on the risk-weighted assets and the flushing out the models, et cetera. Overall that has got us into a better shape.
Equally, we have got one or two things like exactly what will be the impact of the Basel IV, the U.S. situation that Bill referred to. Our sense at the moment is that running a little bit high probably does make some sense. Obviously, over a period of time, as and when those things become clearer, we will put those into the mix just in terms of deciding what is an optimal level to run at. If we conclude we're higher than that level, then obviously we'll give thought to how we get from where we are to the optimal level. I'm sure we'll update more on that in February. On the other impairment side. The other impairment, so that line is very much, these are not credit impairments, but these are impairments particularly against aircraft and ship leasing assets.
We have seen some increase there, more actually on the shipping side. That is something that we are giving some thought to, and again, will be something I think we'll update more on when we come to February.
I would just add to Andy's answer, Manus, that we remain pretty optimistic and confident that the franchise that we're building will allow us to deploy capital into acceptable returning, so higher returning activities over the course of the next year. We clearly have been shifting our portfolio from a legacy, which was both low returning, obviously historically had much higher loan impairments, towards the client segments that play to our core strengths. We've been generating some good growth in those areas of core strength. Obviously, it's been offset to a degree, both in income terms and in capital terms, by the reductions in the more legacy portfolio. Over a period of time, clearly that balance shifts, and we're much more focused on generating growth from the client segments that are most relevant and attractive to us.
We're pretty optimistic that we can deploy the capital that we're generating into reasonably decent returning, higher growth type opportunities. Of course, if for whatever reason, environmental or our own execution, we can't, then we'll look at how we return capital. That is definitely not the base case in terms of what we see as the value of this franchise.
Thank you. We will now take our next question, and the question comes from the line of Kuldeep Sahay from Goldman Sachs. Please go ahead.
Hello. Thank you for taking my question. It's regarding Hong Kong. First of all, on prime rate hike, that just happened at the end of 3rd quarter. There could be another one, let's say, in December. How much could be the impact on group margins? As Andy Halford mentioned, it could be a bit negative given that mortgages go up and Hong Kong dollar savings account pricing also goes up. Is it meaningfully impacting the group margins in the 4th quarter and beyond? The second one is regarding loan growth. Obviously, a good year till date. Given all the uncertainties, and now also slower loan growth in some key areas like Hong Kong, Singapore, how do you see loan demand going into next year?
Okay. Take those in order. The Hong Kong prime rate obviously has just risen for the first time in a long time. We'll see whether it rises further. I think the simple answer to your question is that because we are reasonably well balanced between deposits and mortgages in Hong Kong dollars, overall changes do not actually have a significant impact upon margins in Hong Kong, and therefore do not have a significant impact upon margins for the group as a whole. Hopefully that addresses that one. Loan growth, a little bit more moderated over the last quarter. Has year-on-year still been growing? Obviously, that is something that we are focused upon. We will not go lending where we don't accept the level of risk that comes with it.
Equally, we do know that to grow the business, we do need to keep balance sheet moving forward. No forward projections, I think we should say that the momentum there is something that is key and something that we are very focused upon making sure we have a regular drumbeat on that.
Thank you.
Thank you. We will now take our next question. The question comes from the line of Claire Kane, Credit Suisse. Please go ahead.
Good morning. Two questions, please. The first on costs. You've confirmed that Q4 costs ex the bank levy of GBP 2.6 billion, which is in line with consensus. I just wondered whether you could comment, given some recent press reports, whether there has been any change to your investment spending or capitalization policy this quarter. My second question is around your confidence that you are on track to deliver the financial commitments you set out earlier this year. Just to confirm, are you saying you will deliver 5% income growth at least for full year 2018, which would be a continuation of the 4% year-on-year growth, in Q4 as well?
Just whether you could comment, given the NIM decline and also the loan book decline quarter-on-quarter, how we should think about absolute NII development in the fourth quarter and going forward, whether that will be such a support factor into next year. Thank you.
