Moody's: Sharia-compliant investment accounts at Malaysian banks to continue growing

Moody's Investors Service says that the growth of Sharia-compliant investment accounts at Malaysian banks will remain strong over the next 3-5 years, carrying over the trend started in July 2015, as a result of active promotion by the regulator and banks themselves.

"Malaysian banks have strong incentives to promote the growth of such investment accounts because they provide capital benefits and an additional source of funding to grow their assets," says Simon Chen, a Moody's Vice President and Senior Analyst.

"At the same time, concerns exist over the untested state of loss-sharing mechanisms in the accounts, although the regulators have instituted safeguards to protect the banks," adds Chen.

Moody's conclusions are contained in its just-released report on Islamic banks in Malaysia, "Strong Growth of Investment Accounts Supports Bank Capital and Funding, But Risk-Sharing Mechanism Remains Untested."

The robust growth of Sharia-compliant investment accounts in Malaysia began in July 2015 following the implementation of the Islamic Financial Services Act 2013.

Such accounts are defined in the Act as those under which money is paid and accepted for investment in accordance with Sharia principles and on terms that state there is no express or implied obligation to repay the money in full.

Moody's notes that by February 2017, these accounts had grown to MYR74.2 billion, or 13% of total banking system liabilities, and they will become an increasingly important tool in managing business and income growth, as well as capital adequacy.

On the question of risk, a key issue is whether and to what extent loss-sharing mechanisms in the accounts between the banks and investors will be honored in case of actual losses. A significant loss event to test the resilience of this regime has yet to occur.

Our concern is underpinned by our observation that Islamic banks in other Islamic jurisdictions, notably some Gulf Cooperation Council(GCC) countries, in practice do not exercise the contractual loss-absorbing nature of investment accounts.

This situation is perhaps because of customer expectations and out of fear of reputational damage, and can result in Islamic banks bearing much, or all, of the assets risk on behalf of investment account holders.

However, a mitigating feature for Malaysia is that the regulators have put in place safeguards to protect the banks, such as the segregation of the investment accounts from deposits.

Such safeguards will put Malaysian banks on a strong legal footing for upholding the risk-sharing principle behind these investment products when actual losses arise.

Another credit risk is liquidity, as similar to customer deposits that are placed with banks and that can be withdrawn on demand, Sharia-complaint investment accounts could also be subject to withdrawals, which may lead to liquidity issues for the banks.

Moreover, investment accounts are more likely to be sourced from retail and corporate customers seeking higher returns for their excess funds. As such, these funds could be more volatile than deposit accounts, which are mainly the cash balances of companies maintained for daily operational purposes and are hence more stable.

However, this liquidity concern is partially mitigated by Malaysia's regulatory requirement for investment accounts and which helps maintain liquidity coverage ratios for individual accounts.

In such instances, the banks need to ensure that investment accounts have sufficient liquidity to overcome outflows in a 30-day period. That said, liquidity coverage ratio compliance would entail additional costs for the originating banks.