The Malaysian banking system is at its strongest — thanks to lessons learnt and foundations put in place after previous crises — but is it enough to overcome an unprecedented calamity that has upended economies the world over?

Bank Negara Malaysia deputy governor Jessica Chew does not discount that the risks are great and recognises that “the challenges ahead will be significant” for the banking system, but she points out that banks are going into this crisis from a position of strength.

“There is certainly no question that the banking system today is far more resilient than at any time in its history. A lot of it has been because of reforms we have put in place after the Asian financial crisis [AFC] — that was a bitter pill for us and we took major steps to reform the banking system, but we didn’t stop there,” Chew tells The Edge in an exclusive interview last Tuesday.

“We believe the reforms were good for the banking system and they will stand us in good stead for exactly a situation like what we are in now. It does put us in a position to endure quite a bit of pain ... probably a substantial amount of pain.”

Data from 2019 shows that the banking sector had a total capital ratio of 18.4%. It has excess capital of RM121 billion versus RM39 billion in 2008 and is capable of withstanding potential credit and market losses.

The sector recorded a common equity tier-1 capital ratio of 14.4% and gross impaired loan ratio of 1.6% in February this year. Liquidity continued to be ample with a liquidity coverage ratio of 148.0%. The loan loss coverage ratio stood at 125% at end-February compared with an average of 120% from 2015 to 2019.

Notably, economists tend to agree with Chew. They also believe that the financial system’s capital and liquidity buffers at the current levels are strong enough to cope with the Covid-19 pandemic, which has inflicted shocks on both the economic and health systems in the country.

Lee Heng Guie, executive director of the Associated Chinese Chambers of Commerce and Industry of Malaysia’s Socio-Economic Research Centre, observes: “During the 1997/98 AFC, Malaysian banks needed to be recapitalised, owing to a deep economic recession and overexposure to the overheated property and share markets, which had tumbled because of the severe regional currency crisis.

“Since then, Malaysia’s financial system has built a strong capital base to withstand major economic shocks and absorb potential losses, thanks to enhanced risk management, liquidity management, assets-liabilities management as well as asset quality management.”

When the time of testing came in the form of the 2008/09 global financial crisis (GFC), the country’s banking system was “unscratched”, Lee recalls.

While the effects of Covid-19 are expected to be more severe than previous crises, Lee believes the banks’ substantial capital and liquidity buffers will help them survive this economic downturn.

For perspective, the excess capital of RM121 billion is 3.1 times larger than it was during the GFC. As such, the banking system is in a stronger position to absorb losses in the current crisis, says Dr Yeah Kim Leng, professor of economics at Sunway University Business School.

In the central bank’s financial stability review (FSR) simulations, in severe stress scenarios, potential losses from household debts at risk are estimated at 42.6% to 67.5% of banks’ excess capital buffers.

Yeah says this means that, in order to shake the banking system, the downside will have to double in intensity.

Doubtless, the banking system is a vital part of the economy, as it holds the country’s financial system together.

Currently, credit extended by the banking system to firms and households amounts to RM1.77 trillion, or 117% of the country’s gross domestic product (GDP) in 2019.

Commenting on the importance of the country’s banking system, Yeah says: “A troubled banking system will cause a deeper recession as the country had experienced during the 1998 AFC, where the economy contracted 7.5%. By contrast, the recession was shallower at -1.5% in 2009 during the GFC. A weak banking system certainly impedes economic recovery, as evident in advanced countries hit by the GFC. Owing to a robust banking system, Malaysia recorded a strong growth rebound of 7.4% in 2010.”

Bank Negara had earlier introduced measures such as the automatic loan moratorium for businesses and individuals to ease cash flow pains that could arise during this crisis. It has also undertaken two rate cuts this year, cutting the overnight policy rate to 2.5%.

UOB economist Julia Goh notes that these measures have been among the key stabilisers for the economy, as stress mounted with the extension of the Movement Control Order (MCO) amid ongoing global supply-and-demand shocks.

“Interest rates are much lower and more stable today, with greater flexibility in exchange rates than during the AFC, when interest rates saw a sharp spike that worsened NPLs [non-performing loans] and intensified economic stress,” Goh says (see “Expect NPLs to rise”). “The main concern today is the extent of the economic weakness and the shape of recovery post-MCO.”

Untested waters
Indeed, the banking system is in a stable position, but the banks’ playbook all these years may not be as useful in an untested environment clouded by a pandemic.

A key challenge for banks now will be to monitor the credit developments in their portfolio, Chew says, reasoning that, for a period of six months at least, banks will not be able to observe payment behaviour because of the moratorium.

