KUALA LUMPUR (April 26): The outlook for Malaysia's banking system is stable over the next 12–18 months, according to Moody's Investors Service.

In a statement today, Moody's vice president and senior analyst Simon Chen said the key drivers of the Malaysian banking system's stable outlook were Moody's expectation that operating conditions will stabilise on the back of a gradual recovery in global growth, resulting in more stability in the banks' asset quality and profitability.

"The banks' strong capital and stable funding levels, and our expectation of a continued high degree of government support, also underpin our stable outlook for Malaysian banks," added Chen.

Moody's conclusions are contained in its just-released report titled Banking System Outlook — Malaysia: Stabilizing Asset Risks and Profitability, Strong Capital Drive Stable Outlook, authored by Chen.

The stable outlook is based on Moody's assessment of five drivers: operating environment (stable), asset quality and capital (stable), funding and liquidity (stable), profitability and efficiency (stable), and systemic support (stable).

With the operating environment, Moody's says operating conditions are stabilising, with the improvement in global growth, recovery of global commodity prices, and continued growth in domestic demand.

It said real GDP growth should register 4.3% on average in 2017–18, up from 4.2% in 2016, indicating that domestic economic activity will remain robust.

However, Moody's said ringgit volatility will likely persist because of further adjustment in capital flows, and will weigh on business and consumer sentiment.

On asset quality, Moody's report says asset risks are stabilising on the back of improving macroeconomic conditions.

"But the high leverage among corporates and households remains a tail risk, with risks mitigated by Malaysia's diversified economy and stable employment conditions," it said.

As for capital, the report said the banks will demonstrate stable capitalisation, as capital generation exceeds consumption, owing to moderate loan growth.

In particular, Moody's says the banks' capitalisation will remain sufficient to withstand asset quality shocks, even under various stress scenarios.

"With funding and liquidity, the banks will show stable funding and liquidity profiles because of benign credit growth, and despite a tightening in domestic liquidity from volatile capital flows. So far, the impact of fund outflows since late 2015 has been manageable for the banking system, with retail deposits maintaining robust growth and offsetting pressure created by institutional deposit outflows.

"Deposit competition among the banks remains healthy, and banks are positioned well to comply with Basel III liquidity coverage ratio requirements," it said.

As for profitability, the rating agency said that over the next 12–18 months, profitability will stabilise — as credit costs normalise from elevated levels — owing to stabilising asset risks.

However, it said margin pressure will persist because of keen competition for deposits.

On the issue of government support, Moody's report says the Malaysian government (A3 stable) will continue to demonstrate a strong capacity to provide support to the banks in times of stress, given its commitment towards fiscal reforms and a narrower fiscal deficit.

Moody's continues to view Malaysia as a high-support country, pointing out there have been no bank failures since Bank Negara Malaysia was established in 1959.

Moody's also noted that recent regulatory reforms have not suggested any shift in government policy on the resolution of ailing banks, outside of liquidation.

Moody's rates 11 banks in Malaysia: eight conventional commercial banks, one investment bank, one Islamic bank and one government-owned development financial institution.

The rated commercial banks accounted for around 80% of Malaysian banking system loans and deposits at end-2016.