Okay. Costs. Let's just address that one as I know I got quite a lot of commentary at the half year. We have over the last three years, as you know, we have taken out a lot of cost in order to significantly increase the investment, particularly IT investment, into the business. That we profoundly believe is important for the business going forwards. We continue to believe that investing into those areas is important, and consequently, that we do need to take the cost out of the business in order to be able to fund that. There is no change whatsoever in our capitalization policy. We apply exactly the same way of capitalizing these costs as we have ever done before.
What we have done is just got a little bit tougher on some of the discretionary costs to make sure that the commitment that we made, that we would see the second half costs being similar to the first half costs is what we deliver, and that is what we are working very much to. If we can do that, then that implies that we would have sort of just over $10.2 billion of cost for the year, against $9.9 billion last year. That's a 3% increase. That's roughly the level of inflation that we're seeing in the markets we operate in. That is consistent with what we also said was that we would try to contain cost increases below the level or at or below the level of inflation, notwithstanding making significant levels of investment. We are continuing to invest.
We will continue to invest. We think that's the right thing for the future of the business. On your second point, on track with our financial commitments. Clearly, we are doing everything we can do to land this year within the ranges that we have indicated, albeit they were ranges over the medium term. They were not specific to individual quarters or years. We are just above 5% on a year-to-date basis, and we will do our utmost to try to get the full year to end up at the 5% or above level, if we can possibly do that. There will clearly be a number of moving parts that sit there. One is, as you referred to, about asset growth. Another will be about NIMs. I'm not going to forecast NIMs on a quarterly basis.
As I said earlier, the intent as we evolve the business is that we would hope that we can be progressively improving the NIM over a period of time. That may not be true in every single quarter, but that is the direction of travel that we would hope for. Credit impairments clearly are at the moment, touch wood, operating in a helpful way in terms of the bottom line. If we can end the year with a bottom line print on the operating profit. Remember, we are printing now in each quarter about the same amount of operating profit as in 2016, we were printing in a full year. We really have ramped up the bottom line effect here. The ROE at 6.1% is clearly the highest we have had for quite a period of time. Obviously, want to get it higher.
I think the direction of travel is pretty good. The team here are very focused on delivering as close as we can or within those ranges as possible at the end of the year.
Thank you very much. Could I maybe just have one follow-up just in terms of what we can expect at the Q4 with your three-year plan? Are you going to give a similar update on that ROTE walk that you gave at the 2015 results, showing that you're going to exceed 8% ROTE in 2021? Will it be above 10% in that year? Is that what you're going to show us? Thanks.
You wanted me to pre-trail our February announcement. Listen, I think as Bill said, we have, I think, covered a lot of ground in the last three years. Obviously, over a three-year period, a lot of things change externally. As you'd expect with any business, we need to sharpen up, reflect, refocus, look at the areas of opportunity, make sure we put any resources behind them. Those are all the sorts of things we'll talk about in February. We'll talk about where we think we can get the returns for the business. I haven't exactly worked out what charts we're going to use for February, but we'll progress that over the coming weeks. I think you should see it more as being, how do we sharpen the business further? How do we build on the foundations we've put in place?
How do we get to the high levels of return that we all know the business is capable of, even if it has taken us a little bit of time to get there? I think it is better to do that in a safe and steady way, and we will talk further about that in February.
Great. Thank you.
Thank you. Your next question comes from the line of Robert Sage, Macquarie. Please go ahead.
Thank you. I've got a couple of questions, please. The first is on going back to the segmental presentation, where one of the good performing bits, whether by client segment or geographic region, is the central and other items. I guess the question is this presumably mostly to do with rising interest rates where it's captured within the group reporting? Is there anything particularly in the Q3 numbers that is sort of one-off in nature, or could we see that as being a basis for extrapolating future expectations? My second question is entirely different. It sort of goes back to one of the earlier questions, I think from Manus, which is sort of talking about looking at your business, your strategy, where you're talking about several areas where you have differentiated advantages.
