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Malaysia: Selected Issues

Author(s):
International Monetary Fund
Published Date:
September 1999
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III. Malaysia: Financial Sector Issues1

A. Introduction

1. Beginning early in 1998, Malaysia’s economic growth slowed and then turned sharply negative. The deterioration, accompanied by high interest rates, quickly showed up in the nation’s financial institutions in the form of rising nonperforming loans (NPLs), strained earnings, and declining capital. This chapter reviews financial sector issues in Malaysia. The sections that follow include background on recent events affecting the sector (Section B), discussions on the structure of the banking system and current banking conditions (Section C), measures introduced to restore financial sector soundness and to strengthen the supervisory and regulatory infrastructure (Sections D and E), and identification of vulnerabilities and conclusion (Section F).

B. Background

2. Though sharing many characteristics with its regional neighbors, Malaysia has avoided the effects of full-scale financial sector crisis that have wreaked havoc on Indonesia, South Korea, and Thailand. Characteristics that Malaysia had in common with these other countries were its rapid loan growth in past years (over 26 percent in 1996 and 1997), high level of credit in relation to GDP (160 percent), and significant credit exposures by financial institutions to vulnerable economic sectors (namely property and securities). However, early on in the regional crisis of East Asia (late 1997–early 1998), the general sentiment within the banking community, especially the central bank (Bank Negara Malaysia (BNM)), was that Malaysia would weather the crisis without experiencing significant deterioration in its own situation. This is because its financial institutions had lower NPLs and higher capital, and there was a stronger banking culture, with a better control environment and superior prudential supervision.

3. These strengths, however, proved to be only relative, as the reality of a sharp downturn in Malaysia’s economy took hold, significantly affecting the credit quality, profitability, and capital adequacy among all financial institutions. In an effort to address the most vulnerable part of the financial system, the authorities embarked early on a strategy to consolidate the finance company sector (with government assistance as needed). This initial effort proved insufficient in the face of the rapidly deteriorating economic environment. Extraordinary action would be needed.

4. By mid-1998, the authorities augmented the narrowly focused finance company effort, with a strategy to restructure and revitalize the banking system, creating (i) Danaharta to acquire NPLs; (ii) Danamodal to provide fresh capital; and (iii) the Corporate Debt Restructuring Committee (CDRC) to help negotiate the restructuring of large corporate loans. The strategy imposes measured market discipline, looking first to the banks and their owners to absorb the costs of restructuring. Loans must be discounted before being sold to Danaharta and new Danamodal capital will come only after shareholders absorb the first loss and experience dilution to their ownership. To establish Danaharta and Danamodal, the government provided the initial capitalization and stood behind the issuance of approximately RM 30 billion in debt funding. The government expects to be repaid when the assets are sold.

5. On a parallel front, BNM sharpened its supervision over the financial sector by first tightening loan classification requirements and, later, by pushing banks to sell NPLs to Danaharta. Banks have the incentive to sell NPLs because a nonearning asset is replaced with a negotiable government bond and BNM allows that the discount from each loan sale to Danaharta be written off over an extended time period of up to five years. BNM hired new examiners and increased the frequency of on-site examinations, scrutinizing closer the banks and bank managers. Other strengthening measures at BNM included upgraded supervision over affiliates of banking institutions, including the parent holding company. The parent company and shareholders are now subject to new reporting and to prior approval requirements for borrowings to reduce over-leveraging. BNM is considering making mandatory the establishment of a dedicated financial services holding company that will exclude entities that it does not directly supervise.

6. The rest of this chapter addresses the structure, trend in financial condition, roles of Danaharta, Danamodal, and CDRC, and issues regarding the supervisory and regulatory framework.

C. Structure and Performance of the Banking Sector

Structure

7. Malaysia has three categories of financial institutions authorized to take deposits. These include commercial banks, finance companies, and merchant banks.2 (See Table III.1 for relative market share information for assets, loans, and deposits by institution categories.)

  • Commercial banks engage in retail and corporate banking and are the only institution type able to take demand deposits. Banks provide other financial services through subsidiaries; these include merchant banking, stock-brokering, insurance, and finance company activities. Foreign banks have operated in Malaysia since before independence in 1959. Current regulation limits new entry of foreign banks to minority equity stakes up to 30 percent and restricts existing banks from opening new branches. Despite the restrictions, foreign banks have maintained an important market share in wholesale and retail banking. At March 31, 1999, Malaysia’s 13 foreign banks held 25 percent of loans and 22 percent of deposits in the commercial bank segment (18 percent of loans and 16 percent of deposits for the financial system as a whole).3
  • Finance companies are able to offer hire-purchase lending and other types of installment credit to consumers and small businesses, with funding provided primarily from time and savings deposits. Facing diminishing returns from traditional business lines, finance companies went into riskier real estate and share purchase lending, making them more vulnerable to an economic downturn. Because of the vulnerability, BNM has long pursued the consolidation of the finance company sector. In 1998 five finance companies were absorbed by their affiliated parent banks and two others merged, while in January 1999 BNM assumed control of two other finance companies because of contravention of the Banking and Financial Institutions Act, 1989 (BAFIA), primarily for failure to meet capital requirements.4 Among undercapitalized finance companies, Danamodal resources will be used only for the recapitalization of three, as they meet eligibility criteria5. For the others, which are small, sources of new capital must come from owners or other investors.
  • Merchant banks are involved primarily in fee-based activities such as syndication of loans, corporate advisory services, securities underwriting, and portfolio management. Although they do take commercial deposits and make loans, they can only accept time deposits greater than RM 200,000. In past years lending by merchant banks grew to be a key—and at the time profitable—activity, but with a souring economy the diversion proved very costly. BNM is redirecting merchant banks back to the traditional investment banking and other fee-based activities by introducing restrictions on lending activities.
Table III.1Malaysia: Banking System (Depository Financial Institutions (DFIs)(In billions of ringgit, as of March 31, 1999)
Type of Depository Financial

