Local banks face mounting challenges from intense deposit competition and slower-than-anticipated economic growth, which may pressure loan expansion, asset quality, and net interest margins (NIM), according to a recent report by CGS International (CGSI) Research.

The research firm highlighted that weaker economic conditions projected for 2026 and 2027 could lead to increased loan loss provisions and slower growth in loan and fee income. At the same time, the banking sector is contending with elevated deposit competition, which may push up banks’ funding costs and compress NIM if the trend persists or intensifies.

CGSI noted that Malaysia’s 10-year government bond yield increased by 21 basis points to 4.03% as of September 20, 2026, during the third quarter of the year. This rise could negatively impact some banks' investment income due to mark-to-market losses on fixed-income securities holdings. However, the research house viewed the higher yields positively over the longer term, anticipating improved returns on new fixed-income investments that could help support NIM.

Loan growth in the domestic banking sector showed resilience, with total loans rising 3.7% in the first eight months of 2026, from RM2.36 trillion at the end of December 2025 to RM2.45 trillion as of August 2026. This corresponds to an annualized loan growth rate of 5.6%, slightly above CGSI’s forecast range of 4.5% to 5.5% for the year. The uptick in loan growth may partially offset the downward pressure on NIM in the latter half of 2026, especially as the repricing of fixed deposits slowed following the central bank’s overnight policy rate cut in July 2025.

Despite this, loan applications for the banking industry were largely flat in August 2026, declining 0.3% year-on-year after two months of strong double-digit growth—27% in June and 17.1% in July. On a month-to-month basis, applications dropped 15% in August, partly due to a high base in late July. Specifically, residential mortgage loan applications fell 6% year-on-year in August, compared with a 1.8% increase in July, while auto loan applications declined 10.1% year-on-year, a wider drop than the 1.2% year-on-year decrease in the previous month. Working capital loan applications continued to grow at a double-digit pace of 11.5% year-on-year in August, albeit slower than the substantial increases seen in June (82.3%) and July (59.8%).

Loan approvals also showed a moderation in growth, slowing from a 22% to 25% year-on-year increase in June and July to 11% in August. This moderation was still supported by a 50.9% year-on-year rise in working capital loan approvals in August, although growth in this segment decelerated from 71.6% in July.

Regarding asset quality, gross impaired loans (GIL) increased by RM1.53 billion, or 4.5%, from late February to the end of August 2026. CGSI attributed this deterioration partly to credit risks related to elevated oil prices following the outbreak of conflict in the Middle East. The research house projected the GIL ratio could rise further to around 1.5% by the end of 2026. Nonetheless, banks have taken proactive steps by engaging borrowers and offering repayment assistance to those adversely impacted by higher oil prices, which has helped contain the rise in impaired loans.

Despite these headwinds, CGSI maintained an overweight rating on the local banking sector, citing expectations of robust fee income in 2026 and a rising dividend payout ratio through 2028 as supporting factors for investor sentiment.