Banking Sector: Future Looks Brighter February 13, 2017
In 2017, we believe that the prospects for banks have become brighter, and we will be highlighting some of the key points in this article.
Author : Lee Tien Xiang

Banking Sector: Future looks brighter!
  • banks’ profit margin to improve on prudent spending measures, lower loan-loss provisions and better net interest spread
  • appetite for deposits returns likely to expand banks’ asset base and improve loan-to-deposit ratio; banks able to lend more
  • loosening lending standards allow banks to grow their loan portfolios; potentially more interest income going forward
  • headwind: subdued loan demand, amid cautious spending trend, to weigh on banks profit margin, but partially offset by better interest income growth and improving net interest margin going forward.

Two years back, we have issued a neutral outlook for the banking sector, part of it due to rising deposit rates, stringent lending standards, heighten concerns on potential increase of bad debts as well as significant overhead costs amid initiation of Voluntary Separation Schemes (VSS). Nonetheless, in 2017, we believe that the prospects for banks have become brighter. In the section below, we will be highlighting some of the key points that lead to our positive view on the banking sector going into 2017.

Things turn better for the banks

Profit margin to improve

Banks’ profit margins have been affected negatively over the past years. Yet, we expect the trend to reverse going into 2017. There are a few contributing factors. Firstly, during 2015, due to challenging economic environment, various banks have initiated voluntary exit options for their staffs. The hefty cost has impacted banks’ profits during 2015, and possibly 2016 (spill-over effect from 2015’s cost-cutting actions). Going into 2017, we expect the impact from these layoff schemes to subside, and along with the prudent spending measures taken by the banks over the past years, such as freezing headcounts and trimming operating costs, it is likely for the banks to be leaner going forward.

Secondly, non-performing loan (NPL) ratio remains fairly stable over the past years (see Figure 1a), even with the local and external headwinds surrounding Malaysia. This indicates the effectiveness of the banks in containing their bad debt exposure. Historical data showed that non-performing loan is trending downward (see Figure 1a). During 3Q 2016, total aggregate loan-loss provisioning for the banks has declined to RM1.08 billion, as compared to previous quarter’s RM1.55 billion (see Figure 1b). Likewise, capital strength of the banks, as represented by the Tier 1 capital ratios, also improved over the year (see Figure 1c). This implies that the banks could better protect against unexpected losses going ahead. With the expectation that the non-performing loan will not increase as sharply as the past two years, on improving O&G environment and better economic prospects, this year’s loan-loss provisioning is also likely to be lower compared to 2016. This will contribute positively to the banks’ profit margin for 2017.

Figure 1a: NPL to Total Loan ratio
Figure 1b: Provisions for loan losses (RM ’mil)
Figure 1c: Tier 1 capital ratio

Likewise, the overnight policy rate (OPR) cut by the Bank Negara Malaysia during July 2016, also contributed positively to the net interest spread of the banks. Typically, when there is an adjustment of benchmark interest rate by the central bank, the banks will subsequently alter their offered deposit rates and base rates, with the latter being done at a lagged time compared to the former. When the central bank cuts the OPR by 25 basis points last year, banks have reacted by lowering down their offered fixed deposit rates (see Figure 2), resulting in a decrease of their cost of funds. One might think that banks will also revise down their base rates subsequently, by the same magnitude. Nonetheless, the data showed differently. Information released by the central bank showed that over half of the 34 banks, that offered retail loans, reduced their base rates by 0.20 percentage point (%), with the average reduction being merely 0.16 percentage point (see Figure 3). The difference in the rates’ reductions, an average of 0.09 percentage point after the OPR cut, should allow the banks to achieve higher net interest margin on their loan portfolios going into 2017.

Figure 2: Malaysia 12M-average fixed deposit rate (%)
Figure 3: Base rate reduction (%) after OPR cut

Appetite for deposits returns

Another positive development within the banking sector is the comeback of deposit growth. Since 2014, individuals have been pulling out their monies, much of it in the form of fixed deposits, from the bank. This situation worsened when the oil price slump occurred, which led to further depreciation of the ringgit. At that time, the outflows have been redirected into foreign currency accounts, as reflected by the surge of demand in foreign currency deposit (see Figure 4, shaded region), or even into these individuals’ overseas accounts. As a result, total deposit growth slumped significantly. This has also caused a huge spike in banks’ loan-to-deposit ratio, despite the fact that the loan growth moderated during the said period amid dampened consumer sentiment and sluggish business activities.

