Regulatory changes: Reforms have made for a sector in transition, with a need to refocus

The banking sector is currently facing a period of readjustment, absorbing the implications of a more mature regulatory environment and looking at ways to support the government’s development plans. In a moderately sized market with limitations on the opportunities to boost loan growth in place, the challenges for commercial banks remain substantial. Nonetheless, most of the players in the Sultanate remain bullish, devising new strategies and products to capture a greater share of the retail and corporate segments of the market.

The eight commercial banks in the country face unique challenges. With a population of 425,000 in 2012, that was growing at 2% annually as of 2010 – according to the Department of Economic Planning and Development – and a government-led economy, Brunei Darussalam will likely remain a highly competitive market with moderate growth potential.

According to Vincent Ho, the CEO of HSBC Brunei, “Brunei is not necessarily overbanked and it all depends on the appetite of the banks; however, competition is always very tight in the Sultanate due to the market’s small size.”

OVERALL STRENGTH: Given these conditions, the sector has performed well historically. In October 2012 at the 8th Annual Brunei Roundtable, the deputy-chairman of the monetary authority, Autoriti Monetari Brunei Darussalam (AMBD), and development minister, Pehin Dato Suyoi Osman, announced that the country’s total financial assets have increased by more than 70% in the past 12 years. From 2007 to June 2012 alone the total assets of the commercial banking sector grew by 30.5% to BN$20.1bn ($15.7bn), according to AMBD data. In the same period, despite a low interest rate environment, total deposits in commercial banks have grown by 34.8% to BN$17.8bn ($19.9bn).

The sector appears to have been putting this money to good use from an investor’s perspective. In the first quarter of 2009, for example, the sector was running a return on assets of 1.5% and a return on equity of a staggering 13.3%.

GOVERNMENT INFLUENCE: This is impressive considering that the government, which has amassed significant surpluses, plays such a dominant role in the local economy. According to Javed Ahmad, the managing director of Bank Islam Brunei Darussalam, an Islamic operator and one of two home-grown banks in the market, “As financial institutions, we have challenges when 70% of the economy is made up of the public sector and the public sector is not a borrower. Where do you grow your books?”

This growth, historically, has come from lucrative high-interest retail lending, particularly through credit cards. Personal loans (including mortgages) as a percentage of total loans have remained above 60% since 2005 and as of September 2011 comprised 59.6% of the total loan portfolio.

PERSONAL DEBT: With the government keen to address personal indebtedness in the country and improve the asset quality of the banking sector, a number of regulations regarding personal lending have been introduced since 2005, which not only mitigate risk in the sector but also continue to clip the sector’s growth potential.

On the domestic risk front, the government first looked to address the sector’s exposure to personal and consumer loans in 2005, with a Ministry of Finance (MoF) directive mandating that personal loans should not comprise more than 30% of a bank’s total loan portfolio by 2010. This was supported by a regulation stipulating that the credit limit for individual borrowers should not exceed 12 times their gross monthly salary and that the repayment period should be capped at six years.

These initial moves to address high levels of personal indebtedness were joined in June 2010 by new MoF regulations on credit card usage. Cardholders must also be at least 21 years and receive a monthly gross salary of at least BN$500 ($389). Limits on cards have also been imposed based on a sliding scale related to salary. Credit limits for those earning between BN$500 ($389) and BN$999 ($778) gross is equivalent to one month’s salary. For gross salaries of BN$1000 ($778) to BN$9999 ($7787), there is a two-month salary limit and for those earning over BN$10,000 ($7780), the credit limit is set at the discretion of the individual bank. Credit card interest rates have been revised from pre-2010 levels of 24% to 18%. The minimum monthly payment was also increased from 5% to 8%. Under the new regulations, debt exceeding these new parameters has to be bundled into personal loans that have to be paid off within 36 months of issue.

REGULATION: While these regulations will ensure the heady days of returns on equity (RoEs) of 20% have passed, most of the banks readily admit that measures that have been introduced and enforced by the regulator (established at the beginning of 2011) were necessary. The rationale for introducing these regulations seems to be to bring the indebtedness of Bruneians down and avoid future expansion of the credit bubble to bursting point. According to Lai Pei-Si, the CEO of Standard Chartered Brunei Darussalam, it was not a reaction to current issues of default. “Personal loans have always been a good portfolio. [The regulation] is not a function of the portfolio not performing,” she told OBG.

