• ICRA Lanka says financial institutions were on weaker footing even before pandemic
• Cautions about bad and reckless borrowers seeking free rides on easy money 
• Says reduction in policy rates beyond a certain point may not generate appreciable expansions in credit 
• Notes credit guarantee scheme, step in the right direction as it improves risk appetite

The extremely dovish monetary policy and liquidity injections into the system may be required to resuscitate the pandemic-hit economy, but that should not undermine the strength and stability of the financial institutions as excessive credit could increase credit risks of the system, specially at a time when certain rules on capital, liquidity and supervisory requirements are relaxed, according to ICRA Lanka. 

Sri Lanka’s Central Bank cut its key policy rates for the fifth time last week, bringing the year-to-date cut in key rates to 250 basis points. The monetary authority also reduced banks’ Statutory Reserves Ratio (SRR) by 300 basis point—releasing about Rs.180 billion in liquidity, introduced Rs.150 billion concessionary credit scheme and set up a credit guarantee scheme undertaking to underwrite up to 80 percent of the risk in case of default, among a string of measures to accelerate the credit flows into the real economy. 

However, ICRA Lanka, a part of Moody’s, cautioned that the heavy-handed credit expansion inevitably leads to build up excessive credit risks and inefficient allocation of funds as it could attract bad borrowers, who already had a poor financial standing even before the pandemic, and reckless borrowers who do not have a genuine requirement to borrow but are attracted to the low rates.

“With real interest rates falling to lower single-digit levels, the quest for yield will be on. This could drive individuals and companies to take riskier investment positions. The repercussions of such an event can be devastating on the faltering economy as seen from past events,” the rating agency noted. 

ICRA Lanka appears extremely concerned of these likely developments given the relaxed rules on the country’s financial system in response to the pandemic at a time when financial institutions were already on a weaker footing due to deterioration in asset quality and dwindling profits. 

“Given the recent relaxation of macro-prudential requirements, these trends could increase the credit risk for the system,” ICRA Lanka said.

In order to support pandemic-hit individuals and businesses through banks and finance companies, the Central Bank relaxed capital and liquidity rules, various supervisory requirements, recognition of non-performing loans and loan loss provisions of the financial institutes.  

With smaller capital bases, financial institutions now operate with higher leverage, which could increase their vulnerability if credit expands rapidly while the relaxed supervisory requirements delay the recognition of the issues. 

The rating agency also said the reduction in policy interest rates beyond a certain point might not generate appreciable expansion in credit in the economy as the financial institutions’ risk appetite would not improve in a state of crisis. 

However, it viewed the recent credit guarantee scheme as a step in the right direction to improve the risk appetite, but its success depends on whether the banks can recover the value of the guarantee in a timely manner in case of defaults.