Institution
Number of

DFIs
Percent of

Total
AssetsPercent of

Total
Loans 1/Percent of

Total
DepositsPercent of

Total
Commercial banks3545455.874293.673312.872
Domestic-owned banks2228349.557221.055243.356
Foreign-owned banks1317106.31772.61869.516
Finance companies3140120.82087.62295.522
Merchant banks121540.5721.1527.86
All DFIs78100617.1100402.3100436.1100
Source: Bank Negara Malaysia.

Includes loans sold with recourse to Cagamas.

Source: Bank Negara Malaysia.

Includes loans sold with recourse to Cagamas.

Performance

8. The results for the banking system for 1998 were marked by a dramatic rise in NPLs that, because of higher bad debt provisions, adversely affected earnings and capital. Liquidity improved owing to a more favorable interest rate environment and reductions to reserve requirements.

9. Signs of asset quality deterioration first appeared in the second half of 1997, then accelerated through 1998 as economic growth turned negative. NPLs moved from RM 25 billion at the end of 1997 to RM 103 billion at end-March, 1999 (using the 3-month criteria and adding back RM 23 billion in NPLs sold to Danaharta). (See Table III.2 for trend in NPLs both with and without consideration of Danaharta NPL purchases.) Concerned by the growing pace, BNM ordered banks in October 1998 to begin selling those NPLs over RM 5 million to Danaharta so as to reduce the aggregate level to below 10 percent of loans. Without considering the Danaharta loan purchases, the level of NPLs continues to show an increase, but the rate of increase is declining. For the quarters ended September, December, and March, the quarter-on-quarter change was 41 percent, 22 percent, and 13 percent, respectively.

Table III.2.Malaysia: Trends in Nonperforming Loans 1/(December 1997-March 1999)
Dec.1998Mar.
1997Mar.JuneSept.Dec.1999
(In billions of ringgit)
Commercial banks14.222.332.446.644.948.1
Finance companies10.014.317.522.625.923.7
Merchant banks1.11.83.05.27.27.7
Total25.238.452.974.578.079.5
Total including loans sold to Danaharta 2/74.591.0102.6
(In percent of total loans)
Commercial banks4.97.610.915.515.016.4
Finance companies9.213.617.323.627.127.1
Merchant banks4.88.013.323.132.436.5
Total6.09.112.617.818.919.8
Total including loans sold to Danaharta 2/17.821.324.1
Source: Bank Negara Malaysia.

Loans are classified as nonperforming if payments are overdue for three months or more; prior to January 1, 1998, this period was six months. Total loans include housing loans sold to Cagamas.

Loans were first sold to Danaharta beginning Q3 1998.

Source: Bank Negara Malaysia.

Loans are classified as nonperforming if payments are overdue for three months or more; prior to January 1, 1998, this period was six months. Total loans include housing loans sold to Cagamas.

Loans were first sold to Danaharta beginning Q3 1998.

10. At end-March 1999, after loan sales to Danaharta, NPLs stood at RM 80 billion or 20 percent of total loans.6 Protection from bad debts provided by provisions represented 43 percent of NPLs. The shortfall in protection is covered collateral, which on an individual loan basis represented 82 percent of NPLs based on current appraisals.7Table III.3 shows the effect of the September 1998 change in public disclosure requirements by banks, which gave them an option of disclosing NPLs using either a three-month or six-month classification criteria. BNM continues to publish the aggregate NPLs based on both the three- and six-month classification criteria.

Table III.3.Malaysia: Asset Quality Indicators(As of March 31, 1999, except where noted)
Type of Depository

Financial Institution
NPLs (In billions of

ringgit 1/)
NPLs to Loans 2/

(In percent)
Total Bad-Debt Provision

to NPLs 3/

(In percent)
Collateral to NPLs 4/

(In percent

as of Feb. 28, 1999)
3-Month6-Month3-Month6-Month3-Month6-Month3-Month6-Month
Commercial banks48.132.116.410.950.060.785.774.0
Finance companies23.715.827.118.031.245.573.3110.8
Merchant banks7.74.136.519.736.158.189.972.0
Banking system79.552.119.812.943.155.982.484.2
Source: Bank Negara Malaysia.

