BANKING SECTOR. Final guidelines issued for BASEL III capital framework 2 January 2013 OVERWEIGHT. Rationale for report : Sector update

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1 BANKING SECTOR Final guidelines issued for BASEL III capital framework 2 January 2013 OVERWEIGHT Rachel Huang huang-teng-siang@ambankgroup.com Rationale for report : Sector update (Maintained) Investment Highlights Final guidelines almost unchanged from Concept Paper in May Bank Negara Malaysia (Bank Negara) has released the final guidelines on BASEL III s capital components. The final guidelines essentially include all the key proposals from Bank Negara s concept paper in May 2012 in relation to BASEL III s capital requirements. The unrealised gains on financial instruments classified as available-for-sale (AFS) are still subject to the following prudential filters per the Concept Paper:- (a) AFS reserves for equity and debt instruments recognised in Common Equity Tier 1 Capital (CET1), subject to a 55% haircut; (b) Fair value gains for loans not recognised in any tier of capital. Significant investments in the capital instruments of unconsolidated financial instruments, insurance companies and takaful operations to be fully deducted in the calculation of CET1. This is more conservative than BASEL III, which allows for threshold deductions treatment whereby investments in excess of 10% of the banking group s CET1 capital need to be deducted. Counter-cyclical buffer expected to be finalised before The counter-cyclical buffer, which BASEL III recommends to range between 0% and 2.5%, has not yet been finalised. The central bank said it expects to detail out capital buffer requirements before 2016, providing further guidance on how the counter-cyclical buffer requirements will be operationalised. Bank Negara s final guidelines require banking institution to comply with the capital adequacy framework at the following levels: (a) Entity level and (b) Consolidated level. This means that the final guidelines would also be applicable to bank entity level. Maintain overweight. The minimum requirement for CET1 is still 3.5% for the calendar year 2013, and 4.0% for The minimum level is still 7.0% by The final guidelines are broadly in line with expectations, although this means there may be a slight disappointment in the market if there had been earlier hopes that the Concept Paper may be revised to be more in line with the BASEL III s. TABLE 1: VALUATION MATRIX Stock Rating Sh Pr FV Issued Mkt Cap PE (x) EPS growth (%) P/BV (x) ROE (%) G Div. Yield (%) (RM) (RM) shares (m) (RMm) Pros1 Pros2 Pros1 Pros2 FY12 FY13 Pros1 Pros2 Pros1 Pros2 AMMB NR 6.69 NA 3, , AFG HOLD , , CIMB BUY , , HLBB HOLD , , Maybank HOLD , , PBB BUY , , RHB Cap BUY , , Simple average Weighted average MBSB HOLD , , Note: AMMB's forecasts based on consensus. Source: Bloomberg / Company / AmResearch PP 12246/05/2013 (032379)

2 TABLE 2: ESTIMATED DIFFERENCES (GROUP COMMON EQUITY TIER 1) AFG AMMB CIMB HLBB Maybank PBB RHB Cap Quarter Sep-12 Sep-12 Sep-12 Sep-12 Sep-12 Sep-12 Jun-12 Main differences (RM mil) Unrealised gain on AFS n.a Associate , , , Investments in jvs Deferred tax assets , Source: Company / AmResearch... NO CHANGE IN BANK NEGARA S FINAL GUIDELINES ON BASEL III Final guidelines in line with May 12 s concept paper Bank Negara Malaysia (Bank Negara) has released the final guidelines on Capital Components. The final guidelines essentially include all the key proposals from Bank Negara Malaysia (Bank Negara) s concept paper in May 2012, which was a draft document intended to obtain feedback from the industry on instruments that could be included under BASEL III s capital requirements. FINAL GUIDELINES MORE CONSERVATIVE THAN BASEL III S Essentially, BN s final guidelines are more conservative in four key areas: (1) Unrealised fair value gains of financial instruments. The unrealised gains on financial instruments classified as available-for-sale are still subject to the following prudential filters per the Concept Paper:- (a) AFS reserves for equity and debt instruments recognised in Common Equity Tier 1 Capital (CET1), subject to a 55% haircut; (b) Fair value gains for loans not recognised in any tier of capital. The main impact would be on banking groups with any significant investments available-for-sale, although there is no breakdown between unrealised gains related to equity and debt instruments, and loans. In any case, the banks which reported large unrealised gains on securities available-for-sale were CIMB (RM690mil) and Maybank (RM470mil) (see Table 2 above). The mid-ground ones were RHB Cap (RM225mil) and HLBB (RM201mil). The ones which reported smaller unrealised gains were AFG (RM116mil) and PBB (RM28mil). (2) Full deduction of significant investments in unconsolidated investments The final guidelines affirmed the Concept Paper s proposal that investments in the ordinary shares of subsidiaries and unconsolidated financial / insurance / takaful affiliates to be fully deducted in the calculation of CET1 capital. Instead of BASEL III s threshold deductions This is more conservative than BASEL III, which allows for threshold deductions treatment whereby only investments in excess of 10% of the banking group s CET1 capital need to be deducted. Recall that under BASEL III s threshold deductions, instead of full deduction, the following items may each receive limited recognition when calculating Common Equity Tier 1, with recognition capped at 10% of the bank s common equity: (a) Significant investments in the common shares of unconsolidated financial institutions (banks, insurance and other financial entities); (b) Mortgage servicing rights; (c) Deferred tax assets (DTA) arising from temporary differences. BASEL III also requires a bank to deduct the amount by which the aggregate of the three items above exceeds 15% of its common equity component of Tier 1). The final guidelines mean a more conservative treatment of unconsolidated investments, for example, investments in associates and joint ventures. but some phase-in effect allowed by local regulator However, Bank Negara allows phase-in arrangement, with regulatory adjustments to be phased in, with a portion to be deducted using the corresponding deduction approach: 20% in 2014, 40% in 2015; 60% in 2016; 80% in 2017 and 100% in Banks which have relatively larger amounts of investments in associates would be Maybank (RM2,282mil), CIMB (RM1,402mil) and HLBB (RM1,550mil) (see Table 2). AmResearch Sdn Bhd 2

