• Says outlook for finance firms more challenging than banks
• Expects weaker credit growth to provide liquidity comfort but at a cost to earnings 
• Less diversified funding mix and sharp reduction in loan recoveries identified as key issues 
• Says recent regulatory action by the Central Bank could provide some respite

The outlook for finance companies is expected to be more challenging compared to banks in the post-confinement period as asset quality, liquidity and higher capital standards could weigh on the sector’s recovery, but the regulatory response aimed at containing the full impact of the crisis could take some pressure off from the sector, ICRA 
Lanka said. 

In a note on the outlook of Sri Lanka’s non-bank finance companies (NBFIs) in the post-confinement period, the rating agency pointed out funding and liquidity will be the, “most significant vulnerabilities,” of the sector due to less diversified funding mix and sharp reduction in loan recoveries. 

ICRA Lanka noted that 65 percent to 70 percent of the finance company funds consists of customer deposits, moving up to 90 percent in certain smaller finance companies, exposing them more than their larger counterparts in times of 
economic stress. 

The balance funds come mainly from bank loans, although some larger finance companies use their balance sheet strength to raise funds from development financial institutions, commercial papers and corporate bonds. 

At times of economic crisis, there is a tendency to move deposits to safer asset classes as people and investors become more risk-averse. This could expose some of the smaller finance companies to liquidity risks. 

“Higher deposit dependence coupled with limited access to funding lines could create liquidity stress for finance companies, especially for the smaller ones, as deposits will tend to move to safer asset classes during crisis periods,” ICRA Lanka said. The rating agency further said while the already announced moratorium applies to some of the key asset classes such as commercial vehicle leasing, SME loans, loans for self-employed and gold loans, collections of other facilities which are not covered by the moratorium, “are also likely to be much slower during the immediate to short term”, weighing on the liquidity.  

In anticipation of possible strain on liquidity in the sector from sudden withdrawal of deposits and non-repayment of loans, the Monetary Board took some proactive measures such as reduction of the mandatory minimum liquidity asset requirements and opened the access to Sri Lanka Deposit Insurance and Liquidity Support Scheme with acceptable collaterals. 
The Monetary Board further gave a one-year reprieve on the minimum capital by finance companies.

However, subdued loan growth in the sector, which is expected to prolong through the end of this year, “will provide some comfort from a liquidity point of view, for the finance companies,” ICRA Lanka, which is part of Moody’s Investors Service said. 

During the 12 months to December 2019, the NBFIs sector loan growth has been a negative 2.7 percent and the rating agency expects that trend to continue in the short to medium term. 
Meanwhile, ICRA Lanka also expects a significant deterioration in the sector asset quality in the ongoing quarter although the debt moratorium will prevent a larger portion of these facilities being classified as non-performing. 

“Regardless of the NPA classification, the fundamental asset quality of the segment will significantly deteriorate, as a result of the crisis. Also, the recovery of the same is likely to take longer, as witnessed after the April 2019 Easter events,” it added. 

According to data, the licensed finance company sector gross non-performing loan ratio as of December 2019 was close to 10.8 percent compared to 9.2 percent in June 2019—the quarter ended immediately after Easter attacks. 

What makes the sector more vulnerable to asset quality risks than the banking sector is that finance companies cater to the informal and relatively vulnerable segments of the economy such as self-employed individuals, micro businesses and SMEs, whose income levels are largely volatile to economic events and COVID-19 has amplified that volatility. 

On the minimum capital levels of the sector, ICRA Lanka is of the view that meeting the capital levels even at the deferred time lines would be a major hurdle for the sector given the challenging macro environment.