KUALA LUMPUR (Dec 18): The proposed abolition of the Rule of 78 by Bank Negara Malaysia could “pave the way” for similar reforms in other financing products, including hire purchases, having a larger impact on the banking sector, according to Phillip Capital.

The Rule of 78, a widely used method that front-loads interest charges on personal financing products, requires borrowers to pay a higher proportion of the interest early in the loan tenure.   

While this benefits banks in the short term by ensuring they collect more interest upfront, it discourages early loan repayments, as borrowers stand to save little on interest if they settle their loans early.

However, with the potential removal of this method, banks could face new challenges, said Philip Capital in a note on Wednesday.

Without the front-loaded interest income, they may see an increase in early repayments, leading to higher portfolio turnover, it added.

This shift could force banks to redeploy funds into lower-yielding assets, increasing reinvestment risk.   

To mitigate this, banks may look to raise their effective interest rates, which could offset some of the lost interest.  

In a note on Wednesday, Phillip Capital said the net effect on interest income could still be positive.

The research house also noted that shifting to a variable-rate personal financing loan would allow banks to benefit from a rising interest rate environment.

Such a move would allow banks to capitalise on a rising interest rate environment, helping to maintain profitability despite changes in loan structure.  

Among banks, Alliance Bank Malaysia Bhd (KL:ABMB) holds the largest exposure to personal financing products at 11% of its portfolio, followed by Affin Bank Bhd (KL:AFFIN), CIMB Group Holdings Bhd (KL:CIMB) and RHB Bank Bhd (KL:RHBBANK), each with 6%.

Globally, the Rule of 78 has come under fire for being unfair to borrowers, and its removal is seen as a step forward in consumer protection, said the research house.

If implemented, it added, this change could pave the way for similar reforms in other consumer financing products, such as hire purchase loans, potentially having an even broader impact on the banking sector.

Phillip Capital maintained its “overweight” call on the Malaysian banking sector, and likes CIMB ('buy'; target price [TP]: RM9.30) as a liquid large-cap pick with strong Asean footprint, Public Bank Bhd (KL:PBBANK) ('buy'; TP: RM5.10) and Hong Leong Bank Bhd (KL:HLBANK) ('buy'; TP: RM24.30) backed by their defensive nature with strong asset quality, RHB ('buy'; TP: RM7.50) and Malayan Banking Bhd (KL:MAYBANK) ('buy'; TP: RM11.40) for attractive dividend yield, and AMMB Holdings Bhd (KL:AMBANK) ('buy'; TP: RM6.00) as a preferred small-cap bank pick.