This article first appeared in The Edge Malaysia Weekly on April 24, 2023 - April 30, 2023

AS bank deposit rates move up to reflect rises in the overnight policy rate (OPR), Islamic lenders will feel the impact of tighter funding costs more so than their conventional counterparts, according to Moody’s Investors Service.

Moody’s expects deposit rates to continue to go up this year because of competition for deposits among banks and a shift among depositors to higher-yield term deposits, amid “elevated” interest rates.

“We are expecting the average net financing margin (NFM) for Malaysian Islamic banks to contract this year, driven by higher financing requirements and [depositors] shifting [their funds] to term deposits from CASA (current accounts and savings accounts),” its analyst Chong Jun Wong tells The Edge. He, however, did not provide an estimate on the extent of contraction expected, as Moody’s is unable to make specific projections.

In an April 17 report, Moody’s noted that with a rise in deposit rates in Malaysia as well as Indonesia, the impact of rising funding costs for Islamic banks will be greater than for conventional banks in these two countries.

It explains the reasons: “First, Islamic banks have larger funding requirements to cover faster financing growth, driven by policy support for the sector and growing public awareness and familiarity with Islamic products.

“In addition, the repricing of term deposits to reflect rises in interest rates will affect Islamic banks in Malaysia and Indonesia more than their conventional peers because they rely more on such funding.”

Indeed, last year, term deposits accounted for between 60% and 70% of total customer deposits at Islamic banks in Malaysia, compared with between 40% and 50% for their conventional counterparts. (See chart.)

Last month, the country’s largest standalone Islamic bank, Bank Islam Malaysia Bhd, acknowledged that its biggest challenge this year would be in managing funding cost. Its CEO Mohd Muazzam Mohamed told The Edge in an interview that the bank was considering raising funds this year via sukuk in a bid to manage its margins better.

Analysts have noted that although Bank Islam stands to be the biggest beneficiary of OPR hikes among Malaysia’s banks — it had the highest floating-rate financing ratio in the industry, at 91.6% as at end-2022 — the actual positive impact on the lender is much smaller because of the aggressive pricing of deposits in the industry, especially in the final quarter of last year. Hence, despite a hike of 100 basis points (bps) in the OPR last year, Bank Islam’s net income margin decreased to 2.18% in 4Q2022 compared with 2.3% a year earlier.

Nevertheless, Mohd Muazzam has said that the bank expects to sustain its margin at over 2.2% this year, which is above the industry average of about 2%, on the assumption that there will be just one 25bps hike in the OPR this year.

Bank Negara Malaysia, after having raised the OPR by 25bps four times last year to 2.75% in an effort to bring down inflation, has yet to make any changes to the rate at its first two monetary policy meetings this year. Its next monetary policy meeting is on May 2 and 3.

According to analysts, from the OPR hikes last year, the bulk of bank deposits will be fully repriced by the first half of 2023.

Maybank Investment Bank Research, in a March 6 report, notes that banks in Malaysia are generally guiding for a margin compression this year in the range of 5bps to 10bps on average. Public Bank, one of the largest beneficiaries of net interest margin expansion last year, was guiding for compression of more than 10bps this year.

Over in Indonesia, the largest Islamic bank, Bank Syariah Indonesia, is projecting that its NFM will contract by at least 20bps this year.

Moody’s notes that, between Islamic banks in the two countries, the impact of higher funding costs will be milder for those in Malaysia.

“In Malaysia, most Islamic banks are part of larger banking groups and are well integrated in their core operations. Major Malaysian banking groups have adopted ‘Islamic First’ strategies for growth, offering Islamic products first to all new and existing customers across all business lines. This helps the Islamic units of banking groups attract deposits without paying excessively high rates.

“Also, the bulk of financing at Islamic banks carries variable rates, which give them an advantage when interest rates rise,” it says. Moody’s Chong describes these as mitigating factors for Islamic banks in Malaysia.

He notes that, unlike Malaysia, the bulk of financing at Islamic banks in Indonesia is at fixed rates. As such, while banks can reprice part of fixed-rate financing periodically, any adjustments would lag rate hikes.

Asked what his main concerns were for Islamic banks in Malaysia amid a cloudy macroeconomic climate, Chong says: “Our view for Islamic banks in Malaysia is broadly in line with our view for the broader banking system, given that large Islamic banks are part of a larger banking group. Having said that, Islamic banks have a larger exposure to households and we expect low-income individuals to be more vulnerable to the economic slowdown and higher interest rate environment.”

He expects the earnings of Malaysian Islamic banks to remain “stable” from last year. “While margins will be strained, it will be offset by the absence of [last year’s] prosperity tax [on banks]. Based on the largest Islamic banks, their average return on assets for 2022 was around 0.85% on an asset weighted basis,” he says.

Moody’s said last month that it expects Malaysia’s economic growth to moderate to 4.5% this year from 8.7% last year due to a weakening of export demand. It expects system-wide loan growth to decline modestly to about 5% from 5.5% last year as “high interest rates will dampen credit demand”. It expects further policy rate hikes in 2023 given that inflation remains elevated compared with pre-pandemic levels.

Chong says financing growth for Malaysian Islamic banks, though likely to be lower this year compared with last year, will nevertheless continue to outpace conventional banks’ loan growth. “We are expecting financing growth for Indonesian Islamic banks to be the strongest in the Southeast Asia region in 2023,” he says. 

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