This article first appeared in The Edge Malaysia Weekly on March 16, 2020 - March 22, 2020

AT the beginning of the year, banking stocks were starting to regain interest because they were seen to be relatively “cheap” and dividend yields were attractive at 5% to 6%. But that is no longer the case, owing to the tumultuous events of the last few months.

“We saw fund managers getting interested in banking stocks at the start of the year because the yields were really attractive. Then, all this happened. Now the interest is gone,” says a market observer.

The market observer is referring to the Covid-19 outbreak, which the World Health Organization has just labelled a global pandemic, as well as the plunge in crude oil prices and domestic political upheaval.

Do banks warrant attention once the volatility subsides?

One of the main concerns is the tighter net interest margins (NIM) that banks are facing in 2020. Following the two overnight policy rate cuts so far this year, the OPR now stands at 2.5%, the lowest in a decade.

There is also the expectation of another 25-basis-point cut in the OPR in May. Some see this as detrimental to the NIMs of banks.

While the margin compression may be temporary, it would still take some time before normalising as term deposits are only repriced after maturity while floating rate loans are immediately adjusted.

“Previously, it was only one rate cut a year. The issue now is that the rate cuts are sequential. If there is another rate cut in May, NIMs will further compress. It will take banks a longer time to recover from the compression, possibly six to nine months,” says an analyst with a local bank.

CGS-CIMB Research sees the OPR cuts as a negative for banks’ NIMs and net profit because for most banks, the size of floating rate loans is larger than the size of fixed deposits.

MIDF Research analyst Imran Yassin says in a report that 79.2% of the total loans of the nine listed banks, estimated to be valued at RM1.4 trillion, are floating rate loans. Meanwhile, total fixed deposits based on Bank Negara Malaysia’s data release for January stood at RM1 trillion.

Banks have guided that margins will be compressed by 5bps to 10bps as a result of the two rate cuts this year while analysts forecast profit to be affected by 2% to 3%.

In theory, a cut in OPR should boost loan growth, encouraging more spending and thus spurring the economy. On the other hand, it also means there is less incentive for people to save, given that deposit rates would also be reduced.

Would this then cause the loan-to-fund ratio (LFR) to become stretched?

LFR is a measure of a bank’s liquidity, and takes into account its total loans over deposits and debt instruments. The latest data as at end-January shows banks’ LFR at 83.4%. It has been hovering around 82% to 83% since 2019.

“I don’t think the LFR will become overly stretched. The sentiment in the market now is pretty cautious. Even if there are more rate cuts, I don’t see consumers being willing to commit to a car purchase or a house purchase at the moment.

“Business sentiment is weak too and not many are looking to spend on expansion at this juncture. It is hard to be sure that the interest rate cuts will achieve the purpose of spurring growth now.

“At best, it would probably help ease the burden of borrowers with lower interest rates,” observes an analyst.

This means that even with the interest rate cuts, lending growth is expected to be muted this year. This, in turn, means that banks will not be competing for deposits.

“Did you notice that there were significantly less fixed-deposit promotions in the second half of last year and this year?” asks another analyst.

According to Imran in his report, the requirement to meet the net stable funding ratio played a key factor in banks accumulating deposits in 2018 and the early part of 2019. Since they have shored up the necessary deposits to meet the requirement, he does not think there will be aggressive competition for deposits this year.

Imran also points out that deposit growth has been on a downward trend since the rate cut in May 2019. That month, fixed deposits grew 7.9% year on year. In January this year, growth was only 2.5% y-o-y.

AffinHwang Investment Bank Research believes that loan growth could slow further to 3% this year from 3.9% in 2019 on the back of economic uncertainty, the Covid-19 outbreak and political tensions, which will hold consumers and businesses back.

That said, analysts are monitoring asset quality closely. They agree that while there will likely be some deterioration in asset quality this year with the uncertain economic outlook, they do not expect the impact to be severe.

The gross impaired loan ratio for the banking sector crept up in January to 1.55%, from 1.51% in the previous month.

“What will help with asset quality is the moratorium period offered by the banks to businesses and individuals who are affected by Covid-19. With the facility for restructuring their repayment schedule, it will help with potential impairment,” notes another analyst.

AffinHwang IB Research says should the situation be prolonged for six months or more, banks may face the risk of higher default rates and may have to set aside more provisions for impairment.

“Based on Bank Negara’s statistics, the banking sector’s loan exposure to the wholesale and retail/restaurants and hotel sector stood at 7.3% as at January while manufacturing sector and transport sector loans are at 6.8% and 2.3% respectively,” it says in a recent report.

One analyst points out that another source of concern is the spillover effect from those who are infected by Covid-19, adding to the economic uncertainty.

Nevertheless, Hong Leong Investment Bank Research’s Chan Jit Hoong is of the opinion that households and corporations have sufficient financial buffer to withstand severe macroeconomic shocks. The household segment has assets, excluding housing wealth, in excess of 2.2 times of debt. Businesses have a debt-to-equity ratio of 24.9% and healthy interest coverage of 4.5 times.

Be that as it may, with muted loan growth, asset quality concerns and compressed earnings, the outlook for the banking sector this year appears dim at this juncture.

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