I think you're also putting into your statement today, you've learned a lot since 2015 about areas where you do not have differentiating advantages. I was just wondering, without being necessarily specific about particular business units, whether we could be finding, when you do unveil your update on the strategy in February, whether there could be further updates to the business that you would be downsizing, whether there could be further creations of new legacy portfolios, or whether what we see today will remain intact going forwards.
Okay, Robert, let me take the first and Bill the second. The simple answer to your question is the central and other is a beneficiary of, to some extent, the interest rate increases, that is a good part of the reason why its numbers are higher. There is nothing particular that I'd call out in the quarter itself. As a guide going forward, there's nothing X-ed out. I would equally observe that does tend to be a little bit lumpy over time. It's not the most predictable of lines just because the sheer volume of the balance sheet, et cetera, that sit there is quite significant. Bottom line, beneficiary of interest rates, nothing particular to call out within the period.
Robert, on your second question around areas of differentiation and flip side areas of lack of differentiation. This is a body of work that we've been doing pretty continuously since 2015 with data as it comes in. You can imagine, the business in many ways was a very good business, but underneath a lot of crud in 2015. We spent a fair amount of time scraping the crud off, at which point you check just how sound the hull is and how strong the engine is and how quickly that machine can move. Thankfully, having removed a lot of crud and upgraded the motors and streamlined the hull and things like that, we're doing a lot better than we were in 2015.
We have learned a lot about the things, the investments that we've made that have really worked, the areas of focus that have worked, and some that still lag. You obviously can see from the results that we have significant components of our business that are still well below their cost of capital by any measure. We have others that are well ahead. We've confirmed, I think, our key understanding about differentiated strengths in a few markets where we have sizable market share, strong brand. Obviously some markets intrinsically are more attractive than others. We have some very attractive markets, and we have some less attractive markets. Looking at our differentiation, we see key strengths with affluent clients. We see key strengths with corporate clients that are able to access our network or our cross-border services and capabilities in some way.
We see that we have a harder time hitting acceptable levels of return where we don't have those attributes. In some cases, we've got less differentiation, but still some in a very attractive market, and that sounds fine to us. In other cases, we've got a bit of differentiation, but in very unattractive markets. We're going to figure out how we can get our returns above cost of capital in those segments or those markets. We have no doubt, as we dig further and further, some operations that are showing no signs of differentiation and perhaps not very attractive markets, which we'll look to reposition, sell, or otherwise focus on a differently differentiated strategy. This is all the work that's been ongoing pretty continuously since 2015.
We thought we would bring it together in February, together with some refreshed perspective on how we're going to get to a return that is a lot more exciting for all of us.
Thank you.
Thank you. Your next question comes from the line of Fahed Kunwar from Redburn. Please go ahead.
Hi, Andy. Hi, Bill. Thanks for taking the questions. Just a couple of questions. One on margins. This might be my lack of understanding, but they're down two or three basis points QoQ. I know you've talked a lot about the funding change from current accounts and time deposits, but you said in the third quarter that kind of slowed down. If that's not the reason that margins are down QoQ, why are they down QoQ? I apologize if I haven't quite understood that point, but it seems like the funding stuff has been resolved in the third quarter, at least moderated. Is there any other reason as to why margins are down QoQ as much as they are?
The second question, you might defer to the strategy day, but if you look consensus has 6% income growth for the next couple of years, year-on-year. You talked about 5% to 7% income growth. Revenues are down QoQ. I understand the point that within a kind of market malaise, you would take share off a shrinking pie, so to speak. Is that kind of growth rate realistic, even though your competitive position is improving? If you're having across the board malaise in the emerging markets, is that the right kind of number we should be thinking about? Realistically, will it be lower with you taking market share? Thanks.