Credit card debt was reduced by 36.7% in the five years to 2010, though the general indebtedness of the public had been increasing substantially. The Prime Minister’s Office revealed in March 2012 that civil servants owe the government $485m in unpaid housing loans and $84m in car loans. Credit card debt was the greatest concern. Not only had interest rates reached an exorbitant rate – climbing as high as 26% – but there was a high rollover of debt with monthly payments sometimes falling short of the previous regulatory minimum of 5%.

PROTECTING BORROWERS: The new regulatory regime is expected, therefore, to help to shield and protect borrowers from overreach. According to Ahmad, “The non-performing loans have been an issue, but they have been at a reasonable level. Where there has really been an issue is the level of personal indebtedness.” The regulations have seen personal loans (not including mortgages) drop from 59.8% of the total loan portfolio in 2005 to 39.6% in the third quarter of 2011, a substantial decrease, but still above the mandated level of 30%. There have also been suggestions that personal indebtedness, while falling, remains 18 to 20 times an individual’s monthly salary, far above the cap of 12 times. Nonetheless, the monetary authority is beginning to bring indebtedness under control, a project that will be facilitated by the new credit bureau established in 2012, allowing banks to build a much more complete picture of personal debt in the sector (see analysis).

ASSET QUALITY: These regulations will not only help to protect individual borrowers but also to improve the asset quality and risk profile of the banks. Indeed, while many of the banks have insisted that the quality of their loan portfolios is strong, the non-performing loan ratio has historically been high on the back of a large share of high-priced loans; in the last quarter of 2009, the gross non-performing loan ratio stood at 11.2%. While Azlan Mike Skinner, the country manager of AmCapital, the local asset-management firm of Malaysia’s AmBank Group, told OBG, “The 90 day non-performing loans (NPL) for Brunei is still very high,” the gross non-performing loan ratio for the total portfolio has begun to come down. By July 2012, it had declined to 10.3%, according to the IMF statistical appendix from that month. This supports the idea that the domestic asset quality of the banking sector is improving.

The government has also taken steps to lessen the external risks facing the industry. In December 2010 the MoF introduced the deposit protection order that will insure customer deposits of up to BN$50,000 ($38,940) in value through the Brunei Darussalam Deposit Protection Corporation (BDPC). The body will receive premiums from banks within the Brunei Darussalam to finance this deposit protection fund. The order also stipulates that all banks must maintain a minimum level of eligible assets in Brunei Darussalam in a ratio of 3:1 to eligible deposits to cover liabilities in the Sultanate, though this was revised downward in 2012. The ratio will be overseen and regulated by the BDPC, a new body established in January 2011, with institutions failing to meet these requirements subject to financial penalties.

Not only does this mean that borrowers have full protection and peace of mind on their deposits of up to BN$50,000 ($38,940), but it also means that in order to meet the requirements for assets within the country, banks will have to bring capital back onshore and lessen their exposure to foreign assets and hence risk. Indeed, in the first seven months of 2012 alone, the foreign assets of the commercial banks decreased by 16% to BN$10.6bn ($8.26bn), according to data from AMBD.

The sector is, therefore, reducing its exposure to global risks and the potential fallout from the Euro zone uncertainty. Nonetheless, foreign assets still accounted for 55.4% of total assets in July 2012.

PROTECTING BANKS: However, all these measures taken together should ensure the good health and financial robustness of the Sultanate’s banks. Indeed, they have been strong for some time and are well placed to deal with risk and any unexpected shock to the system, performing well over a number of financial soundness indicators. For much of 2011, the regulatory capital to risk-weighted assets hovered around the 20% mark, while in the third quarter of that year the regulatory tier one capital to risk weighted assets stood at exactly 20%, according to the IMF. Therefore, while the AMBD is not actively working on the implementation of Basel III, the sector, whose base consists primarily of only common equity, easily meet the capital adequacy requirements of these international standards.

LEVERAGE: The sector is also only moderately levered with an accounting leverage of 2.5 times in July 2012, according to AMBD data. This, of course, is a long way from the position of many Western banks as the financial crisis hit. Royal Bank of Scotland, for example, had a leverage ratio of 31.2 in 2007.

As a further indication of a sound and robust sector, the Bruneian banking sector has the double assurance of high liquidity to support the equity position of its players. As of September 2011, the liquid asset ratio stood at 63.3%. This compares to a ratio in the US that remained below 20% for the majority of the first decade of this millennium, according to a Bank of Canada paper.

