This article first appeared in The Edge Malaysia Weekly on November 2, 2020 - November 8, 2020

THE going has been tough for the two remaining standalone foreign Islamic banks in the country — Kuwait Finance House (Malaysia) Bhd (KFHM) and Al Rajhi Banking & Investment Corp (Malaysia) Bhd (Al Rajhi Malaysia). Both have struggled for a long time to make strides in the competitive Islamic banking space and the coronavirus pandemic has only made things more challenging, raising questions about their long-term survival or future in the country.

KFHM slipped into a net loss of RM39.89 million in the second quarter ended June after posting a net profit of RM13.68 million in the preceding quarter, and a net profit of RM8.62 million in 2QFY2019. It made an annual net loss of RM79.02 million in FY2019.

Operating revenue, at RM107.65 million, was lower than the RM119.19 million a year ago. Credit losses on financial assets stood at RM6.7 million compared with RM327,000 a year ago.

The group booked a one-off modification loss of RM54.18 million in the second quarter owing to cash-flow modification on personal financing and hire purchase accounts, as a result of the six-month blanket repayment moratorium that kicked off in April. According to CEO Mohd Hazran Abd Hadi, KFHM does not expect further modification loss.

“No more modification loss [is] expected under the targeted repayment assistance. KFHM continues to focus on business amid the challenging times of the pandemic,” he tells The Edge via email, when asked to comment on, among other things, market speculation that KFHM is open to considering an exit or merger-and-acquisition (M&A) options in Malaysia.

As for Al Rajhi Malaysia, it made a small net profit of RM1.92 million in the second quarter, which represented a decline of 65.4% quarter on quarter and 60.7% year on year (y-o-y). Revenue, at RM86.41 million, was lower than the RM96.75 million a year ago. It had a writeback for credit losses on financial assets of RM3.06 million compared with a writeback of RM2.46 million a year ago.

It is understood that Al Rajhi Malaysia’s 2Q financial results do not reflect a modification loss. According to an industry source, it can book the modification loss before the financial year-end.

Al Rajhi Malaysia CEO Steve Chen declined to comment.

KFHM and Al Rajhi Malaysia were among the first to set up operations in Malaysia when the country opened its Islamic banking sector to foreign players 14 years ago.

Another early standalone player, Asian Finance Bank Bhd, was acquired by Malaysia Building Society Bhd in 2018. National Bank of Abu Dhabi Malaysia Bhd, which set up operations in the country in July 2012, closed six years later in 2018. The reason for shutting down is not publicly known but The Edge understands it was on the instruction of its Middle Eastern owner First Abu Dhabi Bank PJSC.

What is clear is that standalone foreign Islamic lenders have not had it easy, and their small returns amid an increasingly competitive and challenging market have prompted many to question whether an exit or M&A is imminent for KFHM and Al Rajhi Malaysia.

Lack of scale and footprint, to a certain extent, has put KFHM and Al Rajhi at a relative disadvantage to other Islamic banks, say industry observers and analysts. The two are small, with an asset size of RM8.7 billion and RM6.83 billion respectively as at end-June, compared with their peers, especially the largest standalone, Bank Islam Malaysia Bhd (RM64 billion). KFHM has 11 branches while Al Rajhi Malaysia has 16.

“Like it or not, when you talk about banking, scale matters … because with scale, you can be more efficient. The kind of capital expenditure we incur just to keep our doors open for operation is high. So, if you don’t have scale, your unit cost to service each customer is going to be high,” a senior Islamic banker tells The Edge.

“And to make things worse, it is a highly competitive financing market. When you look at it, the mortgage financing [rate] is about 3%, business financing about 4% … very competitive. So, if you don’t have scale and your unit cost cannot be kept low, it’s going to be very challenging … there won’t be enough margin for you to cover your overheads.”

As it is, Bank Negara Malaysia’s move to cut the overnight policy rate by an unprecedented 125 basis points over the course of this year to a record low of 1.75% as at last week poses a major challenge for banks.

“Margins have really shrunk. When the OPR is cut that fast, our funding cost is not able to come down as quickly as the asset return. So, I think, for those two [Islamic banks], when you lack scale and margins are being slashed in that manner, it will be challenging for them to cover their fixed costs, their overheads,” the banker continues.

Apart from KFHM and Al Rajhi Malaysia, there are three other foreign Islamic banks — HSBC Amanah Malaysia Bhd, Standard Chartered Saadiq Bhd and OCBC Al-Amin Bank Bhd — but these are non-standalone in that they can leverage the branches of their conventional franchise.

But the second quarter was tough on them too. HSBC Amanah reported a net loss of RM4.21 million compared with a net profit of RM38.54 million a year ago as impairments almost tripled to RM68.33 million. As for Saadiq, its 2Q net profit fell 56.9% y-o-y to RM4.88 million while OCBC Al-Amin’s fell 36.9% y-o-y to RM18.8 million.

“These are banks that operate on a leverage model; like Maybank Islamic and many of the other local banks, they have natural efficiency because they can tap on the scale of the franchise itself. So, for standalones to survive, they need to up their game,” says the banker.

“M&A is always an option. But with Covid-19, that would have to take a back seat for now. I think they have to either come in in a big way, that is, put in capital and scale up immediately, or really differentiate themselves in the products and services they offer, so that customers are willing to go with them even though the pricing may not be competitive.”

As it stands, he opines that most Islamic products and services in the market today are not that distinctly different. And even if they are, their uniqueness is not well communicated to the customer.

The good thing about KFHM and Al Rajhi Malaysia is that they are backed by Middle Eastern shareholders with deep pockets. Hence, there is no issue with capital, he adds. Both banks are in a strong capital position.

“It’s actually quite difficult for the two standalones to attract local consumers, much like what Malaysian banks face in foreign countries. I think, being Islamic on its own is not a force because all the local banks already have Islamic entities. It really comes down to pricing,” a banking analyst remarks.

KFHM, wholly owned by Kuwait Finance House KSC, is mainly a retail lender. House financing, personal financing and other term financing made up more than half of its gross financing of RM4.81 billion as at end-June.

Al Rajhi Malaysia, however, is a little different in that, while it does have a retail strategy, its commercial business constitutes a higher share. Corporate financing accounted for 69.2% of its gross financing of RM4.91 billion as at end-June. It is owned by Saudi Arabia-based Al Rajhi Bank, the world’s largest Islamic lender by assets.

Until today, there has been no update on a planned merger between Al Rajhi Malaysia and MIDF Bhd, but it is understood that neither party wants to officially call it quits as yet. The Edge reported in June, citing sources, that the two have yet to resolve an impasse related to the application of shariah rules in the merger. Adding to the complication is the Covid-19 pandemic, which has changed the banking landscape.

If the merger were to proceed, a review of some of the terms may be necessary, the sources said. The two first began negotiating a merger in January 2019 and submitted their proposal to the central bank in September last  year.

KFHM, which started operations in August 2005, has had a volatile financial history. It incurred losses from FY2009 to FY2011 after having to make massive provisions for bad financing. This was shortly after the 2008/09 global economic downturn, but critics say its problems were also because of weak leadership, a lack of corporate governance and lax risk management practices in the earlier years.

KFHM turned in its worst performance in FY2011, with a net loss of RM471.6 million and gross non-performing financing ratio of 23.2%.

After rectifying mistakes, the group managed to return to the black in FY2012. But it posted losses again in FY2015 and FY2016 because of high provisions, mainly for the legacy portfolio, only to return to profitability in FY2017. But it made a loss again in FY2019.  Mohd Hazran, who became CEO in February, is its seventh in 15 years.

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