“Banks will need to be a lot more agile in how they approach credit monitoring and credit assessments. For example, they will need to go beyond their usual sources of information to size up developing risk within their portfolios ... and we do see the banks that we supervise doing this,” she says.

Citing examples, Chew says banks are observing the facility utilisation rates of their customers and how operating account balances are developing, as well as reaching out to small and medium enterprise (SME) clients and engaging them on recovery plans.

Acknowledging that the country is in unchartered territory, she points out that this is where Bank Negara’s stress tests come in.

“Ultimately, it’s very hard to predict where a hit or a shock is going to come from and you don’t have much control on how the shocks will transmit and evolve. We do stress tests precisely to give us the ability to see where these pressure points could be and, regardless of the source of the crisis, we want to know that banks will be able to respond.” She adds that the banks are much more agile than before in responding to the current crisis.

While the severity of the impact of Covid-19 on the economy and banking system has yet to be determined, looking at past crises, Malaysia fell into a recession in 1985, with GDP contracting 1% that year.

The unemployment rate rose to 5.6% in 1985 and 7.4% in 1986. The NPL ratios of commercial banks hit a high of 30% in 1987 and 1988.

The government then embarked on a contractionary fiscal policy and devalued the local currency. There was also an emphasis on promoting foreign direct investment in the economy. New prudential regulations were introduced in the financial sector in 1989.

For 2020, Bank Negara has forecast that GDP growth will be between -2% and 0.5%. Meanwhile, unemployment is expected to rise to 4% this year.

In the central bank’s most recent macro stress test, two recession scenarios are assumed: a V-shaped one, where negative growth is followed by recovery; or an L-shaped one, where there are four years of negative growth (a scenario never before experienced by Malaysia).

In the extreme L-shaped scenario, which assumes an NPL shock of five to six times the NPL levels of 1% today (compared with the AFC, when NPLs rose three times their pre-stress position), the banking system as a whole still has a sizeable buffer, with the total capital ratio falling to 12.5%, which is still comfortably above the 8% regulatory minimum. In 2019, the capital ratio stood at 18.3%.

“That gives you a sense of the resilience of the banking system,” Chew says, but quickly adding that it is a “highly fluid situation” and the regulator is not complacent, although it is comfortable with the results of the stress tests.

“This crisis is both difficult and complex to balance between health and economic considerations. It is global in nature and we don’t fully understand the epidemiology as well. There is still a lot of uncertainty, so we do need to keep our ear to the ground and make sure we understand what is happening ... The only way to do that in this environment is through direct engagement with the banks and the banks with their customers,” she says.

Asked about red flags resulting from the stress tests on banks, Chew says there are none at this point in time.

“All the banks are well capitalised. We do see that they are aggressively and proactively managing their loan books. Many of them are going out of their way to reach out to their borrowers to understand their recovery strategies and understand their business profile — how that will change post-Covid-19.”

Chew expects to see more loan modifications during this period.

“With the moratorium and relief measures taken, we are reasonably optimistic that many businesses, certainly not all, have the prospect of coming out of the crisis and being able to continue to service their loan obligations. What the banks do during these six months will be quite critical,” she says.

As the AFC spurred a banking consolidation, will the current crisis spark off mergers and acquisitions in the sector?

“We leave that [M&A] to market forces, so we will see how things go. It is not a policy prescription. For some smaller institutions, we don’t rule that out,” Chew says.

“Compared with the AFC, it is night and day in terms of the resilience of banks, the larger banks especially. They went through consolidation; that was a policy-induced consolidation then because we saw a critical need to strengthen domestic institutions. We’re not in the same situation as then, so we very much leave it to market forces.”

Fair-weather friends?
Indeed, as a new normal has emerged from this crisis, banks will have to be agile and adapt.

They will have to review underwriting approaches and assumptions around income, particularly for the foreseeable future, as businesses are going to take a while to adjust to and restart in the new environment, Chew predicts.

“It is an opportunity for banks to tap into segments and new businesses. In this new environment, there will be new opportunities.”

Banks also need to manage their credit portfolio and credit risk in this environment so they can respond pre-emptively to mitigate the cost, she adds.

Chew believes the support that borrowers need is being extended by the banks at this point, but the regulator stresses the importance of banks continuing to lend.

“We don’t want to see excessive risk aversion in the economy at this point in time, as that can amplify the risk that the economy is facing. It is important that they have strong buffers, and that will reduce their risk aversion substantially.” She adds that it is imperative for banks to work with existing borrowers so that there is no subsequent shock to the banking system.

Chew expects banks to see some impact on earnings this year and the next, as loan growth will be slower and credit cost is likely to increase in the current environment.