NPLS are shown gross of interest in suspense (“IIS”). Malaysian accounting calls for the continued accrual of interest on nonperforming loans with an offsetting provision to the IIS account. The IIS balance is a provision equal to the amount of interest accrued but not collected from nonperforming loans.

Loans = total loans plus loans sold to Cagamas (sold with full recourse).

Total bad-debt provision = aggregate of provisions for general, specific, and interest-in-suspense.

Collateral amount = the sum of the value of collateral held against individual nonperforming loans.

Source: Bank Negara Malaysia.

NPLS are shown gross of interest in suspense (“IIS”). Malaysian accounting calls for the continued accrual of interest on nonperforming loans with an offsetting provision to the IIS account. The IIS balance is a provision equal to the amount of interest accrued but not collected from nonperforming loans.

Loans = total loans plus loans sold to Cagamas (sold with full recourse).

Total bad-debt provision = aggregate of provisions for general, specific, and interest-in-suspense.

Collateral amount = the sum of the value of collateral held against individual nonperforming loans.

11. NPLs of finance companies remain especially high, averaging 27 percent at end-March (3-month criteria). Unlike commercial banks, the NPLs of finance companies will not easily be sold to Danaharta, as generally the individual loan size is smaller than the RM 5 million cutoff that Danaharta requires. For the finance company segment as a whole, there will be some relief in NPL levels as more finance companies are absorbed by their parent banks and three finance companies are recapitalized by Danamodal.8

12. The large movement in the exchange rate in the second half of 1997 had little effect on credit quality, because of a long-standing BNM regulation that requires prior approval of loans in foreign currency.9 Borrowers had to show that they had foreign currency revenues with which to repay the loan, thereby restricting most foreign currency borrowing to trade finance. Much of the loan growth prior to 1998 was for the financing of the broad property sector. At end-1998, lending to the broad property sector represented 35 percent of total loans, with lending for construction making up over one-third of this exposure.

13. The banking system reported a RM 2.2 billion pre-tax loss for 1998, down sharply from a RM 7.6 billion profit for 1997. Despite the loss, the capital base for the banking system increased in 1998 by RM 1.2 billion, reflecting primarily the RM 4.6 billion in new capital provided by Danamodal. The commercial banking segment was marginally profitable, reporting income of RM 531 million, while the finance company and merchant bank segments each reported losses of RM 2.2 billion and RM 641 million, respectively. The 1998 results reflected the needed bad-debt provisions and reduced net interest income due to higher interest expense. In 1998 Malaysia’s banks made RM 12.8 billion in provisions, which was more than twice the level of the previous year.10 At year-end, nine financial institutions did not meet regulatory capital requirements. Five of these are affiliated with the Sime and Bumiputra bank groups, and MBf Finance, which are in the process of resolution with government assistance. The remaining four are small finance companies that are under close BNM supervision (Table III.4).

Table III.4.Malaysia: Income and Capital Adequacy Indicators(For the period ended December 31, 1998)
Type of Depository Financial

Institution
Number

of

DFIs
Capital AdequacyProfitability
Number

of DFIs

Under

capitalized
Tier 1 to

RWA 1/

(In percent)
Capital Base

to RWA 1/

(In percent)
Number

of DFIs

Reporting

Losses
Profit Before

Tax (In

millions of

ringgit)
ROA 2/3/

(In percent)
Commercial banks3519.911.713530.90.1
Finance companies3178.711.123(2,149.6)-1.6
Merchant banks12112.915.210(641.2)-1.5
All DFIs7899.911.846(2,259.9)-0.3
Source: Bank Negara Malaysia.

RWA = risk-weighted assets.

ROA - return on assets.

Return is profit before tax to average 1998 assets.

Source: Bank Negara Malaysia.

RWA = risk-weighted assets.

ROA - return on assets.

Return is profit before tax to average 1998 assets.

14. Prior to the crisis period (before 1998) most financial institutions enjoyed relatively stable liquidity provided primarily through domestic deposit funding in ringgit. Although the banking system experienced dramatic loan growth through 1997 (annual loan growth for 1996 and 1997 was 28 percent and 27 percent, respectively), that growth was largely funded by increases in deposits (annual deposit growth for 1996 and 1997 was 26 percent and 21 percent, respectively). Hence, for the system as a whole, the loan growth was matched by increases in deposits, which generally are a more stable funding source.

15. The liquidity picture changed in the second half of 1997, as there was a flight to quality phenomenon that adversely affected several of the weaker banks and finance companies. BNM stepped in with liquidity support, providing as much as RM 34 billion in 1998 to weakened financial institutions. Liquidity needs dissipated after BNM lowered the statutory reserve and the liquid asset requirements; the statutory reserve requirement (SRR) was reduced from 13.5 percent to 4 percent in four moves from February to September 1998 and the liquid asset reserve (LAR) was reduced from 17 percent to 15 percent in September 1998. To further calm depositors, BNM issued a statement in January 1998 that the government would fully protect deposits.11 The implementation of the restructuring program has been a factor in the restoration of depositor confidence.

