This article first appeared in The Edge Financial Daily, on March 23, 2016.

KUALA LUMPUR: RAM Rating Services Bhd (RAM Ratings) has maintained its “stable” outlook on Malaysia’s Islamic banking sector, with “AAA” to “AA” ratings on most banks on support from their parent universal banking groups or shareholders.

RAM Ratings said the “stable” outlook is in line with its view on the overall domestic banking system.

“While the more challenging economic environment has weakened asset quality and funding parameters, we have maintained our ‘stable’ outlook on the 10 Islamic banks in our rating portfolio, which account for close to 90% of this segment’s assets,” it said in a statement, adding that while the Islamic banking sector’s gross impaired financing ratio stayed healthy at 1.2% as at end-2015, the 18% uptick in impaired financing is a concern.

“This year, we expect the sector’s asset quality to face a more trying landscape than the broader banking sector,” said its financial institution ratings co-head Sophia Lee. It expects the Islamic banking sector’s financing growth to decelerate to 12% this year, ahead of the overall industry’s 6% growth. It expects the sector’s asset quality to be tested and capitalisation levels to stay comfortable. There will be sound liquidity with profitability shaved by keen competition for deposits, it added.

RAM Ratings said as at end-December 2015, Islamic banks reported a healthy liquidity coverage ratio of 113%, well above the 70% minimum required by January 2016.

It added that Islamic banks still fared better than the overall banking sector’s 3% growth for deposits and customer investment accounts, where the former slowed to about 9%.

“The tighter funding conditions have intensified competition among Islamic banks for deposits,” Lee said.

RAM Ratings said the financing-to-funds ratio had risen to an estimated 87% as at end-January 2016, compared with 83% as at end-2014, an unfavourable development.

“The challenges posed by strained asset quality and tighter funding may impinge upon Islamic banks’ profitability this year. However, their credit profiles can still be shored up by their comfortable capitalisation levels,” Lee said.