• Says sovereign risk on large banks higher due to their ISB and SLDB holdings 
• Fitch-rated banks had about 1/3 of their combined assets exposed to govt. as at end-2020
• Small banks not fully insulated due to spillover effects from sovereign stress 
• Fitch currently maintains ‘CCC’ junk rating on Sri Lanka sovereign amid heightened default risk 

Sri Lanka’s large banks, which hold the highest amount of foreign currency denominated government securities, have the most exposure to the sovereign credit risk and thereby the risk of deterioration in their credit profiles, according to Fitch Ratings. 

Foreign currency denominated government securities such as Sri Lanka Development Bonds (SLDBs) and Sri Lanka-issued International Sovereign Bonds (ISBs) accounted for around 6.4 percent of the total assets of the Fitch-rated banks and 78 percent of their total equity.   

Sri Lanka’s government is confronted with the uphill task of meeting the country’s foreign currency debt obligations falling due in the medium-term amid depleted foreign currency reserves and rising overall government debt, creating a substantial sovereign risk. 

Sri Lanka is set to settle a billion dollar ISB on July 27 and the country’s foreign exchange reserves fell to US$ 4.0 billion in May. But the Central Bank and the government maintain that they have lined up the means to get through the worst during 2021. 

“In the event of heightened sovereign risk, we would expect any negative impact to be felt more by the large Sri Lankan banks,” said Rukshana Thalgodapitiya, a co-author to the report, which looked at the extent to which the Sri Lankan banks are exposed to foreign currency denominated government debt.  

Fitch estimates that for every 10 percent reduction in the value of foreign-currency denominated government securities, common equity Tier I ratios of banks would have declined by between 18 to 219 basis as at the end of 2020 as bank’s assets are risk weighted based on their market, credit and operational risks after which a charge is made to the capital. 

In 2020, banks provided higher impairments on account of ISBs they held as they assumed a probability of default after Fitch downgraded Sri Lankan sovereign to ‘CCC,’ in November last year, stoking default fears. 

Although some small banks may appear to be relatively unscathed, the ratings agency cautioned that they are not completely spared, as there will be some spillover effects from the sovereign stress.

Overall, Fitch-rated Sri Lankan banks had about one third of their combined assets exposed to the central government as at the end of 2020. 

The banks become exposed to the sovereign via Treasury bills, bonds, SLDBs, ISBs and lending to the government.

Besides those, banks become indirectly exposed to sovereign via lending to public sector entities, of which a significant share is backed by government securities and are mostly with the large State banks. 

During 2020, lending to the government and public sector entities by large State commercial banks rose by 25 percent in gross loans, Fitch noted. 

While commercial banks account for the majority of SLDBs denominated in US dollars, they also invest in ISBs, where Fitch-rated banks hold 15.5 percent of the face value of ISBs issued, though this is concentrated among large private banks.  The maturity profiles also show that there is a bunching up of maturities of SLDBs and ISBs around 2021 and 2022, further heightening the sovereign risk.  

The Central Bank in June lifted its restrictions from banks investing in ISBs provided they could raise foreign currency through fresh borrowings. However, such moneys should be invested equally between ISBs and SLDBs. Meanwhile, the overall exposure of the Fitch-rated banks to the sovereign stands significantly higher at 39 percent of combined assets and 471 percent of equity as at end 2020. Out of this, Treasury bills and bonds account for the largest share, which typically form a bank’s liquid assets.