On the margin one, just a couple of things there. What I was saying was that late in the second quarter, we saw some of that movement between the capital and the time deposit. Therefore, it was not particularly impacting the income in the second quarter. We entered the third quarter with that having changed, and therefore we did see a third quarter impact on income of it, and therefore comparing second and third quarters, that is where it came through in income. I think that another part of the margin reduction in the third quarter was on the asset side, not just the liability side. A little bit tougher to pass on some of the increase in interest rates to customers. Therefore, there was an element of that that was in it as well.
Hopefully the first part of that does more explain the thing that I obviously did not explain clearly before. On the income growth, I think you're right. We'll provide an update, obviously, in February. We have got the target range out there. We have got no reason to think that we should be aiming for anything different. We will be thoughtful about what we do. We're always going to take a risk lens to this, and if we do not think that there is an acceptable level of risk, we're not going to go and rush to do stuff just to get into a particular range. We are much more concerned by improving the quality of the returns in this business over the long term period. We'll do an update on the things we're going to do to deliver those sort of numbers in February.
I would just add to the comment, in response to your question about grabbing share in some situations where markets are more difficult. We absolutely intend to do that. We haven't needed to. We don't feel that we will need to lead with risk or with pricing to pick up share. We can rather lead with focus and service. That's worked well for us in our focus areas over the past couple of years. We will look to step that up. We're not going to be the one that initiates a price war.
Sorry, Bill, could I just follow up with that? Can't you lead on prices, though? You have a structurally lower or your funding costs are higher. Considering your deposit base, you should have a lower funding cost if US dollar liquidity is kind of tightening a lot. You're so long US dollar liquidity. Can you not kind of compete on price and take market share in that way? Just competitively, your funding base is in a different place to some of your local peers.
Yeah. Look, I think this is semantics. Of course, we can take share based on pricing where we have an advantage. We do that today, we'll continue to. We've not had an advantage funding cost in most of our local markets in the recent past. There are some signs of tightness in some markets, in particular in Africa and the Middle East. Obviously, flip side of the challenges that we've experienced there in the third quarter. My real point is, we don't have a deliberate strategy to reduce our margins in order to pick up share right now, because we think we can pick up share by just doing a better job of what we've been doing. Which has, in fact, increased our share in most of our client segments, in most of our markets over the past two years.
Perfect. Thank you very much.
Thank you. Your next question comes from the line of Guy Stebbings, Exane BNP Paribas. Please go ahead.
Morning. I had two questions, one on credit quality and then one back on costs. On credit quality, can I just ask about credit migration in the period? It looks like stage 3 exposures fell as a percentage of total exposures, but we didn't get a split between stage 1 and 2 for Q3. Can you just confirm there was no pickup in stage 2 in the period? I'm presuming, given CG12 exposures fell and the low credit impairment charge, that there wasn't a adverse credit migration, but that would be helpful just to get the split there. On cost, if I can come back to your comments that you reduced some discretionary spend in Q3 to help meet your commitments of flat costs on H1 ex the levy. How should we think about that discretionary spend?
Is it simply delayed into next year or it falls away?
Yeah, Guy. No particular movement in terms of phase II, phase III migration that I'd call out in the quarter. As you can see from most of the indicators, non-performing CG12s, et cetera, they have been on a gently improving trend. There is nothing particular I'd call out there that is a distortion that is not visible. On the cost, it's a bit of several things. There will be some things where we are flying people less, we're using more video conferences. There'll be one or two things where we've said to people sort of just tighten the belt and whatever. Our overall belief that we can manage this business with the cost increase at or below inflation remains our view.
Okay, thanks.
Thank you. Our next question comes from the line of Martin Leitgeb, Goldman Sachs. Please go ahead.
Yes, good morning. Just to follow up on a earlier question, income growth is slowing. Risk costs, I think you've hinted before that they are currently below through the cycle average. I was just wondering if that means there's an increased focus on cost for yourself as a lever to improve returns from here. I was just wondering how comfortable are you with the current cost base, with the current geographic footprint, and do you see scope here for more aggressive cost measures going forward? Is your focus here predominantly on growing revenues in February? Thank you, and apologies for the voice today.
