We see BNM’s move to raise provisioning levels as a proactive and prudent step in ensuring that banks have sufficient buffers in place as we  head  towards  a  period  of  higher  inflation  and  interest  rates.  In  our view,  the  change  will  have  an  impact  on  CET-1  capital  and,  possibly, dividend  payouts,  but  total  capital  and  earnings  should  be  intact. Maintain OVERWEIGHT, as the banks are a good proxy to the economy.

Bank Negara Malaysia (BNM) is requiring banks to set aside higher buffers.  BNM’s  issued  letter  requires  banks  to  maintain,  in  aggregate, collective impairment allowance (CA) and regulatory reserves of no less than  1.2%  of  total  outstanding  loans/financing,  net  of  individual impairment allowance, by 31 Dec 2015.

Is  this  new?  The  requirement  to  hold  additional  regulatory  reserves  is not  new  but,  perhaps,  not  widely  publicised.  In  its  2011  guideline “Classification  and  Impairment  Provisions  for  Loans/Financing”,  BNM stated  that  it  may  require  banking  institutions  to  maintain  additional regulatory reserves for a period and manner it determines. We note that CIMB Bank has been maintaining a regulatory reserve since 2Q10.

Which  bank  is  impacted  the  most?  At  this  stage,  the  feedback  we gathered  was  mixed  as  to  whether  the  new  ruling  applies  to  the  local regulated  entity  (ie  entity  level  only)  or  on  a  group  basis.  Either  way,  it appears that Public Bank (PBK MK, NEUTRAL, FV: MYR18.70), with an estimated  MYR1.1bn  CA  shortfall,  will  be  impacted  most.  As  for  the others, the impact does not appear to be too significant.

What  will  PBK  need  to  do?  First-off,  it  will  need  to  decide  whether  to top-up  its  MYR1.1bn  shortfall  via  a  one-time  transfer  from  retained earnings to regulatory reserve or a series of (smaller) transfers until the 2015 deadline. The end impact? Its book value remains unchanged but the transfer from retained earnings (CET-1 capital) to regulatory reserve (Tier-2  capital)  will  reduce  its  CET-1  ratio  by  an  estimated  53bps  (at group  level  and  assuming  one-time  transfer)  but  total  capital  remains unchanged. Beyond that, PBK will likely need to continue topping up its regulatory  reserves  via  periodic  transfers  from  retained  earnings. However, these transfers will be significantly smaller than the initial one-time  adjustment  and  the  impact  to  capital  is  not  expected  to  be significant,  by  our  estimates.  For  now,  PBK  is  keeping  to  its  45% dividend payout policy for FY14.

Investment case. We remain OVERWEIGHT on the sector as the banks are well poised to benefit from the pickup in GDP expected for this year, underpinned by the various economic programmes. Maybank (MAY MK, FV:  MYR11.40),  Hong  Leong  Bank  (HLBK  MK,  FV:  MYR16.60)  and CIMB  (CIMB  MK,  FV:  MYR8.90)  are  our  BUYs.  The  impact  from  the higher required provisioning buffer is also minimal for them.

Raising provisioning buffers

BNM has issued a letter requiring banks to maintain, in aggregate, CA and regulatory reserves  of  no  less  than  1.2%  of  total  outstanding  loans/financing,  net  of  individual impairment allowance or:

Banking institutions will need to meet this requirement by end-2015.

Is this a new requirement?

The  requirement  for  banks  to  hold  additional  regulatory  reserves  is  not  new  but perhaps,  not  widely  publicised.  In  BNM’s  2011  guideline  “Classification  and Impairment Provisions for Loans/Financing”,  the central  bank  had  stated  that  it may require banking institutions to maintain additional regulatory reserves for a period and in a manner as it determines. We also note that CIMB Bank has been maintaining a regulatory  reserve  as  part  of  shareholders’  equity  since  2Q10.  This  serves  as  an additional credit risk absorbent reserve and stands at MYR1.4bn (at bank level) as at 30 Sept 2013.

Possibly, BNM’s move to  raise  the  provisioning  buffer  may  have  been  prompted  by the  trends  in  recent  years.  While  system  loan  growth  has  stayed  relatively  resilient, the  CA  ratio  (CA/gross  loans  less  individual  allowance)  has  declined  significantly, 
especially  from  2012,  when  all  banks  fully  adopted  the  MFRS139  accounting standard. We believe the lower CA ratio may be partly justified by the improvement in asset  quality.  However,  with  the  non-performing  loans  (NPL)  cycle  likely  having bottomed out, and as we head towards a period of higher inflation and interest rates, the  central  bank  appears  to  be  taking  a  proactive  and  prudent  step in ensuring  that banks  have  sufficient  buffers  in  place  to  meet  any  potential  asset  quality  issues ahead

Relative  to  regional  peers  (see  Figure  3),  the  total  loan  provision  set  aside  by Malaysian  banks  appear  reasonable.  That  said,  we  do  note  that  provisioning practices are more conservative in certain countries, eg Singaporean banks set aside 0.9-1.3% of gross loans for collective allowances.

