We keep our NEUTRAL call. We think the two areas that would hog the spotlight next year are asset quality and liquidity. In our view, local banks are heading into softer macroeconomic territory but may not have sufficient allowance buffers. Liquidity has also tightened. We expect banks to pay up for deposits, putting NIMs under pressure. On the flipside, the sector de-rating suggests concerns are partly reflected.

Spotlight ahead on asset quality and liquidity. The two key themes we see in 2016 for the sector are asset quality and liquidity.

Asset quality cycle – just the beginning? We expect asset quality to be among the forefront of investors’ concerns ahead. Banks are heading into softer macroeconomic conditions, amid above-average credit growth in recent years as households continue to leverage up. As for the business segment, weaker consumer spending and macroeconomic conditions, coupled with low commodity prices, are potential factors that may impact asset quality ahead. Even more disconcerting, sector loan loss coverage (LLC) has dropped to 83% in 3Q15 (2014: 90%, 2013: 94%). This raises concerns that banks may not have built up sufficient loss coverage as we enter the soft patch ahead. Potentially, early signs of stress may have surfaced. 3Q15 sector impaired loans rose 7% QoQwhile loan impairment allowance surged 57% QoQ. Even banks that are domestic-based saw a sizeable rise in impaired loans.

System deposit growth has softened significantly (September: +5.4% YoY) due to, among others, capital outflows and weaker ratio (LDR) had risen to 91% at end-3Q15 (2014: 87%), a level unseen since the Asian Financial Crisis (AFC) days. Baring a sharp reversal in capital flows, we expect system deposit growth to moderate further due to weaker macroeconomic conditions.

Bottomline growth remains challenging. We expect the above factors to constrain asset growth, keep net interest margins (NIMs) under pressure and see credit cost rise ahead, all of which we have modelled in our numbers. That said, banks’ earnings are more sensitive to credit cost and NIMs, and we think downside risks to earnings would likely stem from these two factors.

Forecasts. We project underlying sector net profit to rise 5% YoY in 2016 (2015F: flat YoY) but sector ROE is expected to be diluted further to 10.9% (2015F: 11.3%), as sector leverage continues to trend lower due to the Basel III capital requirements.

Investment case. We remain NEUTRAL on the sector, with Public Bank (PBK MK, NEUTRAL, TP: MYR19.00) as our preferred sector pick while CIMB (CIMB MK, SELL, TP: MYR4.15) is our least preferred pick.

Investment Summary Sector headwinds yet to subside Two key themes for the sector in 2016: i) asset quality, and ii) liquidity. The two key themes we see in 2016 for the sector are asset quality and liquidity. Banks’ earnings are more sensitive to factors such as credit cost and NIMs. While our earnings projections are generally below consensus, we think downside risks to forecasts outweigh the upside risks, especially if macroeconomic conditions pan out to be weaker than expected.

Asset quality – concerns unlikely to subside anytime soon We continue to believe banks’ asset quality may be heading for a softer patch ahead,on the back of: i. A softer macroeconomic front. Domestic demand is expected to decelerate, given weaker consumer spending, lower oil prices and a weaker currency environment, among others.

ii. Stronger credit growth post the Global Financial Crisis (GFC) has raised household leverage. Asset quality for the mass segment has deteriorated. System loan growth post GFC (the 5-year CAGR of 11.3% vs pre-GFC growth of 8.9%) as households took on more leverage. Consequently, household debt to GDP jumped to 86.8% at end-2014 from 60.4% at end-2008, rising further to 88.1% as at August. This leaves households vulnerable to interest rate, unemployment and/or inflation shocks, in our view. As for the business segment, weaker consumer spending and macroeconomic conditions, coupled with low commodity prices, are potential factors that may impact asset quality ahead.

iii. Little scope for lending rates to drop. One potential reason that may help explain the resiliency of domestic asset quality is the current low interest rate environment. The average lending rate of commercial banks stood at 4.54%. However, with global interest rates on the rise, the sharp depreciation of the MYR and falling ROEs faced by banks, we see little scope for lending rates to ease significantly from current levels. Indeed, during the recent 3Q15 results quarter, some banks said that lending yields for new loans have been repriced up due to funding cost pressures.

iv. Banks drawing down on coverage buffers recently raises risks of negative surprises for credit costs. Sector LLC has dropped to 83% in 3Q15, as compared to 94% end-2013. Thus, we are concerned that Malaysian banks may not have built up sufficient coverage buffers as we enter the soft patch ahead. Already, credit cost for banks has ticked up (3Q15: 39bps vs 2Q15: 27bps, 3Q14: 18bps) but, with impaired loans also trending up, coverage levels have yet to improve meaningfully. We think loan allowances are likely to continue to rise in the quarters ahead. This is because banks would need to rebuild coverage levels and/or in the event of further deterioration in asset quality.

