This article first appeared in The Edge Malaysia Weekly, on November 2 - November 8, 2015.

MALAYSIAN banks and their holding companies are under growing pressure to maintain the higher capital levels required by Basel III global banking rules even as they grapple with increasing headwinds in the industry.

They will likely keep building their capital buffers over the next few years, says Fitch Ratings Singapore Pte Ltd financial institutions director Elaine Koh.

“Actually, it’s a positive that they’re building up capital at a time when there are more headwinds facing the industry, because capital helps to strengthen their balance sheets [and] improve their loss absorption capacity. So, that is a credit positive for the banking sector if they improve their capital buffers,” Koh tells The Edge in an interview.

Three weeks ago, Bank Negara Malaysia finalised new capital rules for financial holding companies (FHCs) and set timelines for them to meet the rules. These were among the things set out in the central bank’s Capital Adequacy Framework (Capital Components) policy document for financial institutions issued on Oct 13.

“The central bank had outlined these rules late last year and it was only recently that they finalised some of the details of their approach.

“Bank Negara’s new capital rules for FHCs are essentially an extension of similar capital requirements that have applied to banks since January 2013. From January 2019, FHCs will have to maintain common equity Tier 1 (CET-1) capital ratios of at least 7%, together with Tier 1 and total capital ratios of at least 8.5% and 10.5% respectively. These ratios include the capital conservation buffer [of 2.5%],” Koh explains.

A further counter-cyclical buffer may be applied later, pending market conditions. “Basel III recommends that the counter-cyclical buffer should vary between 0% and 2.5%, but Bank Negara has not set a cap on the maximum counter-cyclical buffer that it may apply for Malaysian banks and financial groups. We will not expect the regulator to impose a local counter-cyclical buffer in a period of softening growth,” she adds.

Banking groups headed by FHCs — basically holding companies that have majority stakes in banks — such as CIMB Group Holdings Bhd, Hong Leong Financial Group (HLFG), AMMB Holdings Bhd, Affin Holdings Bhd and Alliance Financial Group Bhd are expected to be affected by the new rules.

Some of the bigger FHCs, like AMMB Holdings (fundamental: 1.50; valuation: 2.55) and CIMB Group (fundamental: 1.05; valuation: 1.65), have already started disclosing their capital ratios and should already meet the new CET-1 requirements, based on their latest data.

“Whether they continue to meet the requirements come 2019 will depend partly on factors such as credit growth, profits and earnings retention over the next few years,” says Koh.

“Of course, a better buffer above minimum requirements will place them in a stronger position to weather tougher times ahead.”

CET-1 is a key metric that the investment community watches as a gauge of a bank’s financial health. It measures a bank’s core equity capital against its total risk-weighted assets.

At a recent meeting with analysts, CIMB Group’s management said it was targeting to raise its CET-1 ratio to 11% by 2018 from the current 9.3% on a “fully loaded” basis — that is, based on the rules that will apply at the end of the transition period in 2019.

“Towards this goal, measures in the pipeline include disposing of non-core assets and improving risk weights. Nevertheless, as the operating environment remains challenging, management does not rule out a capital-raising exercise at the group level in the near future,” Maybank Investment Bank (MIB) Research says in an Oct 22 report on CIMB Group.

Analysts point out that any further weakness in the ringgit, spike in bond yields and sharper-than-expected asset quality deterioration could place further pressure on its CET-1 ratio.

“Management’s regular discussions with Bank Negara may have prompted the need to eventually comply with counter-cyclical buffer and potentially D-SIB (domestic systemically important banks) buffer requirements, which would raise the CET-1 requirements significantly above their current [level],” says UOB Kay Hian in an Oct 22 report on the group.

CIMB Bank’s CET-1 ratio is one of the lowest among the big banking groups, some of which have announced rights issues — such as HLFG (fundamental: 2.20; valuation: 2.55), Hong Leong Bank and RHB Capital Bhd — to boost their capital buffers. The average among Malaysia’s top six commercial banks is 10.3% on a fully loaded basis, Koh estimates.

RHB Capital (fundamental: 1.40; valuation: 1.65), earlier this year, chose to overcome the need for additional capital at the FHC level by restructuring the group. In April, it proposed a rights issue of up to RM2.5 billion and announced internal restructuring plans that will result in the removal of its holding company structure, leaving RHB Bank as the listed entity. Those plans are ongoing. Proceeds from the rights issue would be injected into RHB Bank as new capital.

Would it make sense for some of the other FHCs to take the same route as RHB Capital?

“We see less pressure for them to undertake a major restructuring ... perhaps, some streamlining here and there. As mentioned, AMMB Holdings and CIMB Group have already met the capital requirements, more or less.

“For HLFG, the bulk of their balance sheet is Hong Leong Bank, which is adequately capitalised and is undertaking a rights issue, which will further improve its capitalisation. The holding company itself isn’t highly leveraged,” Koh comments.

HLFG’s 64% stake in Hong Leong Bank translates into RM1.9 billion for its portion of the bank’s RM3 billion rights issue.

“Since HLFG is raising just RM1.1 billion, this implies a 43:57 debt-equity structure in its subscription for Hong Leong Bank’s rights issue. We estimate an uplift in Hong Leong Bank’s entity CET-1 ratio to 11% from 8% as at end-June 2015 from this rights issue and at about 10% at the HLFG level,” says MIB Research.

AMMB Holdings has indicated that its CET-1 ratio is 9.1%, on a fully loaded basis, Koh says.

Watching their capital ratios closely will not be the only headache banks face going forward. There are a number of new requirements on banks’ funding and liquidity under Basel III that banks will have to comply with as well.

“We think the regulatory requirements for banks are getting more complex. So, generally, the compliance costs for the industry will continue to rise,” says Koh.

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