Monday, April 27, 2009

The Good and Bad of Financial Liberalisation

For full details read the press release from BNM:

"The liberalisation measures announced today aims to strengthen Malaysia 's economic interlinkages with other economies and enhancing the role of the financial sector as a key enabler and catalyst of economic growth. These liberalisation measures are consistent with the objectives committed under the Financial Sector Master Plan (FSMP) issued in 2001 to develop a resilient, diversified and efficient financial sector. More than 90% of the FSMP initiatives have been completed or are being implemented on an ongoing basis."

The operational measures are fairly minor, except for insurance and takaful companies which will now be allowed to open branches without limit, and onshoring of qualified offshore FIs. The other two categories are more interesting however: BNM is offering two new Islamic banking licenses (subject to a minimum capital base of USD1 billion), five new commercial banking licenses, and two additional takaful licenses. Foreign equity limits have also been raised to 70% for all institutions except for the depository banks, and potentially higher for insurance operators.

My first instinct as an economist is this is all good - the more competition, the greater should be the efficiency of the banking system, and the greater should be the impact on social welfare. It's also clear that BNM is pushing for the continued development of Malaysia as the centre for Islamic banking and takaful.

However, the pragmatist in me wonders what having all this additional capital pumped into the banking system will do to credit creation (I'm not familiar enough with the insurance sector to make a stab at commenting on the impact). Right now banks aren't lending enough and creating more competition won't necessarily reduce the headwinds against additional lending. On the other, if and when the economy recovers (i.e. when these new banks start business), that's additional capital looking for a source of yield in an already crowded local market.

It would be interesting to see what will happen. These new banks could conceivably cannibalize business (deposits and lending) from existing players, in which case we get the efficiency and welfare gains that we're looking for. If on the other hand they add on to existing business (in other words, if they have to resort to wholesale funding), then we have an increase in systemic risk and the potential for a credit boom-bust cycle.

Assuming the five CBs have a capital base of USD500 million each, adding the USD2 billion from the new Islamic banks gives a total of USD4.5 billion as core capital. Assuming an average of 13% RWCR, and that core capital is half that, that implies additional credit of USD72 billion, or about RM250 billion, which represents a third of current total loans.

If all that goes in as additional lending locally - we are in deep doodoo. In practice, some of it would be cannibalization, some of it additional lending, and some of it is going overseas. The crucial question from the point of view of systemic risk is, how much will be in which category?

Conditions for the new licenses have been released for commercial banks and for Islamic banks and takaful operators. The capital requirements for the new banking licenses were a lot more modest than I expected at only RM300 million as against the USD500 million in my example. That totals up to about USD2.4 billion in additional capital, which at a core capital leverage ratio of 16 adds up to about USD40 billion in potential additional credit or about RM140 billion. That's equivalent to something like only 19% of current loans outstanding, which reduces the potential for a boom-bust credit cycle.

The Labuan offshore liberalisation conditions are available here (warning: pdf link). This doesn't actually amount to much - essentially the only change is having your physical back-office located in KL rather than Labuan. The benefits are obviously better access to customers and human resources, but it appears nothing fundamental has really changed.


  1. Hi HishamH,

    What worries me is operational flexibilities.

    Allowing offshore services to have physical presence onshore is like making the whole system offshore.

    “A strengthened regulatory and supervisory framework”.. I wish that works.

    There are lots of financial instruments (e.g derivatives: swaps, linked notes…etc.) out there which can even trap experts like accountants, financial analysts, sophisticated investors, economists etc..unless they are well versed in that particular field (derivatives) and carry out due diligence.

    Examples are abundant: Lehman Minibonds (and other structured products) which incurred big losses in Singapore, HK, Taiwan investors; ACCUMULATOR product in HK which incurred big losses in HK’s companies and HNWI.

    I don’t think M’sian’s investors are ready for these products yet.

  2. I attended a briefing last week where this question came up - in short, the word is that BNM isn't allowing any products in Malaysia that they don't understand themselves. Hence the relative lack of exotic investment instruments in Malaysia.

    BTW, good resource on structured products:

  3. First thing, the local institution will lose their good talents to these incoming institutions....although there are penalties to be paid to IBBM the losses to the organization is pretty big...

    Do we really need more banks into the system? Why cant they become investors instead...limit the licenses (which would help valuation of these institutions via the embedded goodwill value on the license itself) Knowledge transfer can still happen with smart partnership model...

    A catastrophy insurance model can be used to limit the potential systemic risk in which these new institution bring to the system. Assuming a new capital charge component is applied for systemic risk, as institution join the system their specific premium can be based on the potential add on risk rather than a flat rate applied to join

  4. I missed the human resource aspect - good point there. This suggests financial sector wages are going to bid up as well. Maybe it's time to consider going back to the banking sector.

    As to number of banks - I was against the initial post-crisis consolidation in the first place. The new added competition could potentially limit organic growth of individual banks, assuming credit standards don't slip (a big if), which reduces the potential systemic risk from individual bank failures. The conditions of the licenses also stipulate that the new players will necessarily be niche players.

    Re: systemic risk. That sounds familiar - I think that proposal has been doing the rounds lately. The problem is of course, making an accurate determination of the degree of systemic risk against the cycle, when risk measurements tend to be pro-cyclical.

  5. Hi SatD and Hishamh,

    Hope you can shed some lights on:
    1. what is IBBM ?

    2. Is there a model or a way to calculate optimal number of banks or optimal size of banks ? (I know there is Optimum Currency Area for currency)

    3. Is there an institution “controlling” credit standards in M’sia ?


  6. 1. Institut Bank-Bank Malaysia. Basically a industry training body for bank staff. More details here. To discourage staff pinching, BNM mandates that banks that hire staff from other banks within 6 months (I think) of leaving their previous employer have to pay a fine (a multiple of the pinched staff's salary), which is supposedly used to train staff replacements.

    2. Number of banks, no; size of banks quite a few. You can look up "x-efficiency" with "banking" in Google. The last paper I read on this suggested around USD10 billion in assets before diminishing returns set in, but that was in the early 1990s.

    3. In theory individual banks decide their own credit standards through their loan and credit committees, within the framework of BNM Guidelines. In practice however, loan committees only oversee loans of a certain size and above, while department heads and branch managers have their own authority limits. BNM also used to do surprise credit file audits from time to time to keep everyone on their toes - I don't know if they still do this.

  7. Hi Hishamh,

    Thx. Will check on those links.