3 These would have contributed to a large bulk of possible threshold adjustments allowed under BASEL III, thus contributing to the main difference between the Common Equity Ratio Tier 1 ratios based on BASEL III s basis. (3) Deferred tax assets (DTA) BASEL III allows for DTA relating to temporary differences (e.g. allowance for credit losses) to be deducted as set out in the threshold deductions criteria mentioned above. In the final guidelines by Bank Negara, it is stated that DTA that relies on the future profitability of the banking institution to be realised shall be deducted in the calculation of CET1. However, there is no threshold deduction mentioned. Among the banks, Maybank has a relatively higher amount of DTA, at RM1,400mil. (4) Property revaluation gains / losses Bank Negara s final guidelines also affirm that the amount of cumulative unrealised gains arising from the changes in the fair value or revaluation of land and buildings shall be treated as follows: (a) Cumulative unrealised gains shall be deducted in the calculation of CET1 capital; (b) 45% of the cumulative unrealised gains shall be added back in the calculation of Tier 2 capital. While there are no further details on the banks unrealised property revaluation gains, we believe these are relatively small. NO CHANGE TO ESTIMATED GROUP COMMON EQUITY TIER 1 RATIO With the final guidelines, we estimate the following group common equity Tier 1 ratios for the banks (see Table 3 below): (a) AFG is the highest at 11.8%; (b) AMMB reported common equity Tier 1 ratio of 8.6% for the banking entities level; (c) CIMB s group common equity Tier 1 ratio is estimated at 7.7% as at end-september This does not include the impact from completion of acquisition of 60% stake in the Philippines Bank of Commerce and selected cash equities businesses from Royal Bank of Scotland. CIMB had hinted earlier the two acquisitions are expected to shave off 35bps to 40bps from the group s common equity ratio; (d) HLBB s group common equity Tier 1 ratio is estimated at 8.0%; (e) Maybank reported group common equity Tier 1 ratio at 9.2%; (f) PBB reported group common equity Tier 1 ratio at 8.0%; (g) RHB Cap s group common equity Tier 1 ratio is estimated at 8.0% as at end-september TABLE 3: ESTIMATED GROUP COMMON EQUITY TIER 1 RATIO (CET1) AFG AMMB CIMB HLBB Maybank PBB RHB Cap Quarter (%) Sep-12 Sep-12 Sep-12 Sep-12 Sep-12 Sep-12 Jun-12 Group / Bank level Group level Group level Bank level Group level Group level Group level Bank level Tier Total CAR Group / Bank level Group level Banking entities level Group level Group level Group level Group level Group level Common equity ratio per BASEL III n.a high 8% Common equity ratio per Bank Negara > 7% Difference (ppt) (0.29) n.a. (0.55) (1.30) (1.43) (0.10) (1.00) Source:Company / AmResearch. Note: Assumed full deduction without phase-in effect. AmResearch Sdn Bhd 3