Retail-focused banks in a better position to weather asset quality cycle. In our view, the retail-focused banks would offer a safer hideout for investors. Firstly, household debt is largely asset-based (70% of debt backed by assets). Secondly, LLC levels for these banks are relatively higher, at over 100%. We believe the downside risks are more significant for corporate-focused banks, given the nature of business non-performing loans (NPLs). More importantly, the drop in sector LLC noted above was largely caused by corporate-focused banks drawing down on coverage buffers. The LLC for these banks are significantly lower and range between 61% and 93%. Among the banks under our coverage, we see higher risks for Affin Holdings (Affin) (AHB MK, SELL, TP: MYR1.90), CIMB and Malayan Banking (Maybank) (MAY MK, NEUTRAL, TP: MYR7.80) to asset quality issues ahead, given their low LLC levels, among others.

System deposit growth likely to remain under pressure aheadDeposit growth has softened significantly. September system deposits growth slowed down to 5.4% YoY, as compared to +7.6% YoY as at end-2014. This was the result of the moderation in deposits from financial institutions and business enterprises. Factors that could have contributed to the weaker deposit growth from these groups include, among others, capital outflows and weaker underlying economic activities, in our view.

Thus, system LDR had risen to 91% at end-3Q15 from 87% at end-2014 while sector LDR increased to 92% from 89% over the similar time period. Previously, the banks had guided for a target LDR range of 85-90% but, due to the weakness in deposit growth, increasingly, we gathered that the banks have shifted the range to 90-95%. We also understand that despite the higher LDR banks are currently operating at, liquidity coverage ratios (LCR) remain comfortably above the minimum regulatory requirements. Baring a reversal in capital flows, we expect system deposit growth to moderate further due to weaker macroeconomic conditions. While deposit competition generally affects all banks, we think Affin and AMMB (AMM MK, NEUTRAL, TP: MYR4.20) may be more vulnerable to tighter liquidity conditions. This is due to their high LDR and relatively weaker deposit franchises. Pressure on income growth likely to persist, but forex and cost management initiatives to help cushion pressure

Looking ahead, we expect income growth will be challenging given the macro headwinds. A number of banks have toned down their loan growth expectations. This is due to a combination of macroeconomic conditions and is a bid to preserve asset quality and tighter liquidity conditions. We project for 2016 system loan growth to ease further to 6-7% (2015F: 7.5-8.5%, 2014: 9.3%). Meanwhile, NIMs remain under pressure as liquidity tightens and on the back of more stringent liquidity coverage ratio requirements. This ought to keep competition for deposits keen. We also note banks raising longer-term debt instruments, which we believe is to help lengthen the duration of liabilities as well as to beef up Tier-2 capital. Collectively, we see these factors to continue driving up funding cost.

In terms of non-interest income, we think markets-related income may be hampered by the volatile bond yield movements as well as subdued capital markets. Forex income, however, has been a bright spark for banks thus far . This is because the volatile exchange rates should be positive for both forex volumes and spreads. 2016 should also see the full impact of the cost management initiatives undertaken by several banks this year, which would help to cushion some of the pressure on income growth. Capital fund raising – CIMB the next in line?

The past four years have seen the top five banking groups all raise capital. Heading into 2016, the spotlight could turn to CIMB and AMMB in terms of potential banking groups that may need to raise capital. The fully-loaded CET-1 ratios for CIMB and AMMB stood at 9-9.1% and 9.1% respectively, the lowest among the banks once Hong Leong Bank (HL Bank) (HLBK MK, SELL, TP: MYR11.70) completes its MYR3bn rights issue. Between the two, we think CIMB is at greater risk of a capital call as, chiefly, AMMB appears to have more room to optimise its risk weighted assets (RWA). AMMB’s RWA to total assets is estimated to be more than 75%, as compared to CIMB’s c.65%. We estimate CIMB may need to raise MYR4bn-6bn in order to raise its CET-1 ratio to 10.5-11% (based on its capital position as at 30 Sep).

Risks We think the key downside risk to our forecasts lies with a sharper-than-expected deterioration in asset quality, which should then impact credit costs. Apart from that, income growth is also a risk and this could be due to: i) weaker -than-expected NIMs arising from competitive pressures on both the asset yields, and ii) funding costs and/or softer-than-expected non-interest income, which would be attributed to adverse market conditions. Key upside risks include benign asset quality, an upturn in capital market activities as well as better-than-expected NIMs, which could be due to loan repricing and/or surge in liquidity.

Forecasts We project underlying sector net profit to rise 5% YoY in 2016 (2015F: flat YoY) on the back of operating income growth of 5% YoY. 2016F net interest income is expected to rise by a modest 4% YoY, with loan growth of 7% partly offset by 7bps NIM compression. Non-interest income growth is expected to remain relatively stable at 6% YoY. We expect 2016F operating expense growth to ease to 3% YoY, as the cost restructuring exercises in 2015 kick in. This ought to result in the cost-to-income ratio trending down to 47.5% in 2016F from 48.3% in 2015F. These, however, would be partly offset by higher loan impairment allowances (+21% YoY), as we project sector credit cost to rise to 37bps from 33bps in 2015F. 2016F sector EPS, however, is projected to rise by a more modest 2%. This is due to dilution from 2015’s capital-raising exercises and ongoing capital preservation initiatives. Similarly, 2016 sector ROE is expected to be diluted further to 10.9% from 2015’s 11.3%, as sector leverage continues to trend lower due to the Basel III capital requirements.