The regulator does see opportunities for banks over the long term. “This is the chance for banks to build more enduring customer relationships and not be a fair-weather friend. Their borrowers and customers are going to remember how they were treated and supported during this challenging period,” she points out.

Nevertheless, bank analysts have cut their earnings forecast for the sector.

In a recent report, Credit Suisse says that, over the past month, it has lowered its FY2020 to FY2022 net profit estimates for banks by between 8% and 14% on average. In its revised forecast, it factored in lower loan growth, more net interest margin compression, higher credit cost in anticipation of a pickup in default rates and lower non-interest income, as the slowdown in capital market activity and slower loan growth are likely to result in lower fees.

Meanwhile, CSG-CIMB Research has reduced its net profit forecasts for Malaysian banks by 8% for FY2020F and 12% to 13% for FY2021/22F since Feb 13, as it factored in the 125 basis point cut in the overnight policy rate expected by their economist and lowered its projected loan growth by four percentage points for all banks.

This is to reflect the negative impact from Covid-19, which will dent credit demand and dampen economic growth, it adds in an April 30 report.

Following the earnings cuts, the local research house projects a decline of 5.8% in CY2020F net profit for the sector, from an increase of 3.2% previously.

The local economy is expected to contract this year with business activity almost at a standstill since the start of the Movement Control Order (MCO) on March 18. The country has lost about RM63 billion in revenue since then, Prime Minister Tan Sri Muhyiddin Yassin announced last Friday.

Even as businesses look forward to the lifting of some of the restrictions under the MCO this week, it is a given that they will not bounce back quickly as consumers are still cautious about venturing out of their homes.

As such, it is worth considering what will happen after Sept 30, when the automatic loan moratorium extended to businesses and individuals ends. Will we see more defaults in the near future?

“In this environment, yes, we should expect to see NPLs (nonperforming loans) rise because there will be businesses that will continue to face difficulties,” states Bank Negara Malaysia deputy governor Jessica Chew.

Nevertheless, she points out that the NPL levels for the banking system is at a historical low now. As at end-February 2020, the gross impaired loan ratio for the banking sector stood at 1.57%.

“With low NPL levels and strong buffers backing the banking system, that does [stand] the system in good stead to manage the challenges,” says Chew.

Dr Yeah Kim Leng, professor of economics at Sunway University Business School, believes that delinquency rates might start to edge up slightly even during the loan moratorium period, and potentially spike after it ends.

“As social and business activities are shut down and movements restricted to contain the virus spread, the loss of business income and retrenchments are expected to contribute to the rise in loan defaults.

“The defaults are likely to escalate after the moratorium period, especially if the over-leveraged companies or individuals are unable to continue servicing their debts due to continuing business losses and layoffs,” says Yeah. He adds, however, that a stress test by the central bank has indicated that the banking system can absorb such losses if they materialise.

The 2H2019 Financial Stability Review (FSR) report by Bank Negara released in March highlights that household debt levels had moved up to 82.7% of gross domestic product compared with 82.2% of GDP at the end of June last year. Meanwhile, corporate debt levels had inched down to 99.4% of GDP.

However, how high the delinquency rate will be is a question no one can answer.

Bank Negara’s Chew comments that it is “really very hard to predict” how high NPL levels may rise at this juncture, but she believes there will be more visibility and insight into the situation in a few months’ time.

“But we certainly don’t expect impairments to rise to a level that will threaten financial stability, for all of the reasons we mentioned before. The strong buffers, better quality of loan book and institutional arrangement are all in place to manage the risk of defaults.

“All of these will be critical factors and they put us in a strong position to manage any impact from NPLs,” she explains.

While the risk of higher delinquencies is present, Chew points out that corporate borrowers have been shown to have an interest coverage ratio that was in aggregate 4.6 times as at end-2019, based on the review that was done before the escalation of the Covid-19 situation. She says this is above the prudent level, which is typically about two times.

Even the segments that the central bank has flagged as facing high credit risk — such as oil and gas, palm oil, construction, wholesale retail and trade — registered an interest coverage ratio of above three times.

“Obviously, that picture may change because of the challenges we are facing but they are going into the crisis based on this matrix with financials reasonably healthy. Now, it is about how they adapt,” Chew states.

The small and medium enterprise sector, which has become a concern since the start of the MCO, has seen improvement in terms of its credit profile over the years.

“Some years back, it was about 4%; now the impairment ratio is about 2.7% for the sector. But, this was before Covid-19,” she says.

On the household sector, the FSR report states that household assets have continued to outpace its debts. Meanwhile, the debt-at-risk from the sector remains low at around 5.2% of total household debt.

As many wait in trepidation to see the effects after Sept 30, the hope is that the banking system will continue to be run like a well-oiled machine, with everything in place.

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