Sri Lankan non-bank financial institutions’ (NBFIs) rising exposure to microfinance could pose a risk to their credit profiles, Fitch Ratings Lanka said in a 
recent study. 

The exposure among Fitch-rated NBFIs, which stood at just 4 percent of total loans of these entities by March 2014, has now increased to 27 percent by December 2015. This exposure to microfinance reached a peak of 30 percent of loans by end-March 2015. Sri Lanka’s banks and NBFIs engage in easy businesses which usually operate in boom and bust cycles. 

The banking and financial services sector went on lending on poor people’s gold until the global gold prices crashed in late 2012 and paid hefty price in terms if write-offs. Some banks had exposure levels in excess of 35 percent to such lending from the total lending book. 

A similar cycle ended in December 2015 when everyone expanded their loan books by growing their leasing books until the government slapped hefty taxes and lending restrictions on vehicles after causing much damage to the economy and society. With the vehicle leasing coming to a standstill, banks say they see hardly any growth in their loan books. 

Microfinance is also one such sector which could at anytime explode as such lending is uncollateralized and repayment ability is predominantly based on the general economic condition, which is getting tougher by the day with rising taxes and inflation amid higher interest rates. Hence, any such shocks to the financial sector stability could be a blow to the economy as delinquencies of such loans occur at a time when the financial services sector is riding tougher times, the analysts pointed out. 

Microfinance lending among Fitch-rated NBFIs takes the form principally of lending to an individual who is part of a small group, with the rest of the group members cross-guaranteeing the loans in the event of default. Lending is generally in small amounts, and is used to support income-generating activity. It involves uncollateralized lending to a customer segment that is usually characterized as low income and with limited access to formal 
financial services. 
Fitch believes that lending to this segment is likely to be more susceptible to asset-quality deterioration during periods of economic stress. In fact, several microfinance institutions – banks or NBFIs – lending to the same individual or family which could then aggravates the problem. If the individual or family finds it difficult to repay, they could easily take another loan from a different institution to repay the earlier loan until the system collapses. 

The analysts pointed out this could have a contagion risk where the failure of one such institution could have a direct impact on another. They question whether these lenders do a proper follow up on what these micro funds are being used and in most cases they are used for consumption and this is a key risk, they warned.  

Furthermore, Sri Lanka continues to lack a comprehensive regulatory and supervisory system for the microfinance sector. As a result, many of the large number of institutions engaged in the provision of microfinance are unregulated. Efforts to introduce such regulations have been ongoing for many years, including the passing of a microfinance bill. Fitch maintains that the passage of prudential regulatory requirements on microfinance entities should be positive for the financial sector.

Fitch-rated NBFIs have made efforts to manage the risk of their significant exposures to microfinance through product structuring, regular collections and close contact with borrowers. Lending rates on microfinance are also generally high, due to the greater credit risk of this type of lending.

Nonetheless, the rising exposure to microfinance points to increased risk for NBFIs, especially during a period when operating conditions could become more challenging for the financial sector as a whole. Fitch expects Sri Lanka’s real gross domestic product (GDP) growth to remain relatively high at above 5 percent through 2017. But the outlook for the financial sector is largely dependent on the operating environment, and volatility remains a key risk in the economy. Notably, Fitch downgraded the sovereign to ‘B+’ in March with a negative outlook.