Malaysia’s Liquidity Conundrum - New liquidity metrics may ease concerns on liquidity and hold off the need for monetary easing

KEY POINTS

• Concerns over shrinking liquidity due to tight funding conditions in the banking system may have been one of the reasons that prompted BNM to recently introduce two new liquidity metrics
• The Loan to Fund ratio (LFR) and Loan to Fund & Equity ratio (LFER) reflects the wider avenues available for funding instruments which largely led to more moderate deposit rate growth
• Comparatively the LFR and LFER are lower than the commonly referred to Loan to Deposit ratio (LDR), indicating that technically banks still has ample liquidity
• Once the new liquidity metrics becomes widely acceptable to measure banks’ short-term financing viability it would invariably ease pressure to raise deposit rates
• As the pressure to raise deposits gradually dissipates it may allow the transmission mechanism of the monetary policy to gain better traction and reaffirm BNM’s current accommodative monetary stance
• Unless the shrinking liquidity issue persists, another SRR cut looks unlikely in the near term.
• A possibility of an OPR cut is still dependent on the state of the economy which still looks rather murky. Our base case for no change in the OPR for the year remains.

 Overview

Managing liquidity constraint. In an effort to address system wide liquidity pressures in the banking system Bank Negara Malaysia (BNM) has been using a few tools in its capacity as a lender of last resort to influence the availability of liquidity in the banking system. Apart from the lending and borrowing in the open market, such as repos and reverse-repos, the bread and butter of the liquidity management during normal times, it made a surprise cut of the Statutory Reserve Requirement (SRR) by 50 basis points (bps) to 3.50% on 20th January. Releasing an estimated RM6.3b worth of funds it further added to the total of about RM40.0b which BNM said it has added into the system since early 2015 till Jan 21 this year via its regular monetary operations to offset the impact of net external outflows. So far it has brought about little impact to the Loan Deposit ratio (LDR). Though the LDR had come off slightly from its recent record high of 90.4% in August last year, it has inched up back to 89.0% in January from 88.7% in the preceding month, reflecting the continued dearth of supply of available funds in the banking system.

New liquidity metrics. In its December 2015 statistical bulletin BNM introduced two new liquidity metrics; Loan to Fund ratio (LFR) and Loan to Fund & Equity ratio (LFER) in addition to the long-established LDR (refer to Table 1). The LFR appears to be an expansion of LDR with the additional “fund” component comprising of deposits plus all debt instruments which includes subordinated debts, debt certificates/sukuk issued, commercial papers and structured notes. Meanwhile, the LFER is an extension of LFR as well as incorporating “equity” which comprises of ordinary and preferred shares as well as share premium and retained earnings.

Liquidity constraints. Though the introduction of the new metrics seems to be done rather unassumingly, it was timely nonetheless. The main reason, we believe, is to address seemingly unfounded concerns of the constant quarter-end and year-end build-up frenzy of deposits, a staple of banks’ source of funding to generate interest income. Perhaps another reason can partly be attributed to banks’ overzealous compliance to the Basel III minimum capital adequacy and liquidity requirements,

driving banks to aggressively amass deposits. As a result, the industry liquidity coverage ratio (LCR) has overwhelmingly exceeded or over two times (130%) the Basel III requirement of 60% for 2015 (The aim is to reach a minimum of 100% by 2019). With the supply of funds for deposits running low, growing at a sharply moderate pace of 0.9% YoY in January, its lowest in almost 16 years, loans still growing by a decent 7.7% YoY, it’s no wonder that LDR has remain elevated at a decade high of 89.0%. Higher LDR would limit loans growth and put downward pressure on banks’ net interest margins (NIMs) as they compete for deposits by raising deposit rates.

New approach – re-educating bankers. Perhaps the conventional approach and tools may require some time to have a meaningful impact. Not to question the effectiveness of the tools applied by BNM so far, we believe that the central bank

may want to try a different approach to deal with this purported shrinking liquidity issue. This may involve practically changing the way bankers approach in measuring liquidity and managing their balance sheets. And trying to change the long-standing practice in the way bankers’ measure liquidity in the banking system could be tough. On the other hand, we expect it could be less challenging as banks are already complying with the more demanding Basel III minimum liquidity requirements.

Broader funding base. With the new expanded definition on the liability portion of the liquidity ratio comparatively the LFR and LFER are much lower than the commonly referred to LDR, indicating that the banking system technically has more resource balance than initially realised. This is because it takes into account the wider avenues available for funding instruments, which invariably result in more moderate deposit growth. While the LDR is 89.0% for January 2016, the LFR and LFER are 83.3% and 74.7% respectively. The ratio gap between the LDR and the new liquidity metrics would mean tentatively more funds could be extracted for lending purposes or based on our calculations that would amount to about RM154.0b (Please refer to the latest Banking Sector Update Report).

The rationale. Nonetheless the introduction of the new ratios could not have been timelier. Concerns over liquidity deficit in the banking system, due to occasional tight funding, may have been one of the reasons that prompted BNM to introduce the new metrics to measure liquidity in the banking system. But more importantly BNM is fully aware that the LDR may no longer be the most suitable indicator for assessing liquidity in the domestic banking system given the structural changes that have taken place over recent years. “While deposits remain a primary source of stable funding for the Malaysian banking system, banks have gradually broadened their funding sources by raising funds in the capital market. As such the increase in the LDR is a natural consequence of deeper domestic capital markets and well-developed, maturing banking system with more diversified funding sources.” 1

Changing the perception. Though it may take some time to educate the financial institutions to accept and adopt the new metrics we expect it would gradually bring about a positive impact on the actual state of liquidity in the banking system. The lower LFR versus LDR indicates that banks have ample liquidity especially now that the source of funds apart from plain vanilla deposits includes a wider range of debt instruments and repos. With repos the cost of funds are relatively lower as assets are collateralised; more effective to address short term liquidity issues especially when banks’ faces resource shortfall in their balance sheet.

Interest Rate Outlook

Strengthens monetary policy signal. More importantly, once the new liquidity metrics becomes widely acceptable to measure banks’ short-term financing viability it would invariably ease the pressure to raise deposit rates. This would reduce cost of funds and help improve banks’ NIMs and boost profitability.

Minimise the need to cut SRR. Once the perception of tight liquidity is being address and the market realise that this is only a temporary condition then there is no need for BNM to reduce the SRR. Unless the shrinking liquidity issue persist, another SRR cut looks unlikely in the near term.

Accommodative monetary policy intact. As the pressure to raise deposits gradually dissipates it may allow the transmission mechanism of the monetary policy to gain better traction and reaffirm BNM’s current accommodative monetary stance. However, a possibility of an OPR cut is still dependent on the state of the economy which still looks rather murky. Based on our study there is still room for BNM to cut rates if the economic growth continues to deteriorate. But the probability remains low for now. Our GDP growth forecast for this year is 4.5%, slower than 5.0% last year on account of slower global growth, lower commodity prices and weak emerging economy led by China. We also view the external sector of the economy to continue to be weak and unable to generate the demand required for growth to turn around. Nevertheless, we are not expecting BNM to make changes to the OPR this year, even if the US Fed decides to further hike rates this year subsequent to the first one in December last year. Hence, our base case for no change in the OPR for the year remains. 

Source: Kenanga Research - 10 Mar 2016