That's all right, Martin. Thank you for your one-part question. That is appreciated.
I think running any business, one's going to have an eye both to the top line and cost. Our absolute belief is there's a lot of potential in the markets in which we operate, that we need to make some investments to actually realize that full potential. If we can take out enough cost to fund that investment, that is the right way to go forward. I think if we're just totally focused upon the cost reduction, that in the long term is not a great way to grow a franchise. Our focus very much is going to be on investing in the areas where we believe there is opportunity for us, and taking out enough cost to be able to fund that growth. We'll talk about both of those in February.
Yeah. Just specifically to your question on geographic footprint. We don't look at the question around where we operate as primarily a cost question. It's a return question, with a couple of key components. One is the return of the business itself, and second is the degree to which it contributes to our broader network effect. Of course, if and when we do adjust our geographic footprint, we have in key products over the past two years, we will continue to look at areas where we should be either investing more or investing less in a particular location. We're going to do that. That could have the effect of adjusting expenses, that's not going to be the primary driver. You're not going to see us exiting countries in order to hit artificial expense targets.
We will focus on how we get the best return from the geographic footprint that we've got.
Thank you.
We've got time for one more question.
Would you like to take the next question, sir?
We can take one more question.
Thank you. Your question comes from the line of Chris Manners, Barclays Research. Please go ahead.
Good morning, Andy. Good morning, Bill.
Good morning.
yeah, a couple of questions, if I may. The first one was maybe just to follow up on Manus' point on capital. You printed a 14.5% CET1 ratio. Given how well you did on RWAs, maybe it could have even been a little bit higher in the quarter. That still looks like around 200 basis points ahead of your midpoint of your guidance range. That would be about $5.3 billion. Say we do $1.5 billion to clear your legacy conduct charges. That still gives you $4 billion of surplus capital to the midpoint of your range. It looks to me that a buyback could be really quite. You could take out a lot of your share count. Say a $2 billion buyback would be 9% of your share count, and you'd still be above your guidance range.
How comfortable are you in that 12%-13% range? Do you consider that type of capital management as something that might reward shareholders, albeit maybe people think it's throwing the towel on growth if you buy back. How do you look at that risk reward? The second one was, really looking forward to the update in February. On the returns target, is that return on stated equity, which is, I guess, what you put out in 2015, it's not going to slip to a return on tangible equity target? Thanks.
Chris, your precision on your math is commendable. It's sort of nice to be having discussions about whether we've got excess, whereas three years ago, it was very much the other type of discussion. We will obviously be giving more thought as we update in February to what we think over the medium term is a sensible range to continue to have capital at. As you partly referred to, there are a couple of things for us before on the U.S., which with time we'll share a little bit more about what impact we'll have from those. To Bill's point earlier, this is not all about returning capital, this is about deploying capital and how can we grow the franchise.
I think I understand the question, we will certainly in February be updating, I think, on where our overall capital ranges we believe should be in the longer term. Sorry, your other question was on?
ROE.
Oh, ROE. Listen, we've said that we directionally believe we can get up and above 10% over a period of time. Again, we'll talk more about that in February. Whether it's 10% on one metric or 10% on the other metric, frankly, over the long-term periods of time, the difference between the two is not hugely significant. Both of them are higher than where we are today. That is going to be the important thing to talk to.
Just to repeat what we've said a bunch of times, our target isn't to get to 10%, our target is to consistently deliver above 10%.
Okay. No, that's understood. It was just that because if it was to slip to a tangible equity target, then if we were just looking at what's your book value and what's 10% of that might make a delta on where we sort of, us simple analysts peg that net income number.
Witnessing your demonstrated mathematical competence, I know you can make that adjustment really quickly in your head.
Thanks, Bill.
Thanks, everybody, for joining us this morning and for your ongoing support and challenge. I look forward to speaking to you as a group next in February.
That does conclude our conference for today. Thank you for participating. You may all disconnect.