The next step: Regulatory reforms have laid the groundwork for further expansion

The Malaysian banking system is characterised by strength: its eight main institutions are well capitalised, stress tested and solid, while the country has some of the most satisfied banking customers in the world. After a number of years of consolidation and in an environment of tight regulation, Malaysia’s commercial banks have continued to improve and have become better able to withstand shocks. Regulation was further tightened and refined in 2013, and the measures implemented promise to make the banks more resilient, more transparent and better managed. Smaller businesses remain underserved, because they are risky and expensive to analyse, and certain types of debt have hit worrying levels, but these gaps and concerns have been and are being addressed.

Sound Sector

According to Bank Negara Malaysia, the central bank, the country has a total of 27 licensed commercial banks. Of these, eight are local and the rest are foreign. The country also has 16 Islamic banks and five international Islamic banks. In a stress test conducted in early 2014, the central bank found that the banks would be able to hold up even if the system faced shocks greater than those in the 2008 financial crisis. The test assumed a six-fold increase in the probability of default, a 330-basis point increase in government bond yields and 30% fall in real estate prices. Bank Negara found that under the hypothetical conditions, the capital adequacy of the commercial banks would drop to a still comfortable 10%.

The IMF has also positively reviewed the Malaysian banking system. In its 2014 Financial Sector Assessment, it said that the banks have strong enough capital buffers to withstand significant credit losses. It added that many of the banks have a good first line of defence in terms of domestic and foreign earnings. In Bloomberg’s list of the World’s Strongest Banks, published in 2014, local firm Maybank was number 17. In late 2013 the World Bank noted that the sector was well regulated and able to handle risk. José de Luna Martínez, a senior financial economist at the bank, said in public comments that the Malaysian banking system was a success story.

Stable Ratings

Moody’s weighed in in May 2014 with its “Banking System in Malaysia Outlook”, for which it examined all eight of the country’s domestic commercial banks. Citing the strong economy, the ratings agency was optimistic about the stability and growth of these institutions. It also noted improvements in asset quality and a low impaired loan ratio. According to Bank Negara, the impaired loan ratio was 1.3% in April 2014, down from 1.9% in February 2012.

Fitch affirmed the stable rating on three banks in late 2013: Hong Leong, AmBank and Maybank. It cited regulatory measures put into place as a reason for its optimism, saying that while these measures may slow growth, they will help strengthen the sector.

More Regulation

The Malaysian banking system is rated as one of the best regulated in the world, and supervision is being increased and improved. Malaysian banks have been ordered by Bank Negara to increase their collective assessment (CA) ratio to 1.2% by the end of 2015. The ratio was previously called the general provisions ratio and was set at 1.5%, but after new accounting standards were adopted it became known as the CA ratio and banks were allowed to pick a level that they believed would cover their risks. In most cases, the level chosen was under 1.2%. According to CIMB research, four banks had CA ratios under 1.2% as of September 2013: Maybank, Public Bank, Affin Bank and Alliance Bank. Analysts had argued that a lower CA ratio would reduce cost of funds and ultimately increase profitability, but the central bank thought the higher level was justified in the face of strong credit growth, according to analysts quoted in the local press.

The biggest recent change in regulation has been the passage of the Financial Service Act (FSA) in June 2013. The act supersedes all relevant legislation: the Banking and Financial Institutions Act 1989, the Insurance Act 1996, the Payment Systems Act 2003 and the Exchange Control Act 1953. It greatly increases the power of the central bank and broadens its mandate. Now all financial institutions, including the hire-purchase, adjusting, factoring and leasing businesses, are regulated by the bank under one law. The central bank can remove officers, directors and senior managers, and intervene in operations if good governance is in question. Strict liability is introduced, and an increased level of disclosure is required of corporate officers.

Bank holding companies are included in the list of regulated entities, and this is a major change that will have a significant impact on the sector. The central bank has the power to examine their operations and intervene in their management and corporate structuring; this includes veto power over acquisitions and capital raisings. CIMB Group Holdings, RHB Capital, the Hong Leong Financial Group, AMMB Holdings, Affin Holdings and the Alliance Financial Group are holding companies likely find themselves regulated by the FSA.

Foreign banks are exempt from the holding company regulations, as that would require the central bank to exercise extraterritorial powers. A number of banks, including Public Bank, the Hong Leong Financial Group and AMMB Holdings will be grandfathered in and exempt from a rule limiting individuals to 10% ownership in a single institution.

