The new regulations issued by Sri Lanka’s Central Bank to increase minimum core capital levels for all licensed finance companies could spur small companies to improve their capital buffers and may reignite industry consolidation, says Fitch Ratings.
Fitch believes the new directive is likely to address the need for higher capital buffers for the non­bank financial institutions (NBFI) sector as a whole to ensure financial system stability, given our expectation of a deterioration in asset quality and capitalisation in the sector following aggressive loan book growth in recent years and persistent weak operating conditions. 
The Central Bank of Sri Lanka issued a directive in February 2017 requiring all licensed finance companies to increase their minimum core capital levels to Rs.2.5 billion by end­2020 in stages from the current Rs.400 million, with the first target of Rs.1 billion to be reached by January 1, 2018. 
Capitalisation for the NBFI sector remains relatively low, with the core capital ratio at around 11.7 percent at end­September 2016. This level of capitalisation is similar to that of the banking sector, but we feel insufficient, as NBFIs have higher risk appetite than banks. At end­September 2016, finance companies’ reported six­month nonperforming loans (NPLs) accounted for 5.4 percent of total advances, compared with the three­month ratio of 2.9 percent for the banking sector. Fitch estimates that the ratio could be much higher for the finance companies at a three months level. 
The new rules follow a previous plan to bring about financial sector consolidation, which did not significantly reduce the number of finance companies. There were 58 NBFIs covered by the ‘Master Plan for the Consolidation of the Financial Sector’ in 2014­2015, some of which merged with larger finance companies or were acquired by banks. The sector currently comprises 46 licensed finance companies, of which the 20 largest ones accounted for about 80 percent of the sector’s assets as of end-September 2016.
Based on publicly available information within the top 20, nine companies’ core capital were below the Rs.2.5 billion mark but above the intermediate target of Rs.1 billion as of March 2016, while one company had negative core capital. Fitch estimates there are at least 18 small finance companies each with an asset base of less than Rs.10 billion at end­September 2016; among these, 12 had an equity base (approximated core capital calculated as equity less capital reserves based on publicly available information) of less than Rs.1 billion.
Further, eight of the finance companies in the sector are fully or partly owned subsidiaries of banks. As of September 2016, four of these fell short of the January 1, 2018 target. We do not expect the banks’ credit profiles to be significantly affected by the capital injections they may have to make in their finance­company subsidiaries from time to time. 
Among the Fitch­rated entities, all 12 met the intermediate target of Rs.1 billion due by January 1, 2018 as of end­2016, although six fell short of the final target. We believe most of the relatively larger finance companies are likely to reach the required capital levels through internal capital generation within the stipulated time frame but nearly all the small finance companies are likely to require capital injections or will have to be merged with larger entities with stronger capital.