Figure 4: Surge in demand for foreign deposit

Nevertheless, towards the 3Q of 2016, we have seen an improvement in the demand for fixed deposits (FD), implied by the positive growth in total deposits and FD deposits towards the end of 2016 after two-year of contractions (see Figure 5). The comeback of appetite for fixed deposit is likely to ameliorate banks’ asset base, leading to a better loan-to-deposit ratio, which will allow banks to lend out more funds going forward.

Figure 5: Asset base to expand with improvement in deposits

Banks loosen up on lending

Compared to early-2016, banks seemed to have loosened up on their lending, as reflected by the moderation in the year-on-year contractions of their loan approvals (see Figure 6). For the banks, big bulk of their revenues comes from the consumer group, with the purchases of big ticket items, such as property and vehicles, making up close to 40% of their overall loan portfolios. These respective segments have also witness moderations in their year-on-year lending’s contractions, as compared to the beginning of 2016. Loosening lending standards imply that the banks’ loan portfolios are likely to expand, and this will allow the banks to receive more interest income going forward.

Figure 6: Moderation in contractions of loan approval YoY growth

Headwind for the banks

One potential downside for the banking sector is the still-lagging loan growth (see Figure 7a) The impact is broad-based, with all of the banks experiencing a slowdown in loan demand throughout the past 3 years (see Figure 7b). Going forward, Malaysia will still be in a “rising-cost” environment and consumers are likely to spend cautiously. Thus, we expect the situation of modest loan growth to persist; loan growth to be at mid-single digit in 2017 (see Figure 5). Nonetheless, the negative impact arising from subdued loan demand is likely to be partially offset by the banks’ loosening lending standards, which will allow the banks to garner more interest income further down the road. Also, the widening net interest spread, which improves banks’ profit margins, should also help them in addressing this issue.

Figure 7a: Subdued loan growth
Figure 7b: Loan growth for banks moderated substantially over the years


Going into 2017, the banking sector is likely to see a turnaround with prudent operating expenditures, lower loan-loss provisioning and better profit margin. Improving economic activities, albeit gradually, should also fare well for the banking sector moving ahead. In terms of earnings, we expect the banks’ earnings estimates to experience upgrades this year, after two consecutive years of earnings downgrades in 2015 and 2016 (see Table 1); this should be a positive for the banks’ share prices going ahead. With the aforementioned key developments, coupled with the cheap valuations of various major banks (see Figure 8), we believe that the banking sector warrants an overweight call (which has been made in our Malaysia 2017 Outlook ).

Table 1: Earnings Revisions Over The Year


Source: Bloomberg, iFAST compilations as of end-January 2017

Figure 8: Banks remain cheap

Also, the banking sector, which constitutes close to 25% of the KLCI Index, is expected to do most of the heavy lifting for the KLCI Index, in terms of earnings growth. Referring to table 1, analysts in 2016 predicted banks to have earnings decline of -6.4% for the year of 2017. However, in last month, analysts have revised upwards that forecast to -0.4% earnings decline for banks in 2017. This bodes well for the overall market as the earnings drag by banking sector is expected to be minimal. As such, investors should not completely shun away from home-country investments. There are still hidden gems to be discovered, and active management and stock picking will remain to be the key investment themes for the local equity market.

For those who are interested in the banking sector, they could consider the conventional local equity funds (as compared to Shariah-compliant local equity funds), given that most of them will have some exposure to the banking sector. For those who prefer more weightage on this sector, they can consider the Eastspring Investments Equity Income Fund ; this fund has close to 21% allocation towards the banking and finance sector as of end-December 2016.

As for those who seek stronger growth opportunities within the local market, they could opt for those funds that have exposure to small cap segment, which presents relatively better upside potential. Some of the funds that investors could take into consideration are the Eastspring Investments Small-cap Fund and the KAF Vision Fund.

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