Which bank is impacted the most?

At  this  stage,  the  feedback  we  gathered  was  mixed  as  to  whether  the  new  ruling applies to the local regulated entity (ie entity level only) or on a group basis. However,  either  way,  it  appears  that  Public  Bank,  with  an  estimated  MYR1.1bn  CA shortfall,  will  be  impacted  the  most  by  the  requirement.  Coincidentally,  when  Public Bank  moved  to  full  adoption  of  MFRS139  back  in  2012,  excess  CA  of  MYR1.1bn (MYR859m after tax) was written back to retained earnings.

While  we  estimate  a  MYR302m  shortfall  for  CIMB  Bank  (see  Figure  4),  this  should not  be  an  issue  after  we  take  into  account  its  regulatory  reserve  of  MYR1.4bn. We are  not  overly concerned with respect to Maybank Islamic’s shortfall,  as  its  capital needs should be easily covered by parent company Maybank. As for the others, the impact does not appear to be too significant.

What will affected banks need to do?

For banks that face a shortfall, there are two possible options in our view, namely: i) topping-up  directly  its  CA  to  the  required  minimum  of  1.2%,  or  ii)  topping-up  to  the minimum 1.2% via a combination of CA and regulatory reserve.

While there may be potential tax benefits from the first option, we think this is a less likely scenario. Firstly, this may contravene accounting standards that require banks to  set  aside  CA  based  on  historical  incurred  losses,  as  the  1.2%  is  a  regulatory requirement and, accounting-wise, this may need to be treated separately. Secondly, based  on  CIMB  Bank’s  experience,  we  note  that  its  regulatory  reserve  entails  a transfer from retained earnings.   

Thus, following from the above, we think the second option is a more likely scenario. In  addition,  CIMB Bank’s accounting treatment for its regulatory reserve suggests that  this  option  will  not  impact  earnings  as  it  merely  involves  a  transfer  of  reserves within the shareholders’ funds. We use this option and Public Bank as illustrations for the rest of our discussion below.

First-off, Public Bank will need to decide whether to top up its MYR1.1bn shortfall via a  one-time  transfer  from  retained  earnings  to  regulatory  reserve  or  a  series  of (smaller)  transfers  until  the  end-2015  deadline.  Either  method  will  reduce  retained earnings  but  result  in  a  corresponding  increase  in  regulatory  reserve,  leaving  book value  unchanged.  However,  as  retained  earnings  are  recognised  as  CET-1  capital and regulatory reserves are classified as Tier-2 capital, the resulting effect will be to lower CET-1 capital while total capital remains unchanged.  

Beyond  that,  and  assuming  a  one-off  transfer  is  done  and  the  CA  ratio  does  not change significantly, Public Bank will likely need to continue topping-up its regulatory reserve  via  periodic  transfers  from  retained  earnings.  However,  these  transfers  will be significantly smaller than the initial one-time adjustment and the impact to capital is not expected to be significant, by our estimates. 

As at 31 Dec 2013, we estimate a fully-loaded CET-1 ratio of 8.4% for Public Bank at bank level. Adjusting for the required transfer to regulatory reserve, we estimate this ratio will fall further to 7.7%. Assuming management targets a CET-1 ratio of 9.5%, ie within  the  9-10%  range  that  peers  have  cited  as  comfortable  CET-1  ratio,  at  bank level, we estimate Public Bank will need to raise MYR3bn in equity (4.5% of current market  capitalisation).  At  this  juncture,  we  understand  that  management  is  still waiting for further details from BNM with respect to various further capital buffers (eg countercyclical  buffers)  that  it  may  require  banks  to  hold.  Upon  further  clarity,  the group will proceed with its capital-raising plan. In terms of dividends, management is keeping to its 45% dividend payout guidance for FY14 for now. 

Risks

The  risks  include:  i)  slower-than-expected  loan  growth,  ii)  weaker-than-expected NIMs,  iii)  a  deterioration  in  asset  quality,  and  iv)  changes  in  market  conditions  that may adversely affect investment portfolio.

Forecasts

No changes to our earnings forecasts.

Valuations and recommendations

We  remain  OVERWEIGHT  on  the  sector,  as  the  banks  are  well-poised  to  benefit from the pickup in GDP expected for this year, underpinned by the various Economic Transformation  Programme  (ETP)  initiatives.  We  see  both  Maybank  and  CIMB  as excellent  proxies  to  the  ETP  and  key  beneficiaries  as  capital  markets  improve. However,  Indonesia’s  challenging  macroeconomic  conditions  remain  a  bigger dampener for CIMB than Maybank, as contribution from Indonesia makes up 31% of 9M13 pre-tax profit for CIMB vs 7% for Maybank. However, we continue to view any sharp  selldown  in  CIMB  as  an  opportunity  to  buy.  As  for  Hong  Leong  Bank,  we expect  growth  to  accelerate  now  that  its  post  merger  restructuring  activities  are largely  done.  Our  Top  Picks  are  also  not  expected  to  be  significantly  impacted  by BNM’s move to raise provisioning buffers.

Source: RHB