PETALING JAYA: The banking sector is entering the second half of financial year 2026 (2H26) on a softer footing with early optimism, driven by falling bond yields, attractive dividend prospects and expectations of capital management initiatives, gradually faded amid a lack of stronger catalysts.
Hong Leong Investment Bank (HLIB) Research said heightened geopolitical uncertainty also added to this expectation.
“The outbreak of the Iran war triggered a broad risk-off sentiment, accelerating foreign fund outflows from Malaysian equities and erased the sector’s earlier gains.
“While the first quarter of this financial year (1Q26) earnings remained broadly resilient, supported by steady loan growth and stable asset quality, softer non-interest income and higher provisions signalled that the operating environment is becoming increasingly challenging,” it told clients in a report.
HLIB Research said it was expecting a softer earnings outlook for the banking sector as credit strategy shifts and margin pressures persist.
“We project that earnings momentum could weaken over the remainder of 2026.
“Banks are increasingly prioritising higher-quality corporate lending over riskier small and medium enterprise exposures which is a prudent strategy that should strengthen portfolio resilience but potentially temper loan growth and dilute yields,” it said.
It added net interest margins are likely to remain under pressure amid persistent deposit competition and the lingering impact of the July rate cut.
Treasury gains are also expected to moderate as bond yields stabilise, while elevated foreign-exchange volatility may continue to weigh on banks with sizeable US dollar funding exposures, HLIB Research said, adding that collectively, in its view, these factors point to limited earnings upside in the near term.
Downgrading the sector to “neutral”, it said it anticipated two potential headwinds for the banking sector in 2H26, namely asset quality deterioration risk and potential index- related overhang.
“Our key concern has shifted from margin compression to asset quality,” it said, adding that statistical analysis suggests global supply chain disruptions lead deterioration in industry gross impaired loan ratios by around 12 months.
Although banks maintain a healthy RM4.1bil management overlay (2.6 times cover on 2025 aggregate provisions), sustained cost pressures could still test these buffers if macro conditions deteriorate.
Separately, the proposed expansion of the FBM KLCI to 50 constituents introduces an additional short-term headwind, with lower sector index weightings potentially creating a transitory overhang for banking stocks that are currently represented in the bellwether index, HLIB Research said.
A banking analyst told StarBiz banking stocks have not performed as well as expected so far this year, and the current volatile global environment is not helping.
“Foreign fund outflows from Malaysian banks have been significant but fundamentals are still intact for now,” he said.
In its report, UOB Kay Hian Research said it was “overweight” on the banking sector.
It said that despite the ongoing US-Iran peace deal negotiations, Malaysian equities are likely to kick off 2H26 defensively, amid expectations of the 16th General Election (in 4Q26) and a “higher-for-longer” cost inflationary impact from the Iran conflict.
