The Malaysian banking industry is drifting. The country's banking incumbents are well capitalized, enjoying historically low ratios of nonperforming loans (NPLs) and credit costs for its domestic loan book, and stable market share. However, S&P Global Ratings projects the banks' loan growth in 2019 to be half the level it was four years ago, and that profit will disappoint yet again amid a declining net interest margin.

Malaysian banks' loan growth has stayed in single digits (4%-6%) for the past three-and-a-half years, amid domestic policy uncertainties and slow external growth. The banks are battling on multiple fronts: trade war, a China-led regional economic slowdown, dampened domestic business sentiment, and continuously soft commodities prices. Moreover, the lenders need to contend with the possibility that financial technology (fintech) may radically disrupt their industry, just as they are shaving costs.

While such factors don't yet affect our ratings--we maintain a stable outlook on all the Malaysian banks we rate--we believe it's critical to flag the issues. Malaysia's incumbent lenders are facing cyclical and secular pressures that may slowly erode their financial standing if not addressed.

The Global Trends Buffeting Malaysia

We project Malaysian bank loans will grow 3%-5% in 2019, about half the growth achieved in 2015. We also expect the industry's net interest margin will contract 5-10 basis points in the year, following cuts to the policy rate and heated domestic competition for deposits.

Chart 1

Bank Negara Malaysia trimmed the policy interest rate by 25 basis points in May, and we expect one more interest rate reduction this year. The U.S. Federal Reserve's more accommodative monetary policy has given room for regional central banks to ease policy, weighing on margins.

Chart 2

Malaysia's small, trade-dependent economy is exposed to global stresses. China is Malaysia's main trading partner and the Southeast Asian economy is affected by China's economic deceleration. The Sino-U.S. trade war hurts the Chinese economy and, therefore, Chinese consumption of Malaysian imports.

We see particular weakness in Malaysia's tech-oriented exports to China. An ongoing slowdown in the regional electronics and trade cycle is already affecting Malaysia's tech sector.

Chart 3

Malaysian banks' direct exposure to exports and electronics manufacturing sectors tends to be small. However, we expect the trade war will have meaningful spillover effects to the domestic economy, where Malaysian banks have a significant stake.

Chart 4

Chart 5

While current bad loans in Malaysia are low by regional standards, we expect NPL rates to edge up to 1.6%-1.7% over the next 12-18 months, from 1.5%, taking into account deteriorating conditions.

Chart 6

High Private Sector Debt And Property Overhang Drag On Growth

Malaysian households have been deleveraging for the past three years. Most recently, the trade war and volatile capital markets have weighed on consumer sentiment and discouraged business investment. A slipping Malaysian economic growth is translating into slowing credit demand, and we project the ratio of household debt to GDP to stabilize at the current 81%-82% over the next two years.

The large financial assets buffer of Malaysian households, at 2x household financial liabilities, protects against bad debt. Unemployment remains low--we project a jobless rate of 3.3%-3.4%, and suggests credit risk in the household sector remains well contained.

However, given that Malaysian banks do over half (58%) of all lending to households, any indicator suggesting softness in household borrowing bodes poorly for lenders.

Chart 7

Even as the Malaysian corporate sector's debt-paying capabilities remain solid, the earnings trend is weak. We expect the strain on corporate income to persist amid tough macroeconomic conditions.

Chart 8

Malaysian commercial property market is wading through excess supply. We see signs on the ground in the form of empty shopping malls and vacant office buildings being built in peripheral locations.

The supply overhang has been in place for a few years. While we haven't seen this mismatch translating to banks' NPL book yet--the commercial-property related NPL ratio is low at 1.4%--we expect this will depress demand for loans from the developers.

There is anecdotal evidence suggesting that many Malaysian developers are cash rich and revenue-diversified, and should be able to ride out the downturn. Small developers are more vulnerable.

The Pros And Cons Of Diversification

The return to margin compression worsens banks' profit outlook. Competition for cheap, sticky retail deposits flares up repeatedly as banks vie for high-quality, liquid assets.

Seeing few growth areas, Malaysian banks have responded by trimming operational costs, closing branches, and retrenching staff. The cost-to-income ratio in the sector has stayed at around 47%-48% over the past two years. While banks have been striving to improve this ratio, we believe that is unlikely without better support from earnings.

Malaysian banks have responded to slow growth at home by diversifying offshore, to countries such as Singapore and Indonesia. The overseas diversification has added more-broad-based revenue streams for some of the largest Malaysian banks over the years, boosting their margins.

For example, Indonesia is a highly profitable market for the Malaysian lenders--they achieve about twice the net interest margin in Indonesia compared to what they get at home. But when times are bad, Malaysian banks' overseas operations tend to drag down the group profit, as seen in recent years' losses in the Singapore offshore oil and gas sector, and the Indonesian mining and commodities sectors.

We think the leading banks' overseas operations should recover from their recent troubles as the issues in those segments have largely played out.

However, Singapore, being a highly open economy, is likely to feel the full effect of macro-headwinds over the next 12-18 months, limiting the profit upside for banks. Notably, the Singapore economy grew by just 0.1% year on year in the second quarter, a marked slowdown from the 1.1% growth logged in the previous quarter.

Behold, The Fintech Revolution

In this climate of cost-cutting and strained profit arrives digital banking. Malaysian regulators are expected to hand out the country's first digital banking licenses in the next 12-24 months. This will allow local tech and telecom groups such as Grab Holdings Inc. and Axiata Group Bhd., to compete directly with banks in lending and deposits-taking, without the encumbrance of an expensive branch network.

International leading technology giants such as Alibaba Group and Tencent Holdings, which already have a meaningful share of Malaysia's digital payments market, could challenge the Malaysian lenders. Both have proved highly competitive in digitalized financial services in China.

Chart 9

International experiences in China and Singapore show that a fintech-powered lending business is generally able to keep their cost-to-income ratio low, at slightly above 30%, compared with the current 47% cost-to-income ratio for the Malaysian banking sector. We expect the arrival of digital banking will result in service fee cuts and yet more compression to the net interest margin on deposit competition.

Tech groups have the potential to compete with traditional lenders on almost all fronts in retail banking. To manage this threat, incumbent banks will need to invest heavily in technology.

The risk is that they may not have the money to support this spending given their earning constraints. This will be especially challenging for small Malaysian lenders, and fintech competition may trigger overdue sector consolidation.

The fintech threat is more long term, and we don't expect the competitive landscape to change dramatically for the next three to five years. Banks still have advantages, such as their market dominance, and regulatory and compliance knowledge. They also have consumers' trust, which the fintech newcomers have yet to earn. In addition, this three-to-five year window will give banks time to re-invent themselves, and design coping strategies.

In our view, some banks may cooperate with fintech firms on product design and risk underwriting, some may invest in digital startups, and some may even partner with the fintech arrivistes to run digital banks. It's a plan for next-stage incumbency, but it's certainly not a guarantee of it.

Appendix

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Related Research

• Asia Pacific Quarterly: Weaker Outlook As Trade Tensions Bite, July 9, 2019
• Malaysia: Summary Analysis, July 3, 2019
• Trade Tensions Weigh On Malaysian Banks' Profitability, May 30, 2019
• Banking Industry Country Risk Assessment: Malaysia, Oct. 4, 2018