Valuations and recommendations Despite the challenging banking environment ahead, we are keeping our NEUTRAL sector call. The sector currently trades at 2016F P/E and P/BV of 11.3x and 1.2x, below their respective -1SD levels of 12.4x and 1.6x respectively. While valuations may appear undemanding (sector P/BV is close to the GFC low of 1.17x), we believe that this is fair. This is as our 2016F-2017F ROEs of 10.8-10.9% are lower than the 12% ROE posted back during the GFC period.

Given the challenging macroeconomic environment, we like banks that offer strong and predictable book value growth to continue creating shareholders value. This would entail a combination of superior returns, sound earnings predictability (eg less reliant on markets-related income) and/or solid asset quality. Also, banks with relatively lower market risk should aid in insulating book value against adverse bond yield and foreign exchange rate movements. Public Bank meets the criteria above and is our preferred pick, although we think upside potential may be capped by valuations that appear to have priced in much of the positives. Our least preferred pick is CIMB. Although the full impact of the cost savings from the restructuring of its investment bank (IB) and mutual separation scheme (MSS) exercise should be felt in 2016, we expect loan provisioning to remain elevated, dampening bottomline growth. We also believe the risk of another capital call has risen significantly, as returns in recent quarters have been impacted by restructuring costs and loan impairment allowances.

Two Themes For Banks In 2016 – Asset Quality And LiquiditySector headwinds yet to subside Two key themes for the sector in 2016 – asset quality and liquidity. The two key themes we see in 2016 for the sector are asset quality and liquidity. Banks’ earnings are more sensitive to factors such as credit cost and NIMs. While our earnings projections are generally below consensus, we think downside risks to forecasts outweigh upside risks, especially if macroeconomic conditions pan out to be weakerthan expected.

Asset quality – concerns unlikely to subside anytime soon Asset quality deterioration becoming more pronounced. We continue to believe that asset quality would be among the forefront of investors’ concerns as we head into 2016. During the recent 3Q15 results, sector absolute gross impaired loans rose 7% QoQ and 11% YoY, while loan impairment allowance for the quarter surged 57% QoQ and 158% YoY. This was led by higher provisioning made by Maybank. Also, we had noted in previous quarters that the asset quality deterioration was mainly from overseas operations while domestic asset quality appeared to be holding up quite well. This time round, however, even banks that are predominantly locallybased, such as Affin, Alliance Financial Group (AFG) (AFG MK, NEUTRAL, TP: MYR3.45) and AMMB saw a sizeable sequential increase of 9-13% in impaired loans. We set out below four key reasons for our concerns regarding asset quality ahead.

Four reasons why we believe asset quality is heading for a soft patch i) No smooth sailing on the macroeconomic front. We expect domestic demand to decelerate to +5.1% in 2015, followed by a further moderation to +4.4% in 2016, as compared to +5.9% in 2014. Consumer sentiment remains weak from the implementation of the good and services tax (GST). Apart from that, the sharp depreciation of the MYR ought to likely result in a transition period, as investors and consumers adjust themselves to the new weaker currency environment. This would cause them to delay some of their spending, as imported prices feed into the economy. Finally, rising job uncertainty is likely to cause consumers to remain cautious on spending. At the same time, the impact of lower oil prices on oil & gas investments and government spending is expected to continue to constrain the growth of domestic demand. These would likely be compounded by the earlier policy tightening over the last two years to cool down property speculation, which would likely continue to be felt in the economy.

Overall, we expect Malaysia’s real GDP to slow down to 4.8% in 2015 from 6% in 2014, easing further to 4.5% in 2016. We envisage consumers and businesses to emerge from the difficult GST transition period stronger while the external environment gradually recovers from a slowdown this year. That said, we see downside risks to our growth forecasts and remain cognisant that the global growth is entering a seventh year of the current growth cycle in 2016, the late cycle of an economic growth. Also, further unforeseen volatility in the financial and commodity markets could weaken Malaysia’s economic prospects, posing a downside risk to our forecas

ii) Strong credit growth post GFC as households leveraged up Banks are expected to enter the soft macroeconomic patch ahead after having enjoyed strong credit growth in recent years. System loan growth post the GFC stood at 11.3% (5-year CAGR), as compared to the 5-year growth rate of 8.9% during the pre-GFC period and an average growth of 7.8% in the previous decade. The pickup in growth in recent years was underpinned by lending to the household segment and ,consequently, household debt to GDP jumped to 86.8% at end-2014 from 60.4% at end-2008, rising further to 88.1% as at August. With household leverage at a high, we believe there is little room to move in the event of interest rate, unemployment and/or inflation shocks. At this stage, we do not foresee a spike in these indicators but, nevertheless, expect the banks’ credit underwriting standards to be tested in the coming months ahead. Already, asset quality for the mass segment has deteriorated.

Source: RHB Research - 9 Dec 2015