16. Besides loan sales to Danaharta, the moderating NPLs are linked to lower interest rates. The Base Lending Rate (BLR), which is set by BNM and serves as the primary index rate, is now at 7.5 percent and projected to move lower in coming quarters. BNM enforces a ceiling of 2.5 percent over the BLR as the maximum that banks can charge borrowers for most types of loans. The ceiling imposes some discipline on banks, as it prevents pricing commensurate with higher risk lending; consequently, banks are forced to seek out higher quality borrowers. As well, BNM is pushing financial institutions to maintain their lines and identify new lending opportunities. The lowering of interest rates has facilitated the restructuring of NPLs, lessening the likelihood that weak borrowers will become delinquent and encouraging creditworthy borrowers to take out new loans.

D. Restoration of Financial Sector Soundness—Role of Danaharta, Danamodal, and CDRC

17. The multiprong strategy involving Danaharta and Danamodal to acquire NPLs and recapitalize banks, as well as the CDRC to facilitate debt workout by large borrowers, represents a credible plan to restructure Malaysia’s financial sector. The implementation reflects the strong efforts to preempt extreme financial sector distress by pushing banks and borrowers to restructure early. Danaharta will purchase at market value the NPLs that cannot be restructured. To the extent that losses from loan restructuring or sales to Danaharta cause undercapitalization in banks, the government will provide new capital, taking a stake proportionate to its interest. The multiprong program is coordinated through a steering committee chaired by BNM’s Governor, which meets every two weeks.

18. The primary funding for both Danaharta and Danamodal is through the issuance of zero-coupon bonds. Danaharta bonds carry an explicit government guarantee and are issued to banks as needed in exchange for the purchase of NPLs. Danaharta is authorized to issue up to RM 15 billion (face value) in zero-coupon bonds and has RM 1.5 billion in capital provided by the ministry of finance. The Danamodal bonds have an implied government guarantee as Danamodal is owned by BNM. The Danamodal bonds were issued in conjunction with the lowering of the BNM’s statutory reserve requirement. Pricing and liquidity for bonds issued by Danaharta and Danamodal are a function of the market for Malaysian government securities, which trade readily in the secondary market. The bonds are frequently retained by banks, as they count toward BNM’s LAR, are fully eligible for discount, and carry a zero risk-weight for regulatory capital purposes.

Danaharta

19. The life cycle for Danaharta is comprised of four phases: (i) establishment; (ii) acquisition; (iii) asset management; and (iv) exit During the establishment phase, the government resolved to push through legislation that gave Danaharta special powers over borrowers. Key aspects of the Danaharta legislation are: (i) special vesting powers insulate Danaharta and subsequent purchasers from undisclosed claims made after Danaharta acquires the NPL from the selling bank; (ii) Danaharta is able to appoint special administrators without having to go to court; and (iii) when Danaharta forecloses on collateral, it can abrogate underlying contracts.

20. Danaharta will have a limited life, intended to be less than ten years. Its board, which is appointed by the government, is comprised of a chairman (former senior government official retiring in 1988), Danaharta’s managing director, two directors from the government (finance ministry and BNM), and five other directors from the private sector, of whom two represent the international community. Danaharta’s staff has been sourced from the private sector and compensation includes performance incentives tied to the success in selling loans and collecting on assets. Decisions on asset sales only require the approval of the board and for smaller transactions certain managers have decision authority.12

21. Through March 1999, Danaharta had acquired RM 23 billion in NPLs from 37 financial institutions, with loans purchased representing a quarter of total system NPLs. The average price has been about 60 percent below book value. Excluding one large loan, however, the discount has been 37 percent. Danaharta will complete the first phase of loan purchases by midyear, focusing next on asset management and restructuring. After midyear, Danaharta will only purchase new NPLs arising after September 30, 1998.

22. Danaharta’s financing needs were based on the principle that it would only purchase NPLs over RM 5 million. Further, Danaharta will only manage the assets of Sime and Bumiputra on behalf of the government.13 For the Sime and Bumiputra loans, while there is no associated funding requirement, there is a cost paid in terms of time on Danaharta’s staff. The Sime and Bumiputra loans under management range in size down to RM 1 million, compared to the RM 5 million minimum for loans that Danaharta purchases for its own account.

23. To speed up loan restructuring and achieve meaningful reduction in overall NPL levels, Danaharta and BNM created incentives for banks to participate. In October 1998, BNM forced banks to sell NPLs, requiring that they consider offers from Danaharta on individual NPLs over RM 5 million. There are four important incentives to sell NPLs to Danaharta:

  • Banks selling NPLs to Danaharta retain a right to receive at least 80 percent of any profits realized when Danaharta subsequently sells the loan or liquidates the underlying collateral.
  • Banks avoid the immediate recognition of any loss that would normally result when an asset is sold below its book value as they are allowed as much as five years to amortize the difference between the book value and the sale price (see discussion of forbearance below).
  • Banks will exchange a nonearning, illiquid NPL for a bond that generates income and is readily marketable. Moreover the bonds have zero-risk weight for regulatory capital purposes.
  • A bank that declines an offer from Danaharta for the purchase of an NPL must make a provision that brings the value of the NPL down to 80 percent of the offer price.