From a regulatory perspective, therefore, the employees of the AMBD will be able to sleep soundly. However, from the perspective of the banks and their investors, the introduction of these new measures on personal lending and deposit protection are likely to come at an opportunity cost and rein in their revenue generating potential.

The recent restrictions on personal credit activities have undoubtedly had an impact on the overall performance of the sector. According to Lai, “Return on equity dropped across the board as a result of [regulations on] unsecured lending. It played a very large role before 2010.”

LOAN SLOWDOWN: Indeed, loan growth in the Sultanate has been contracting for the past three years. Total loans of commercial banks fell by 2.3% and 2.7% in 2009 and 2010 respectively, according to the IMF. In the first three quarters of 2011, this trend continued with the total loan portfolio appearing to contract in successive quarters.

While loan growth figures were not available for 2012 at the time of publication, figures for claims on the private sector by commercial banks from AMBD’s Monetary Policy and Management Department (MPM) suggested that the loan portfolio remained largely flat the year: claims on the private sector increased by 1.1% in the first seven months of the year, reaching BN$6.7bn ($5.2bn) in July. At the same time as loans have been falling, the sector has continued to amass deposits. In 2012 total deposits increased by 26.8% over 2010 levels, to BN$18.9bn ($14.7bn). The reduction in volume of the credit card business has also impacted the banks’ profitability, with the return on assets before tax falling to 0.9% by the third quarter of 2011 and the return on equity after tax diminishing to 6.2%. While these are still respectable returns, they have eroded substantially since 2009, when the return on assets was 1.4% and the RoE was more than 13.9%.

ASSET MAINTENANCE: While the 2011 RoE is above the European bank average of 7%, according to Deutsche Bank, it will remain a challenge for banks in the Sultanate to bolster profitability and earnings. The asset maintenance ratio and the requirements to keep assets onshore will present a tough proposition for the sector. While the banks argue that although it makes the cost of running their operations more expensive, it is a cost that they are more than willing to bear. According to Ho, “We understand it and there’s no reason to dispense with the rights and interests of depositors. It is important from the country’s perspective, with these funds onshore, that they be put to good use. We need to look at how we can leverage these funds to make sure that the country as a whole can benefit. We are looking at what the government does to stimulate interest.”

Currently, it appears the banks are struggling to find revenue-generating places to park their money. While the volume of foreign assets was brought down over the course of 2012, much of this money had been deposited with the AMBD. According to the MPM, claims on the AMBD by commercial banks have increased by 121.6% to reach BN$2.1bn ($1.6bn) from January to July 2012.

ISLAMIC BONDS: The opportunities for low-risk investments within the Sultanate are also limited, making it difficult for banks to place this excess liquidity. Islamic bond issuance ( sukuks), much of it issued by the government, has almost doubled in the six years to 2011, but it still remains at a low level of BN$991m ($709.5m), according to the MPM. Given the strong fiscal position of the government, with a budget surplus driven on by hydrocarbons revenues reaching 23.98% of GDP in 2011, there is little impetus to issue debt. While the government has increased its sukuk issuance, largely as an exercise in creating a benchmark, most of the issues have been short-term (under 12 months).

Indeed, the banking sector continues to hold little government debt. According to the MPM, the banking sector’s claims on the central government stood at BN$544.9m ($424.6m) in July 2012.

EXCESS LIQUIDITY: Therefore, the question for banks is what to do with the additional excess liquidity that these new regulations have produced. With the debt burden on consumers being reduced, the potential for growth in the retail segment will be moderated. According to Ho, “If we look at the demographics, we will generally be adhering to that growth rate within the personal segment.” With the population growing at a rate of 2% in 2010, this will not be that significant. Some 34.2% of the population is under the age of 20, which may help loan growth in the medium term, but the room for natural loan growth in the consumer segment is limited.

Nonetheless, with the size of operations within Brunei Darussalam and the nature of the economy, the banks cannot afford to turn their back on their retail portfolios. According to Lai, “Unsecured lending remains a significant core portfolio for the bank. The new regulations give advantages to payroll banks. Before, we banked with everyone, but now we are more selective and use differentiated services in order to win the business.”

EARNINGS POTENTIAL: Indeed, although the highrisk, high-interest-rate segment now has limited potential, there is still significant income earning opportunities given the strong interest rate spreads for the sector. According to AMBD, the spread between the 12-month deposit rate (0.443%) and the prime lending rate (5.5%) exceeded 5% in 2012, which is considered to be a very healthy margin on the benchmark rate set by the Brunei Association of Banks for commercial banks. Standard Chartered, which has traditionally had a large retail portfolio in the country, is looking at a number of ways to potentially offset any reduction in retail lending. For example, the bank announced plans to target employee banking services, providing structured domestic and regional staff benefit programmes for employees, just as it does in more than 20 countries.