Additional Reform Implications

While the new FSA has the potential to lead to increased scrutiny of existing banks, it also presents an opportunity to change the sector in other ways. Non-bank financials could find themselves forced to restructure, and that could have an impact on the sector, positive or negative. Under the FSA, these institutions, which have essentially been able to be banks without a banking licence, will be regulated by Bank Negara. No changes need to be made right away, but if the central bank believes that these institutions pose a systemic risk, it can force them to undertake significant restructuring. This could include increasing capital, merging, changing management or adjusting the business mix. The result could be the creation of new players, and thus more competition for commercial banks; it could also lead to more discipline and soundness in the non-bank sector, which could reduce competitive pressures.

MBSB is a good example. Formerly the Federal Building and Colonial Building Society, founded 1950, MBSB is an exempt finance company, operating like a bank but to different standards. For example, the company classifies loans as being non-performing only after six months, rather than the three for banks, and its capital ratio is lower than that of the commercial banks. Significantly, the company’s personal loan book has grown rapidly in recent years, with the majority of its loans outstanding now being of this type. Mortgages are currently less than 20% of MBSB’s book. The company has raised capital through a rights issue and has discussed in the press the possibility of a merger or of getting a banking licence. In 2013 a merger between MBSB and RHB was mentioned in the local press, but no transaction ever materialised.

Household Debt

Despite their basic strengths, Malaysian banks are facing some headwinds. In November 2013 ratings agency Standard & Poor’s cut its outlook on four Malaysian banks due to concerns about household debt. The firm said a high level of borrowing at CIMB, AmBank, RHB Bank and RHB Investment Bank could lead to a deterioration in asset quality.

After the 1997-98 Asian financial crisis, the regulator reduced the number of local banking institutions from 50 to 10. This “more oligopolistic” structure, combined with prudent regulation, has led to outsized returns since then, according to an analysis published in Edge Malaysia. It adds that the banking system is well capitalised and has high-quality assets. The Edge does say, however, that the push for stability has led to some practices that may prove to be a problem for the sector over the longer term. The banks tended, after the 1997-98 crisis, to focus more on loans to individuals. It was believed that a portfolio of personal loans, especially loans for housing, would lead to a more diversified and stable book.

While this has generally been true and the asset side of the banks’ balance sheets have been strong, household debt has increased to levels that are too high for the system overall. The household debt-to-GDP ratio hit a record 86.8% at the end of 2013, up from 80.5% a year earlier and the highest in South-east Asia. According to Bank Negara’s annual report, household debt grew annually at the rate of 12.7% in the decade through 2013, while GDP grew 10.4% per year in that time. The bank noted that higher leverage is found in households earning less that RM3000 ($931) per month. Household debt is seven times annual income.

According to Malaysian Rating Corporation, the household debt to service ratio (DSR) hit 43.5% in 2013, up from 39.1% in 2006, while the rating agency added that the financial asset to debt ratio was 2.2%, down from 2.7% in 2007. Fitch worries that rising interest rates could eventually begin to squeeze the borrowers, while debt repayments themselves could become a drag on economic growth.

Secured

The central bank does not believe these levels represent a major systemic risk. It notes that the DSR for new household loans has fallen to below 40% and says that households have plenty of assets, on average, to balance their liabilities, that delinquencies are low, that credit analysis and risk management at the banks have improved, and that employment conditions are good. Fitch notes that most of the household debt is concentrated in mortgages, with personal loans making up only 8% of all household debt and 4% of banking sector loans; 80% of all loans to individuals are secured. The rating agency adds that the strong employment market and strong economy overall are helping to support repayments of household debt. According to the Sun newspaper, demographic changes such as young people moving to the cities are responsible for much of the demand.

Macroprudential

Bank Negara has been instituting macroprudential measures for three years to get the growth in consumer lending under control. It began in 2010 with a 70% loan-to-value (LTV) ratio cap for mortgages. In July 2013 the central bank reduced the maximum tenure of personal loans to 10 years and for home loans to 35 years, and it placed a blanket prohibition on pre-approved personal loan products. In late 2013 more measures were announced. The central bank said that in 2014 interest capitalisation schemes, in which homebuyers are relieved of interest costs during the construction of their property, would no longer be allowed. Under the Developer Interest Bearing Schemes (DIBS), for example, the developer bundles the construction-phase interest into the total price. In the late 2013 round of macro-prudential measures, the bank also said that it would require mortgages and the LTV calculation to be based on the selling price, net of any discounts, add-ons and freebies. In addition, it said that these extras must be disclosed when offering properties.

In early 2014 calls were made to lift some of the macroprudential restrictions. The government of Penang, for example, said that because of the ruling against DIBS and the shortening of the maximum mortgage tenure from 45 years, many first-time home buyers are unable to get bank financing. Critics argue that because wages are not keeping pace with inflation, debt is the only way for young people to afford homes. Penang’s authorities are intervening to help property buyers. Under its Shared Ownership Scheme, the state government offers interest-free loans of up to 30% of the property price. Politicians have been particularly vocal in their opposition to central bank policies that make it more difficult to buy a home.

