We are keeping our NEUTRAL stance on the sector. Although household indebtedness and corporate leverage rose in 2015, BNM was not overly concerned over its impact on financial stability, citing sufficient excess capital buffers to absorb potential losses. We generally concur with the Central Bank’s assessment that asset quality issues are unlikely to impact capital too adversely, but we believe credit cost remains on the uptrend – a factor that will likely see sector ROE moderate further in 2016.

Household indebtedness rose further to 89.1% of GDP in 2015 vs 86.8% in 2014 (2013: 86.1%). Despite the continued rise in household indebtedness, from a financial stability perspective, Bank Negara Malaysia (BNM) did not appear overly concerned due to the following mitigating factors: i) household financial assets to total household debt and household liquid financial assets to household debt were 2.05x (2014: 2.1x) and 1.42x (2014: 1.48x) respectively as at end-2015, ii) better credit risk management and underwriting practices, iii) share of borrowings by highly leveraged lower income households declined further to 23.6% in 2015 from 24.3% in 2014 (2013: 28.4%) of total household debt, iv) households that are already highly leveraged have more than half their borrowings in the form of fixed rate financing, reducing their sensitivity to changes in interest rates, and v) a significant proportion of household debt (>60%) is secured.

Domestic property market. Total exposure of Malaysian financial institutions to the domestic property market was MYR733bn, with c.90% of the exposurerelated to end-financing for the purchase of residential and non -residential properties. The Central Bank thinks the risk from the residential property segment is contained given the moderation in aggregate house price growth following various pre-emptive macroprudential and fiscal measures implemented since 2010 as well as continued initiatives to increase the supply of affordable housing. That said, BNM sees growing risk in the office space and shopping complex segments given rising vacancy rates, incoming supply and weak consumer sentiment. On the flip side, bank loans to the office space, shopping complex and hotel segments formed 3% of total bank loans, ie not too significant.Corporate debt/equity jumped to 46.8% in Sep 2015 from 41.5% in 2014.Part of the reason for the rise was due to foreign currency corporate debt, ie theweaker MYR as well as borrowings for investments overseas. Also, while overall business gross impaired loan ratio improved to 2.5% in 2015 from 2.6% in 2014, there have been pockets of weakness in some sectors mainly from real estate activities and palm oil sector. Banks’ exposure to the palm oil segment was 4% of total credit exposures while the oil & gas sector made up 2.2% of total credit exposures to businesses.

Investment case. We remain NEUTRAL on the sector, with Public Bank as our preferred sector pick as we like the group for its good earnings predictability,sound asset quality and cost efficiency, ie defensive qualities that we think should tide investors through a challenging year ahead. Valuations, however, appear fair currently. Our least preferred pick is AMMB. The bank’s net interest margins (NIMs) have fallen significantly (currently 1.97%) due to its portfolio rebalancing efforts, and are likely to continue drifting lower. We are concerned onthe levels to which its NIMs have dropped, especially amid soft capital market conditions and a turn in the impaired loan cycle.

2015 Financial Stability And Payment Systems Report Highlights BNM held a briefing yesterday in conjunction with the release of its 2015 Annual Report and Financial Stability and Payment Systems Report. We set out below the salient points from the briefing relating to the banking system .

Household indebtedness rose further to 89.1% of GDP in 2015 vs 86.8% in 2014(2013: 86.1%). The various macroeconomic prudential measures that BNM put in place in recent years appear to be taking effect, with growth in household debt moderating to +7.3% in 2015 from +9.4% in 2014 and +12.2% in 2013. We also note that the pace of expansion in personal lending by non-bank financial institutions (NBFIs) had slowed down with outstanding personal financing growing by MYR3bn in 2015 vs MYR4.4bn in 2014 and MYR10.2bn in 2013. Nevertheless, household debt expansion still outpaced GDP growth, leading to a higher household debt/GDP ratio.

Despite the continued rise in household indebtedness, from a financial stability perspective, BNM did not appear overly concerned. The Central Bank cited the following mitigating factors: i) household financial assets grew by MYR98bn in 2015 vs a MYR70bn increase in household debt. Household financial assets to total household debt and household liquid financial assets to household debt were 2.05x (2014: 2.1x) and 1.42x (2014: 1.48x) respectively as at end-2015, ii) credit quality remained sound – underpinned by better credit risk management and underwriting practices, iii) share of borrowings by highly leveraged lower income households declined further to 23.6% in 2015 from 24.3% in 2014 (2013: 28.4%) of total household debt, iv) households that are already highlyleveraged have more than half their borrowings in the form of fixed rate financing, reducing their sensitivity to changes in interest rates, and v) a significant proportion of household debt (>60%) is secured.