For other banks, the credit card regulations have provided direct opportunities. Bank Islam Brunei Darussalam has benefitted directly from the new regulation by offering personal loans on the credit card debt that does not meet the new requirements, bundling it into a cheaper source of personal financing that must be repaid over a three-year period.

According to Ahmad, “From an insignificant player, we became a significant player in the credit card market.” Ahmad told OBG that the new personal loans associated with these credit cards have been performing adequately and that, “We did feel even at a rate of 4.75%, after financing even if it breaks even, we will do well to attract these customers.”

FEE-BASED INCOME: HSBC has refocused on debit card business and the income that this generates in fees. Ho told OBG, “We were able to support this government initiative without feeling the impact of the changes and the reaction from customers has been very positive.” Bank Islam Brunei Darussalam, which had a RoE above the average of the sector in 2011, has also begun to focus on fee-based income such as debit cards. This strategic shift towards feebased income has not fully been reflected in the latest data from the IMF, with interest earning assets remaining their share of income across the sector. The state of interest margin to gross income, across the sector, stood at 53.3% in 2011, with an even higher rate of 48.2% amongst Islamic banks.

Ho has also suggested that HSBC sees strong potential for growth in the mortgage market. Indeed, mortgage lending has been growing since the new limits were introduced on personal lending in 2005. That year, mortgages accounted for 12.5% of total loans across the sector, compared to 56.3% for other consumer loans. By 2011 mortgages had increased their share in the total loan portfolio to 19.2%, compared to 39% for other consumer loans. HSBC currently offers mortgages with a loan-to-value ratio of up to 80% with a maximum of BN$500,000 ($389,400). Loan tenors extend to 25 years, while the bank imposes a one-time BN$500 ($389) fee.

CORPORATE: With the squeeze on lending to consumers, many of the banks in Brunei Darussalam are turning their attention to growing their loan portfolio in other areas. As Lai said, “The first agenda is to ensure that we grow enough of other business. [The credit regulations] mean that most banks are looking at corporate clients.” As well as wealth management, Standard Chartered has focused on growing its business banking. Lending in the corporate segment inevitably mirrors the wider make-up of the economy. According to Lai, up to 60% of their corporate portfolio is in the oil and gas segment, with retail and warehousing providing the other largest loan portfolios. Corporate lending is capped by the single borrowing limit (SBL). The SBL is a function of the banks’ capital (20%), though exceptions of up to 50% are often granted with certain conditions. A bank can apply to the AMBD for an exemption, if it wants to exceed this limit, though instances of loan requests beyond the limit have been rare, according to conversations with bankers.

MORE GROWTH: One way that Standard Chartered bank is looking to grow its local loan book is by introducing start-up financing. The British bank would be the first in Brunei Darussalam to offer this service, a dramatic departure from its current strategy of only considering corporate customers with three years in operation or more. Lai told OBG, “It’s a huge leap of faith for the bank, but we know that it’s needed to help local development.” Beyond these efforts to stimulate, and benefit from, local private sector growth, the banks will be looking to their usual source of business – economic activity stimulated by government spending. Indeed, many of the banks have said that they are eagerly anticipating new opportunities as a result of the National Development Plan 2012-17. Lai told OBG, “Banks are interested in looking at what kinds of facilities we can give to support national development projects. A lot of development projects are going to be started soon.” With the government also keen to build local capacity, in terms of local employment and contracts for local companies, the opportunities for banks to grow both their retail and corporate lending should be strong. “With local business development at the back of their mind, we’ll see more support for SMEs in the next programme,” said Lai.

OUTLOOK: The banking sector is in a period of transition as the industry begins to adapt to a changed lending environment. The new AMBD has inherited a stronger regulatory environment, well placed to ensure that the country’s financial institutions are resilient in the face of any unexpected internal or external shocks and that depositors retain confidence in the security of their assets. While banks have been largely supportive of these measures and the rationale behind them, the profits experienced over the first decade are unlikely to be matched going forward. Nonetheless, even though there is excess liquidity in the sector, the banks continue to perform well with earnings that would whet the appetite of even the most optimistic investor. As such, the sector seems well placed going forward, even more secure thanks to its new regulatory environment. Even still it offers plenty of opportunities for the country’s banks for improvement and growth.