Lending Effects

The macroprudential measures, according to Fitch, seem to be taking hold. Growth in household debt was 11.7% in 2014, down from 13.5% a year earlier. But there is growing concern that the measures will begin to hurt the banks. As a result of the macroprudential policies, analysts are expecting slower loan growth in 2014. Alliance Bank research sees the rate dropping from 10.5% in 2013 to 9.5% in 2014. RAM forecasts 8-9% loan growth, from 11% in 2013, while CIMB puts growth in 2014 at 9.5-10.5%.

Strong fundamentals and demand should underpin growth and stop it from falling too much. The Economic Transformation Programme is also expected to provide additional opportunities for the banks. Analysts point to the Klang Valley Mass Rapid Transit, the West Coast Expressway and the Refinery and Petrochemicals Integrated Development as among the projects supporting loan growth through 2014.

Little Consolidation

The Malaysian banking market has not seen any mergers and acquisitions (M&As) in recent years. At this point there are no longer commercial reasons for banks in the country to combine, and neither the government nor the regulators want to force any transactions. Public Bank may be the best possible target, given its attractive market position, but it would be expensive (because of its high price-to-book ratio) and difficult, as Teh Hong Piow owns 24%. In its first major corporate action since a stock issuing a decade ago, the company recently undertook a restructuring in which it merged its foreign and local shares into one listing. It seems that the manoeuvre was not particularly significant, as all shares in the bank have been freely tradeable by both locals and foreigners for a number of years. “The central bank says it would like to see more consolidation,” said David Chong, a banking analyst at RHB. “But if it is left to the market, it is tough to justify more domestic M&A. The focus has been to expand overseas.”

Interest Overseas

Malaysian banks have long been in a good position to make regional acquisitions. They have solid capitalisations and good businesses, so they can afford to buy overseas. They also lack significant opportunities at home. Rates are low, the market is highly competitive and the products are mature and highly advanced. Foreign banks, therefore, make interesting targets for them. Additionally, the rise of the ASEAN Economic Community (AEC) compels banking institutions to form regional networks. However, the pace of overseas acquisitions has slowed considerably in recent years. Investment banking and brokerage deals have been concluded, but pure bank acquisitions have been slow in coming.

In part, this is the result of a backlash in some countries. Indonesia has felt that regional economies were not reciprocating in terms of openness, so it capped the foreign ownership of banks at 40%. This has led to stalled deals. RHB Capital, for example, has been trying to buy Indonesia’s Bank Mestika Dharma for four years, but had to cut its proposed stake from 80% to 40% after the new limits came into force. As of June 2014, the Malaysian banking group had yet to decide whether it would complete the deal.

Malaysia has been discussing the liberalisation of its banking markets for a number of years, but foreign investors are still limited to owning 30% of conventional domestic banks. Foreign banks are also limited in the number of additional branches they can open (four), the locations of branches, and the distance between branches and local banks, according to the US State Department’s 2013 Investment Climate Statement. Islamic banks can be up to 70% foreign-owned.

While some Malaysian banks have been able to get a foothold in Indonesia and the Philippines, all major banks lack a key piece of the ASEAN puzzle. Thailand remains particularly difficult. Maybank has never been able to get a true banking presence there, though in early 2013 it said that it would open a branch in the country in 2014 and would be seeking acquisitions.

Small Company Financing

The other challenge long faced by Malaysian banks is the financing of small companies. Because of the emphasis on safety, and because Malaysian banks are so large, local institutions have traditionally been more focused on larger corporates and on households. But this is fast changing. The low interest rate environment has compelled many of the commercial banks to start to consider more lending to start-ups, traders and small businesses. Meanwhile, data available for servicing these clients have improved and a good deal of institutional knowledge has developed within the banks themselves.

“A lot of larger banks lose sight of the SME segment,” said Tan Hong Ian, senior vice-president of Alliance Financial Group. “We see there is a gap, a part of the market that is largely underserved.”

Overall, the country is seen as doing an excellent job of providing necessary loans. In the World Bank’s “Doing Business” series, Malaysia was ranked first globally in the “getting credit” category. The study noted that the country has far more credit records as a percentage of total individuals and companies when compared with economies both regionally and globally.

Outlook 

The Malaysian banking sector is strong and sound. Business is good, the institutions are well capitalised, and the regulator is active and steadily increasing its involvement in the sector. Macroprudential measures will help the country get its household debt under control while SME financing is likely improve over time. The vision of creating a regional banking giant remains unfulfilled for the time being, and it is unlikely that large acquisitions will occur that will allow Malaysia’s larger institutions to add the missing pieces inorganically. Nevertheless, organic growth opportunities exist and banking targets may become available from time to time, allowing some of Malaysia’s larger players to cobble together a regional footprint.