Strong capital position to meet higher requirements
Reaffirmed overweight. The Edge’s articles on an ongoing M&A touched on the potential increase in capital requirements for banks due to the revision of the Basel accord.

While we acknowledge that the potential increase in equity capital requirements from the current 2% would be detrimental to banks’ ROE (return on equity) and dividend payments, we note Bank Negara’s confidence in Malaysian banks’ capital positions.

All Malaysian banks would be able to meet equity capital ratios of 4.5%-6% but Public Bank Bhd, AMMB Holdings Bhd and Malayan Banking Bhd (Maybank) would fall short in the worst-case scenario of an 8%-9% floor.

However, we gather from industry sources that the odds of an 8%-9% minimum are low. Backed by our view that Malaysian banks have adequate capital to meet the new likely requirements, we reiterate our overweight stance on the sector, predicated on the rerating catalysts of (1) strong earnings growth, (2) increase in investment banking income, (3) revamp by a few banks, (4) strong growth potential for the overseas operations of larger banks, (5) potential GP write-backs, and (6) M&A activities. AMMB remains our top pick.


Highlights from the article
Higher capital requirements? In December 2009, the Basel Committee released a consultative paper that proposes a redefinition of the Tier-1 capital of banks.

The gist of the proposal is that Tier-1 capital must consist predominantly of common stock and retained earnings — in other words, shareholders’ funds.

Currently, a certain amount of hybrid capital instruments is allowed to be Tier-1 capital. The proposed new rulings are expected to take effect in 2012.

Tier-1 capital ratio to be raised from 4% to 6-8%? While the Basel committee has not given the new benchmark for minimum capital requirements, expectations are running high that the Tier-1 capital ratio could be raised to between 6% and 8% from 4% now.

Under the new proposals, minority interests and intangible assets such as goodwill will no longer be included in Tier-1 capital but unrealised gains and losses are to be included.

The Basel committee has also proposed that banks be subject to a capital charge for mark-to-market losses associated with deterioration in credit worthiness. Counterparty credit risk will be incorporated for the purpose of calculating risk-weighted assets.

Bankers’ take
AMMB’s (outperform) deputy group MD and CFO, Ashok Ramamurthy said while the proposals for capital requirements are still in draft form, three clear points are emerging:

•     Firstly, the minimum Tier-1 capital requirement will be higher and slanted towards ordinary or core equity. It is speculated that ordinary equity composition imposed on banks could increase from 50% to 75%-85% of Tier-1 capital.

•     Secondly, in addition to higher Tier-1 and more ordinary equity, banks will be required to maintain capital conservation or counter-cyclical ordinary capital buffers. Regulatory authorities will be able to impose higher or lower buffers, depending on the economic cycle and place restrictions on the quantum of dividend payments based on the perceived adequacy of the quantum of buffers.

•     Thirdly, the definition for Tier-2 capital will be simplified. Innovative and non-innovative capital under Tier-1 currently is likely to be folded under the Tier-2 capital.

Ashok believes that fewer banks will think about issuing innovative instruments when it comes to raising capital until there is further clarity on these issues.

Limited impact on Malaysian banks. Industry observers believe Malaysian banks will not be that affected by the new capital ruling.

“Malaysian banks have been running much higher core Tier-1 capital. The changes will not be a shock to the local banking system. Some banks will see some constraints but the majority of banks will not be impacted much by the new ruling,” said an industry observer.

Diluting the M&A momentum. A local banker pointed out that with the pressure on ROEs from the higher capital requirements, banks will no longer be able to command the kind of premium they are used to in any M&A scenarios. “Likewise, banks keen to acquire other banks will refrain from overpaying to not spoil the market,” she said.


Bank Negara’s take
Banks Negara, in response to email questions from The Edge, expressed its views on the new capital requirements:

Revision of Basel Accord to affect capital management strategies. While the proposed rules are still at a consultative stage and are premature for adoption, banks have been urged to take into account these international developments in their capital management strategies.

Strong capital position for Malaysian banks. In Malaysia, following the bank’s announcement of the implementation of Basel II in 2008, significant improvements have been observed in banking institutions’ capital and risk management practices in meeting the more stringent requirements under the new capital framework.

Malaysian banks have built up sizeable capital buffers over the years. Their capital management strategies have also remained conservative, with more than 80% of total capital base in the form of common equity and reserves. Furthermore, Malaysian banking institutions maintain lower leverage ratios averaging 13x, which is well below that of most financial institutions in developed economies.

New capital requirements to affect growth plans. Malaysian banks are well capitalised, with the core capital ratio of the banking system at 13.1% at the end of last year. Based on the central bank’s stress test, there is little pressure for banking institutions to raise fresh capital at this point in time. The new proposals on regulatory capital will, however, become more relevant as banking institutions seek to fund their new growth plans.


Comments
No surprise on potential higher capital requirements. The information quoted in The Edge articles is broadly in line with our expectations as they reiterated the proposals by the Basel committee for banks globally to hold higher equity capital.

Bank Negara’s confidence in banks’ capital position. The new information from the article is Bank Negara’s view of the new capital requirements. One particularly positive point is the central bank’s confidence in banks’ capital positions, as reflected by its statements on 1) the significant improvements in banking institutions’ capital and risk management practices, 2) banks’ conservative capital management strategies, with more than 80% of the capital base in the form of common equity and reserves, and lower leverage averaging 13x, and 3) the system’s core capital ratio of 13.1%, which indicates that Malaysian banks are well capitalised.

Based on the central bank’s stress test, there is little pressure for banking institutions to raise fresh capital at this point in time.

Adequate capital positions. As mentioned in the article, the minimum requirement for Tier-1 capital ratio could be raised from 4% to 6%-8%. Assuming that equity has to form 75% of the Tier-1 capital, the minimum requirement for the equity capital ratio would be between 4.5% and 6%, which is in line with our expectations.

As Figure 1 shows, all Malaysian banks are able to meet Tier-1 capital requirements of 6%-8%. Figure 2 shows that Malaysian banks’ equity capital ratios are above the potential minimum requirement of between 4.5% and 6%.

Worst-case scenario. In the worst-case scenario of an 8%-9% floor for equity capital ratio, a few banks would fail to meet the requirement — Public Bank (outperform), AMMB and Maybank (neutral). However, from our checks with bankers, we gather that the odds of the requirement being set at that level are not high as it would lead to overcapitalisation of the banks.

New Basel accord to slow down M&A momentum. We concur with the point brought up in the article that the new Basel accord would slow down the M&A momentum and reduce the valuation for future M&A transactions. The proposed revision of the Basel accord would require banks to hold higher equity capital and hybrid capital would not be classified as Tier-1. This means that the acquiring bank would have to finance the acquisition mostly by equity, which has a higher cost of about 12%-13% compared to 7%-8% for hybrid capital.

The higher funding cost would force the acquirer to be more careful about the offer price. The funding issue may also render non-EPS-accretive the acquisitions of some banks, especially those with lower ROE.


This article appeared in The Edge Financial Daily, February 9, 2010.