24. As the banks are able to avoid the immediate recognition of any losses, there is an element of accounting and regulatory forbearance from those loan sales to Danaharta. However, because the Danaharta design encourages banks to sell NPLs at reduced prices with the expectation that they will realize some recovery when the loan/asset is sold, the extent of forbearance is more limited in practice. The amount that is deemed recoverable from Danaharta is reported as a deferred asset that in all cases is written down by at least 20 percent each year. The bank’s external auditor (and BNM) checks the value of the deferred asset at least annually. If the review determines that there is additional impairment, the amount of the write-down would be more than 20 percent in a given year. In any event, when Danaharta sells the loan or otherwise collects on the collateral and the true extent of losses, if any, can be determined, the selling bank must recognize this immediately. One must recognize that this feature may lead to Danaharta being pressured not to sell loans.

25. While the strong push to show reduction in NPLs could result in pressure on Danaharta to overpay, the occurrence has not been observed. An indication that appropriate valuations are taking place is that selling banks have rejected offers on RM 4.2 billion in book value of NPLs because the offers from Danaharta were believed to be too low. In these cases the selling banks believed that they are in a better position to resolve certain NPLs.

26. While on schedule in purchasing NPLs, loan or asset sales will only just begin in the second half of 1999. Close monitoring is warranted to ensure that Danaharta does not become a warehouse for NPLs.

Danamodal

27. Given the nature of government support, Danamodal’s design has built-in safeguards to reduce moral hazard and protect against downside risk.

  • Before investing, existing shareholder equity must absorb the first losses.
  • Independent valuations of each investment by Goldman Sachs or Salomon Smith Barney are required in advance of Danamodal recapitalization followed by a review by BNM’s supervision and regulation departments.14
  • Danamodal’s injection needs to restore capital to an adequate level (recapitalized banks have an initial capital adequacy ratio above 14 percent) and NPLs need to be reduced to less than 10 percent within one year.
  • Danamodal participates in directing bank management through its representation on the boards of directors. Danamodal will appoint at least two board members. At least one of the directors is to be either an executive director (a full-time director’s position) or the chairman of the board. Additional board members will be appointed commensurate with the injection of Danamodal capital. Participating banks must submit a monitorable business plan that looks at management structure, strategy for NPLs, profitability, and cash flow.
  • Danamodal will have the opportunity to participate in any upside to the valuation of the institution, when it sells its interest.

28. Danamodal with funding of RM 11 billion has injected RM 6.2 billion as fresh capital into 11 banking institutions that represent approximately one-fifth of the banking system by assets.15 Initially, the Danamodal investment was Tier 2 subordinated debt that will be converted into equity, debt, or a hybrid capital instrument. Table III.5 lists those financial institutions participating in the recapitalization program and provides information on the type of capital and the percentage stake to be taken by Danamodal. Though Danamodal had projected a total funding requirement of up to RM 16 billion, improving market conditions and recapitalization by current shareholders now indicate that the RM 11 billion in funding raised to date will be sufficient. A second group of 11 financial institutions, originally slated for capital injections, now appear not to need assistance.16 There is RM 4.7 billion in funding still available for additional capital injections as needed.

Table III.5.Malaysia: Danamodal Investments-to-Date(Investments as of May 1999)
InstitutionAssets as of

March 31,

1999
Interim

ESCL

Funding 1/
Final Investment Structure

(As per definitive agreement)
Danamodal

Share of

Tier 1 Capital

(In percent)
Ordinary SharesINCPS Shares 2/Subordinated DebtTotal
Arab-Malaysian Bank12,61580020060080063
Arab-Malaysian Merchant Bank14,8232002002000
Arab-Malaysian Finance16,45350030020050031
BSN Commercial Bank6,94342042042067
MBf Finance16,9821,6003621,2381,60078
Oriental Bank8,88870025030015070064
Perdana Merchant Bankers65750(Not finalized yet)
RHB-Sime Bank 3/51,4821,5001,0005001,50034
Sabah Bank2,74514024722612235
United Merchant Finance6,96431731731757
Totals138,5524946363,8471,6766,159
Source: Danamodal.

Exchangeable subordinated capital loan.

Irredeemable noncumulative convertible preference shares.

Counts as two institutions to reach a total of 11 receiving Danamodal capital.

Source: Danamodal.

Exchangeable subordinated capital loan.

Irredeemable noncumulative convertible preference shares.

Counts as two institutions to reach a total of 11 receiving Danamodal capital.