4 TABLE 4: ESTIMATED BANK LEVEL COMMON EQUITY TIER 1 RATIO (CET1) AFG AMMB CIMB HLBB Maybank PBB RHB Cap Bank level Sep-12 Sep-12 Sep-12 Sep-12 Sep-12 Sep-12 Jun-12 Common equity ratio per Bank Negara n.a. n.a > 7% 9.57 Main differences (RM mil) Investment in subsidiary companies , , ,072.7 Investment in associated company Investment in jointly controlled entity 76.7 Inv in subsidiaries and associates 17, ,162.3 Holdings of other financial institutions' capital instruments 47.5 Source: Company / AmResearch. Note: Assumed full deduction without phase-in effect. AFG does not disclose banking entity data. Maybank s assumed to have included new share issuance in October LEVEL OF APPLICATION Bank Negara s final guidelines require banking institution to comply with the capital adequacy framework at the following levels: (a) Entity level. This refers to the global operations of the banking institution (i.e. including its overseas branch operations) on a stand-alone basis, and including its Labuan banking subsidiary; (b) Consolidated level, which includes the entities covered under the entity level requirement, and the consolidation of all subsidiaries, except for insurance/takaful subsidiaries, which shall be deducted in the calculation of Common Equity Tier 1 capital. BASEL III said the framework is to be applied on a consolidated basis to internationally active banks. The scope of application of the Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group. The framework will also apply to all internationally active banks at every tier within a banking group, also on a fully consolidated basis. The key difference would be Bank Negara s requirement for BASEL III to be applied to both the bank entity level as well as group level. Thus, in the case of bank entity level, the key difference would be requirement to deduct entirely investment in subsidiaries (see Table 4 above): (a) CIMB Bank has been reporting bank entity figures. Our estimate for CIMB Bank entity level is 7.5%, but this is assuming no impact from phase-in effect allowed under Bank Negara s final guidelines. However, CIMB confirmed that the banking entity level s common equity Tier 1 is more than 10% if assuming full phase-in effect allowed under Bank Negara s guidelines; (b) HLBB s bank entity is also expected to be affected due to investment in subsidiary of RM2.1bil and investments in associate of RM946mil. HLBB confirmed the banking entity s common equity Tier 1 ratio would be 6% (in line with our estimated 6.3% above). HLBB hinted at the possibility of a rights issue in 2016, when the countercyclical buffer ratio is likely to be announced. The other possible option would be to reverse its investment in subsidiary (largely cost of Islamic bank) into a more cost efficient structure. (c) Maybank has the largest amount, at RM17,873mil for investments in subsidiaries and associates (the bulk of this are related to subsidiaries). Our estimates show the banking entity s common equity Tier 1 ratio at 7.6%, assuming this includes the RM3.66bil equity capital raised from its new share placement in October 2012; (d) PBB hinted that the common equity Tier 1 ratio is at slightly above 7% for the banking entity level; (e) We estimate RHB Cap s banking entity at 9.6%; The mitigating factor is Bank Negara allows phase-in arrangement, with regulatory adjustments to be phased in, with a portion to be deducted using the corresponding deduction approach: 20% in 2014, 40% in 2015; 60% in 2016; 80% in 2017 and 100% in CAPITAL FRAMEWORK FOR FINANCIAL HOLDING COMPANIES TO BE ISSUED IN 2013 Bank Negara said proposals for a capital framework for financial holding companies will be issued in 2013, to address the issue of multiple gearing of capital in financial groups. AmResearch Sdn Bhd 4

5 MINIMUM REQUIREMENTS FOR CET 1 IS STILL 3.5% 2013 The minimum requirement for CET1 is still 3.5% for calendar year 2013, and 4.0% for The minimum level is still 7.0% by 2019 (Note that the 7.0% level is still not including any counter-cyclical buffer). COUNTER-CLYCLICAL BUFFER TO BE DETERMINED BY 2016 (e) PBB s common equity ratio of 7.0% for the banking entity level is also relatively lower compared with the group common equity ratio of 8.0%. However, PBB reaffirmed it will likely continue with its policy of raising the quantum of dividends yearly, while dividend payout ratio is expected to be slightly lower than the 48% achieved in FY11. This is reassuring and therefore positive for share price; (f) RHB Cap is still expected to raise a slightly larger rights issue in conjunction with its proposed acquisition of Bank Mestika. No change in expectations. The counter-cyclical buffer, which BASEL III recommended to range between 0% and 2.5%, has not yet been finalised. The central bank said it expects to detail out capital buffer requirements before 2016, providing further guidances on how the counter-cyclical buffer requirements will be operationalised, including the approach to determine the weighted-average of the countercyclical buffer requirements for cross-border exposures, elements subject to restrictions on distributions (e.g. cash dividends and other discretionary distributions) and the interactions of the buffers with other supervisory processes (e.g. the Pillar 2 Internal Capital Adequacy Assessment Process). BROADLY IN LINE WITH EXPECTATIONS The final guidelines are broadly in line with expectations, although this means there may be a slight disappointment in the market if there had been earlier hopes that the Concept Paper may be revised to be more in line with the BASEL III s. With the latest guidelines, we expect the effect on the following banking groups: (a) AFG remains the highest, with no change in expectations and is not expected to require capital; (b) CIMB is still expected to consider the sale of non-core assets, such as its insurance jointventure, as part of its capital planning consideration. The other plans being considered is a possible one-off dividend reinvestment plan; (c) HLBB. A possible rights issue in 2016 is new, in our view, and may be a dampener to share price; (d) Maybank. Banking entity level s common equity ratio of 7.6% is not as high as expected, compared with the group s common equity ratio now of 9.16%;; AmResearch Sdn Bhd 5

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