Economic crisis to test Sri Lanka’s largest banks’ resilience

• Fitch warns of pressure on earnings, asset quality, capital and liquidity of banks  

The ongoing economic crisis, the worst Sri Lanka has ever seen in its post-independence history, would test the country’s largest banks’ resilience, as Fitch Ratings on Monday said their asset quality, earnings, capitalisation and liquidity could come under tremendous pressure, when the operating conditions deteriorate. 

The rating agency said the sovereign credit default in April and rapid deterioration in the broader macro-economic environment, where the soaring interest rates, red-hot inflation and currency depreciation have narrowed the banks’ operational flexibility, which in turn would mute growth, trigger loan defaults and hike operating costs, putting enormous pressure on the earnings. 

The banks are in fact expecting a contraction in their loan books and thereby their balance sheets in 2022 and 2023, with the earnings expected to fall sharply in line with the economy, which is on course to lose 20 percent of its value from its peak reached in 2018. 

Meanwhile, some banks are expecting their non-performing loans ratios to rise to an unprecedented 10 to 15 percent during this period, as corporate and household balance sheets have come under enormous pressure, due to the economic downturn, hampering their ability to service their facilities. 

While the broader concession package announced last week to the affected borrowers may limit the rise in impaired loans, Fitch Ratings said that would mask the true loans under stress. 

The rating agency expressed these sentiments by reviewing the credit ratings of People’s Bank, Commercial Bank and Hatton National Bank, which form the country’s second, third and fourth largest commercial lenders by assets. 

Fitch Ratings maintained their national long-term rating at AA-, with rating watch at Negative, due to the potential deterioration in their creditworthiness, relative to other entities on the Sri Lankan national rating scale, given the stress on the banks’ funding and liquidity and also their significant exposure to the sovereign via investments in foreign currency instruments that raises risks to their overall credit profile.  In the case of People’s Bank, the bank has significant exposure to the sovereign via its foreign currency lending, besides its investments in foreign currency bonds. 

“We believe that PB’s capitalisation is highly vulnerable to even moderate asset quality shocks, particularly if it has to absorb credit losses from its foreign currency exposure to government and SOE loans,” the rating agency said. 

 Heightened capital impairment risks also persist for Commercial Bank and Hatton National Bank, given the pressure coming from the weak internal capital generation, due to pressure on profits, “mark-to-market losses and loan quality deterioration combined with bloated risk-weighted assets from the rupee’s sustained depreciation”, that will exert pressure on the capitalisation matrices. 

“We believe that capital deficiencies could arise in a very likely scenario that the bank has to absorb a haircut on its foreign currency government securities,” Fitch said on Hatton National Bank. 

Meanwhile, Commercial Bank has the second largest exposure among the domestic banks to the foreign currency-denominated government securities, exposing the bank’s capital to the risk of restructuring these instruments, the risk is somewhat mitigated by the increased provisioning made by the bank in the last few quarters. 

The capitalisation risk on the banks is somewhat mitigated, given the muted growth in loans or the potential degrowths in their loan books in the remainder of the year, which could extend to 2023 as well. 

This could however potentially offset or outweighed by pressure on earnings, due to the margin contraction coming from the rising rates, which in turn cause higher credit costs and higher operating costs, due to hyperinflation amid the contraction in their growths that are expected.