29. Foreign banks have an interest in purchasing distressed banks and finance companies. Opening the market to new foreign bank entry would help Danamodal sell the stakes it owns in several banking groups.17 The authorities are considering proposals by foreign banks already in Malaysia to bid on distressed finance companies.18 Malaysia imposed limits on foreign banks to favor development of the domestic banking sector. As there is consolidation in the years ahead—the government-assisted mergers of Bumiputra/Bank of Commerce and Sime Bank/RHB are examples of this consolidation—domestic banks will be better positioned to compete and current arguments limiting foreign bank entry will be less relevant. In the years ahead, the authorities will have to look closely at foreign banks as they endeavor to sell the stakes of banks that they hold through Danamodal. Keeping the market closed to new entry could well affect the success of the restructuring effort.

CDRC19

30. The CDRC was created with BNM’s sponsorship to facilitate debt restructuring by large borrowers. The CDRC employs the London Approach for informal debt workout and is presently reviewing 57 applications totaling RM 31 billion. Through May, nine companies with debt outstanding of RM 2½ billion have been restructured. Since creation, 13 cases have been rejected and turned over to Danaharta for resolution. The CDRC reviews only the largest loans (those over RM 50 million), where the underlying business remains viable. In conjunction with the acceptance to negotiate under CDRC, rights to collateral continue and creditors consent to a sixty-day standstill and agree to maintain credit lines.

31. While the CDRC is still very new and experiencing some growing pains, the perception among many lenders is that the CDRC process unduly favors the borrowers. Important to the credibility of the CDRC is that the process ensures equitable treatment for creditors and borrowers. The issue of equitable treatment will be important to the Danaharta process as well, as it will be important that the outcome of debt restructuring under CDRC not be perceived as more generous than that obtainable under Danaharta. To the extent that there is favoritism—either real or perceived—toward borrowers, some degradation in overall effectiveness will result. The CDRC effort must be observed as one that balances the pain of restructuring between lender and borrower so as to avoid systemic problems and contain moral hazard.

E. Strengthening Supervision and Regulation of the Financial Sector

32. BNM exercises tight control over the banking system. Financial institutions are carefully monitored and submit detailed financial statements on a quarterly, semi-annual, and yearly basis, with supplemental balance sheet information provided weekly and monthly. BNM uses a CAMEL-based approach to supervision for both its on-site examinations and off-site monitoring, placing special emphasis on capital adequacy, asset quality, and management.20

33. After having been made more rigorous in March 1998, public disclosure requirements by banking institutions were relaxed from quarterly to semi-annual in September 1998 and banking institutions were given an option of reporting publicly the NPLs using either a default measure of three months or six months. The relaxing of the frequency for public disclosures and changes to the default period for NPLs was broadly perceived to be forbearance. As a result, banks were able to report their results less frequently and in the case of NPLs, they could elect to disclose results in a more favorable way.21 The relaxation does impede the effectiveness of market participants in providing discipline over the behavior of bank managers.

34. As for provisioning and loan classification requirements, in September 1998, BNM relaxed the classification and provisioning requirements, which had been made more stringent effective January 1998. The September change called for classification according to number of months in default as follows: substandard was six to nine months, doubtful was nine to twelve months and bad was after twelve months. Banking institutions were not automatically required to provide a 20-percent specific provision on substandard loans, instead provisioning for the substandard would be assessed for each banking institution by BNM during the approval of half-year and annual accounts. In March 1999, the guidelines were changed again. The loan grades correspond to the likelihood that the loans will be repaid, and, at a minimum, consider the number of months that a loan has been in default. As well, the loan classification designations set out the minimum provisioning requirements (Table III.6). Once a loan is classified nonperforming, interest accrual shall be credited to “interest-in-suspense,” with any interest recognized up to the date the loan is classified as nonperforming to be reversed.

Table III.6.Malaysia: Loan Classification and Provisioning Requirements(Effective March 24, 1999)
Period of Default
ClassificationSpecific Provision on the

Shortfall in Collateral

Value
Repayment Schedule on

Intervals of Three Months

or Longer
Bankers Acceptances,

Trust Receipts, Bills of

Exchange
Substandard, unless there is evidence to support a worse-off classification20 percent provisioning unless overall loan loss provisions are adequateThree months from the first day of default but less day than six monthsOne month from the first of default but less than two months
Doubtful, unless there is evidence to support a worse-off classification50 percentSix months from the first day of default but less than nine monthsTwo months from the first day of default but less than three months
Bad100 percentNine months and above from the first day of defaultThree months and above from the first day of default
Source: Bank Negara Malaysia.
Source: Bank Negara Malaysia.

