Sri Lankan banks’ credit profiles could improve alongside a completed sovereign debt restructuring, Fitch Ratings said, highlighting the strong link between sovereign financial health and banks’ operating conditions.

Fitch noted that an improvement in the sovereign’s credit profile, currently rated ‘RD’ for Long-Term Foreign-Currency IDR and ‘CCC-’ for Long-Term Local-Currency IDR, would positively impact the operating environment (OE) assessment and the National Ratings of large local banks.

The agency emphasised that this would depend on “their creditworthiness relative to other Sri Lankan issuers.”
Sri Lankan banks’ OE score of ‘ccc-’ is closely tied to the sovereign’s local-currency credit profile due to their substantial exposure to domestic government securities and public-sector lending, Fitch said.

Local-currency treasury instruments accounted for 33.4 percent of banks’ assets at the end of the first half of 2024, while foreign-currency instruments made up 3.4 percent. 

Large banks and the two state-owned domestic systemically important banks (D-SIBs) tend to have higher exposure to the sovereign and state-owned enterprises.

“We expect an improvement in Sri Lanka’s credit profile to alleviate sovereign-related pressures on the banks, which is likely to be credit positive in terms of our financial and non-financial assessments,” Fitch said.
Fitch said its national ratings reflect the relative creditworthiness of issuers within a country.

Any sovereign rating upgrade would lead to a reassessment of these rankings. The last recalibration of Sri Lanka’s national rating scale occurred in January 2023 after the sovereign’s local-currency IDR was downgraded to ‘CC’ from ‘CCC’.

The ratings for most locally incorporated banks are based on standalone credit profiles, with the exception of Cargills Bank PLC, which reflects expectations of shareholder support, Fitch said. 

Despite strong linkages between the state and the two state-owned D-SIBs, their ratings do not factor in government support due to the sovereign’s limited financial flexibility. 

Fitch added that a sustained improvement in the sovereign’s financial flexibility may lead to a reconsideration of state support.

Sri Lanka is nearing the completion of its foreign-currency debt restructuring, which Fitch said could reduce pressures on the banking sector and improve financial profiles.

“Pressures on foreign- and local-currency funding and liquidity have eased considerably due to better external sector flows and the banks’ efforts to preserve liquidity,” it said, adding that banks may regain access to foreign-currency wholesale funding following a restoration of the sovereign’s creditworthiness.