High provisioning costs will continue to weigh on the banks’ profitability, says analyst

by NUR HANANI AZMAN / Pic by BLOOMBERG

MOODY’S Investors Service expects more Islamic banks to pursue mergers as smaller players are crowded out by large competitors.

Analyst Badis Shubailat noted that as Islamic banks remain under pressure to become more competitive, they will require significant cost reductions which they may attempt to achieve through consolidation.

“The Gulf Cooperation Council (GCC) countries and in South and South-East Asia are emerging from the coronavirus-induced economic shock, but remain exposed to an uneven recovery across these regions.

“High provisioning costs will continue to weigh on the banks’ profitability, but their capital and liquidity buffers should comfortably absorb unexpected losses.

Consolidation within fragmented Islamic banking markets presents opportunities,” Badis wrote in a report yesterday.

He added that the fiscal and monetary stimulus, vaccine rollouts and a relaxation of pandemic-related restrictions are fuelling an economic recovery across the main Islamic banking markets.

According to Badis, the GCC countries, as major hydrocarbon producers, and Malaysia, where a significant part of the government revenue is derived from oil production, will benefit from a rebound in oil prices as the global economy recovers.

“Our current medium-term oil price forecasts assume that spot Brent crude will average between US$45-US$65 (RM272.35) per barrel, up from US$42 per barrel last year.

“With the OPEC reversing earlier production cuts, higher oil revenue will improve governments’ capacity to stimulate their non-oil economies. The non-oil sector accounts for the bulk of banks’ lending exposure,” he added.

However, he stated that in most key Islamic banking markets, GDP is unlikely to return to pre-coronavirus levels until 2022.

He added contagious Covid-19 variants emerging, governments that cannot effectively trace and isolate new cases may need to reimpose some restrictions thus delaying the economic recovery.

Many countries have already resorted to lockdown measures to curb the spread of new Covid-19 waves which lead him to expect Islamic banks and their conventional peers will continue to face economic headwinds over the next 12 to 18 months.

He said low interest rates and high provisions will weigh on profitability.

Badis believes return on assets will remain below pre-pandemic levels on average this year because of low interest rates, a still subdued operating environment, and high provisioning costs.

“Strong demand for Islamic finance, which is growing faster than conventional banking, will partially offset these strains,” he added.

Islamic banks have ample capital and liquidity with such banks in Malaysia set to benefit from the profit and loss sharing feature of investment accounts, with losses ultimately borne by account holders.

“As a result, risk-weighted assets associated with financing funded by these accounts are excluded from regulatory capital calculations.

“Parents of Islamic banks also provide indirect capital support through these investment accounts,” he said.

Islamic banks have strong liquidity helped by lower central bank reserving requirements and faster deposit growth as depositors curb their spending amid economic uncertainty.

Islamic deposits continue to grow faster than conventional deposits, mirroring the trend in Islamic financing.

Islamic banks in Malaysia and Indonesia have sizeable exposure to economically sensitive small and medium-sized enterprises (SMEs).

SME loans in Malaysia and Indonesia accounted for 12% and 18.3% of total Islamic lending respectively as of June 30, 2021, the report stated.