Domestic property market. Total exposure of Malaysian financial institutions to the domestic property market was MYR733bn, with c.90% of the exposure related to endfinancing for the purchase of residential and non -residential properties. The Central Bank thinks the risk from the residential property segment is contained given the moderation in aggregate house price growth (c.8% currently from 9.6% in 2010-2014) following various pre-emptive macroprudential and fiscal measures implemented since 2010 as well as continued initiatives to increase the supply of affordable housing. BNM also highlighted

that 70% of outstanding housing loans have a current loa n-to-value ratio of <80% while in terms of borrowers, c.84% of housing loan borrowers have only one outstanding housing loan, of which 88% are first-time home buyers. That said, BNM sees growing risk in the office space and shopping complex segments given rising vacancy rates, incoming supply and weak consumer sentiment. Bank loans to the office space, shopping complex and hotel segments formed 3% of total bank loans, ie not too significant.

Higher corporate leverage, partly from forex impact. As seen from Figure 4 above, corporate debt/equity jumped to 46.8% in Sep 2015 from 41.5% in 2014. Part of the reason for the rise was due to foreign currency corporate debt, ie the weaker MYR as well as borrowings for investments overseas. Also, while overall business gross impaired loan ratio improved to 2.5% in 2015 from 2.6% in 2014, there have been pockets of weakness in some sectors. For instance, impaired loans for real estate activities jumped to 1.5% in 2015 from 0.7% in 2014 while impaired loans relating to the palm oil sector surged to 1.2% in 2015 from 0.5% in 2014. Banks’ exposure to the palm oil segment was 4% of total credit exposure while the oil & gas sector made up 2.2% of total credit exposure to businesses.Slower deposit growth likely to be transitory. Finally, BNM pointed out that the slower growth in system deposits was due to the corporate segment while deposits from individuals have remained stable. The drop in deposits from corporates was due to factors such as investments abroad, the weaker MYR resulting in higher import cost and higher forex deposits. As banks continue to diversify their funding structure, BNM thinks the loanto-deposit ratio (LDR) may become less relevant while the loan-to-fund ratio (LTF) may be a better reflection of liquidity. The LTF has been relatively more stable at 83% vs LDR of 89%.

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

Forecasts No change to our earnings forecasts. We project underlying sector net profit to rise 4% YoY in 2016 (2015: flat YoY) on the back of operating income growth of 4% YoY.2016 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 be at a slower clip of 3% YoY as last year’s strong forex income (partly unrealised from forex positions) is unlikely to be repeated. We project loan-related fee income to moderate, in tandem with the slower loan growth ahead.

We expect 2016 operating expense growth to ease to 3% YoY, as the impact from the cost restructuring exercises in 2015 kicks in. This ought to result in t he cost-to-income ratio (CIR) trending down to 47.2% in 2016F from 47.8% in 2015.These, however, would be partly offset by higher loan impairment allowances (+21% YoY), as we project sector credit cost to rise to 40bps from 36bps in 2015.

We expect 2016 sector EPS, however, 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 10.7% from 2015’s 11.3%, as sector leverage continues to trend lower due to the Basel III capital requirements .

Investment case 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 12x and 1.2x, below their respective -1SD levels of 12.3x and 1.6x respectively.

While valuations may appear undemanding (sector P/BV is close to the global financial crisis (GFC) low of 1.17x), we believe that this is fair. This is as our 2016F-2017F ROEs of 10.6-10.7% are lower than the 12% ROE recorded during the GFC period.

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 (PBK MK, NEUTRAL, TP: MYR19.40) 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 AMMB (AMM MK, SELL, TP: MYR3.60). The bank’s NIMs have fallen significantly (currently 1.97%) due to its portfolio rebalancing efforts, and are likely to continue drifting lower. We are concerned on the levels to which its NIMs have dropped, especially amid soft capital market conditions and a turn in the impaired loan cycle.