35. In other areas, Malaysia continues to make progress in strengthening its supervisory and regulatory framework. Measures taken toward this objective have included:

  • The frequency of on-site examinations for all banking institutions will be increased to at least once a year and the examinations will be conducted on a consolidated basis.22
  • Supervision over affiliates of banking institutions, including the parent holding company, has been tightened. Twice each year, financial institutions must obtain BNM’s approval of their financial statements. The approval is required before the results can be published and dividends declared. The approval process entails a detailed review of asset quality that considers the adequacy of provisions and value of collateral.
  • To complement the on-site examination process and annual review of accounts, BNM is putting in place a system of prompt corrective measures that mandate certain actions by bank managers and owners, depending on breaches of capital or other prudential limits. The measures should enable BNM to work with management and owners to resolve potential problems in a more timely manner.
  • BNM has adopted the BIS risk-based capital framework and requires that all banking institution categories maintain a total capital ratio of at least 8 percent. Since March 1998, the minimum capital requirement has been applied on a consolidated basis against the financial institution and its subsidiaries. Revisions to the capital framework are under way that would impose a higher minimum capital ratio depending on loan concentrations and exposures to different economic sectors. Work is also under way to amend the capital guideline to consider market risk.
  • In April 1999, BNM abolished its two-tier regulatory system (TTRS) for financial institutions. The design of TTRS prompted banks to raise capital as it gave preferential treatment to the so-called Tier 1 banks, whose capital exceeded RM 1 billion. Privileges for Tier 1 banks included freedom to offer foreign currency accounts and open new branches. The goal of TTRS was for domestic banks to merge in order to build their capital base and achieve the Tier 1 status. Instead, TTRS led to overleveraging by holding companies and controlling shareholders that borrowed to inject new equity into banks. In turn, banks engaged in riskier activities because they needed to generate higher earnings in order to pay dividends to the parent company and shareholders so that they could service their debt.
  • Difficulties with TTRS point to weaknesses in the area of consolidated supervision. Within the existing BAFIA, there is scope for an expanded supervisory role by BNM over the affairs of those holding companies that own banking institutions. BNM is moving to remedy the TTRS incentive problem by forcing bank owners (shareholders or holding companies) to create a dedicated financial holding company to hold banking institutions. Financial entities that fall outside of BNM’s jurisdiction are to be disassociated from the holding company. These companies would be required to consolidate their financial reporting at the dedicated holding company level, and BNM would be able to impose risk-based capital requirements, as the entities would be of a similar nature. As a preliminary step, BNM has imposed new regulatory reporting and prior approval requirements for borrowings at the holding company and shareholder levels so as to reduce overleveraging in the banking system.
  • BNM announced to bank managers that they and their directors would be subject to regular reviews for their fitness as bankers. The measure was intended as a process to ensure that executives remain accountable. The primary criteria for assessing performance are the fit-and-proper standards found in the BAFIA. Other criteria will be the performance by executives toward achieving an 8-percent loan growth target. The target growth rate is for the system as a whole and applies to all banks that have capacity, including foreign banks. While prompting more loans, BNM continues to emphasize that banks must appropriately consider the risks when authorizing credit, as they remain responsible for any loan losses.
  • Following an earlier change to the single customer limit, which reduced from 30 percent to 25 percent the maximum that a bank can lend to a single customer as a percent of capital, BNM will revise its policy on loans to related parties. The revised policy will add controlling shareholders to the list of parties that are to be considered related. Controlling shareholders are those that control 20 percent or more of a financial institution’s shares/Previously, the definition of related parties included only directors, employees, and their immediate family members.
  • Beginning in January 2000, the new liquidity framework will replace the current LAR requirement. Under the LAR framework, banking institutions had to hold liquid assets equivalent to an inflexible fixed percentage (15 percent at end-1998) of liabilities. The new liquidity framework gives both the financial institution and the supervisor a good tool to monitor individual bank liquidity.

F. Vulnerabilities and Conclusion

36. Starting from a position of several strengths, Malaysia has made progress in alleviating problems affecting its financial system. Early strengths were the high capital and low level of NPLs of its financial institutions, and a well-developed banking and credit culture based on an effective accounting, legal, supervisory, and regulatory framework. The relative strength of the supervisory and regulatory environment imposed important discipline that contributed toward the system’s resilience.

37. These strengths did not prevent significant financial sector distress but slowed down the impact, providing valuable time to assess and react. While there are still many risks, the strategy for the financial sector appears to be effective, but more time will have to pass to determine the strategy’s ultimate success. Malaysia will have several difficult quarters ahead, during which the banking system will remain vulnerable. Vulnerabilities include the following:

