OREANDA-NEWS. Malaysia's extension of Basel III capital adequacy requirements to financial holding companies (FHCs) - originally applicable only to licensed bank entities - will affect most of its major banking groups, says Fitch Ratings. The measures will strengthen the capital framework for FHCs, and address regulatory arbitrage between parent and subsidiary capital. That said, these rules may lead to shifts in the issuance strategies and structures of some banking groups. In any event, Fitch expects a continued focus on core equity capital by banks and FHCs in the years ahead in light of these new regulations.

The new rules were finalised by Bank Negara Malaysia last week, and are broadly in line with initial proposals from a Discussion Paper published in late 2014. The new FHC capital-adequacy requirements will apply from 1 January 2019, and will affect banking groups headed by FHCs such as CIMB Group, RHB Capital, Hong Leong Financial Group and AmBank Group, among others. The minimum capital adequacy ratio (CAR) for FHCs will be the same as those for banks. These will include an 8.0% total capital ratio; a 2.5% capital conservation buffer; and when required, a counter-cyclical capital buffer.

FHCs have gained popularity partly due to their capital efficient structure, as prudential regulation - including strictly-enforced capital adequacy rules - has typically focused on licensed bank and insurance entities so far. This is changing, with heightened awareness of potential contagion risk between FHCs and their subsidiary entities. FHCs in Malaysia have improved their capital positions and reduced their leverage in recent years.

Under the new rules, additional Tier 1 (AT1) and Tier 2 (T2) instruments issued by fully consolidated subsidiaries can be included as consolidated parent bank/FHC capital, but only if they contain additional loss-absorbency clauses referencing the parent/FHC. This feature will ensure that capital issued by a subsidiary can be used to help recapitalise the group or parent when it fails. As such, it is consistent with the spirit of moves internationally to improve bank resolvability.

This is a potentially significant regulatory change, as many banking groups in Malaysia are headed by FHCs with bank operating subsidiaries. Basel III capital issuance has thus far been largely at the bank entity level. In order to count as consolidated, FHC regulatory capital, subsidiary capital issuance will need to include parent-level triggers. Such securities may incur a higher risk premium compared with existing instruments issued by bank entities, which typically do not incorporate dual-entity triggers.

Cross-entity triggers are not common in Asia, so there are uncertainties as to how banking groups in Malaysia will address the new regulations and how the market will receive instruments which contain such triggers.

FHCs will need to strike a balance between potentially lower-cost issuance by the bank entity, versus the inefficiency of entity capital if it does not count towards capital of the consolidated group. One option for banking groups to address this issue is to place a banking entity at the apex and minimise inefficient subsidiary bank capital. Notably, RHB Capital is already in the middle of such a process.

Groups with bank entities as the ultimate parent, such as Maybank and Public Bank, will be less affected for now. The parent banks are already subject to Bank Negara's regulatory requirements, and the majority of issuance still originates from the parent. However, this issue may become more relevant for Maybank as it prepares to locally incorporate its Singapore business and expand its Indonesian subsidiaries, particularly as these subsidiaries issue capital securities to meet regulatory requirements of their own.