  • Despite early success, the initial recapitalizations and purchases of NPLs could prove insufficient to the extent that the economy does not return to stable growth. The trend in NPLs could reverse course and pick up again. That is, if the “hole” is underidentified or grows substantially larger, the programs may have to be reopened and/or transactions restructured. This could raise the cost of the support program and, depending upon the circumstances, undermine confidence in the banking system or the government’s ability to manage the problem.
  • Though Danaharta is very much on schedule in relieving NPLs from the system, there is reason for concern that it could become an NPL warehouse. Transaction volume to date has been largely loan acquisition followed by some success with debt restructuring. However, there needs to be progress with asset sales and foreclosures, which are not expected until the second half of 1999. Danaharta may come under pressure not to sell assets because, to the extent that Danaharta does not recognize a gain on the sale, the original selling bank will need to recognize a loss from the further write-down of its deferred asset. Close monitoring is warranted to ensure that Danaharta remains effective as an asset management company.
  • Notwithstanding the best efforts of Danamodal to replace directors and install better qualified chief executives in financial institutions, it could happen that inadequate, ineffective, or otherwise deficient management teams remain. In such a scenario, after substantial recapitalization costs borne by the industry, the restructurings do not prevent recurrence of a similar problem in the years ahead.
  • It could turn out that loan growth does not materialize, or worse, there is growth but the new loans subsequently deteriorate. Prompting by BNM that banks grow their loan portfolios to relieve the “credit crunch” appears to be taking hold as loan officers are finding customers. Early indications are that loan originations are up since the start of 1999. Nevertheless, the new loans are too unseasoned to tell if they are of sufficient quality to generate stable interest income and repay at maturity. Banks still reeling from the difficult business climate of 1998 have been cautious and have directed most new lending to homebuyers. In order for the desired kick-start to the economy from renewed lending to materialize, there will need to be some pickup in loans to manufacturing sectors.
1

This chapter was prepared by Michael K. Moore (ext. 38631) who is available to answer questions.

2

Malaysia has one pure Islamic bank—Bank Islam (assets RM 5.7 billion)—and financial institutions are able to offer Islamic bank products of interest-free leasing, hire purchase, profit-sharing, and joint-venture financing. At end-1998, Islamic banking represented less than 4 percent of the banking system assets.

3

Foreign banks also have minority interests in 12 other domestically owned banks.

4

These included MBf Finance (assets RM 16.9 billion) and the smaller Kewangan Bersatu (assets RM 2.3 billion).

5

Eligibility criteria consider an individual institution’s systemic importance and the authorities’ goal to achieve further consolidation and rationalization of the banking system. Danamodal will recapitalize MBf Finance, Arab-Malaysian Finance (assets RM 16.5 billion) and United Merchant Finance (assets RM 7 billion), as each alone has a size that represents a significant share of the finance company segment.

6

The high NPL ratio is not unique in Malaysia’s recent history. NPLs grew dramatically as a result of the recession in the mid-1980s, with NPLs reaching as high as 30 percent of loans in 1988, before declining to below 4 percent in 1997.

7

By regulation, collateral securing an NPL must be valued annually by an independent appraiser. In addition, Danaharta will value collateral for individual loans over RM 5 million as part of its negotiations to acquire NPLs. Malaysia’s legal environment is stable and provides good protection to secured lenders.

8

For example, the level of NPLs at MBf Finance and Arab-Finance alone account for 44 percent of the aggregate level of NPLs among finance companies.

9

The exchange rate depreciated from RM 2.5 per U.S. dollar in June 1997 to RM 4.4 per U.S. dollar in January 1998.

10

Total bad-debt provision is the aggregate of provisions for general, specific, and interest-in-suspense.

11

Replacing the guarantee with a deposit insurance system funded by the industry will be considered in the context of a study on deposit insurance.

12

Certain regulatory approvals will be required for certain asset purchases, e.g., the purchase of a stock-brokering company requires the approval of the Securities Commission.

13

The special management arrangement stems from the government-assisted merger of Sime and Bumiputra with stronger banks, RHB and Bank of Commerce, respectively. BNM will retain ownership of the NPLs that are to be managed by Danaharta. At year-end 1998, Danaharta was managing RM 11.6 billion in NPLs on behalf of Sime. Arrangements for Bumiputra have not been finalized.

14

Salomon Smith Barney is also working closely with Danamodal to complete a blueprint for the banking system. The blueprint helps to guide Danamodal in determining which institutions to assist and under what terms.

15

Funding comprised of RM 8 billion in zero-coupon bonds and RM 3 billion in capital provided by BNM.

16

Four institutions will receive official support outside of the Danamodal process. Bank Bumiputra and Bank of Commerce will be merged with government assistance, Perwira Affin is to be merged with BSN Commercial and will not receive separate recapitalization, and Utama Merchant will be recapitalized by its existing shareholders. Bumiputra and Perwira Affin have substantial government ownership.

17

Under the current framework, foreigners can buy up to 30 percent of the equity of an individual banking institution.

18

The 13 foreign banks operating in Malaysia are ABN Amro Bank, Bangkok Bank, Bank of America, Bank of Nova Scotia, Bank of Tokyo-Mitsubishi, Chase Manhattan Bank, Citibank, Deutsche Bank, Hongkong and Shanghai Banking Corporation, Overseas Chinese Banking Corporation, Overseas Union Bank, Standard Chartered Bank, and United Overseas Bank.

19

More details are provided in Chapter IV: “Issues in Corporate Sector Restructuring.”

20

CAMEL is a rating methodology used by many supervisors to evaluate a bank’s condition along five key measures: Capital adequacy, Asset quality, Management, Earnings, and Liquidity.

21

Of the 78 banking institutions, 21 have retained the three-month NPL classification criteria, and they account for 46 percent of the total system loans.

22

Annual examinations were already required for financial institutions on BNM’s watch list.

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