Banking sector profitability plunges as crisis takes toll on credit costs, growth

• Stockholder returns dive to multi-year lows of 8.5% through September
• Unlikely that sector profitability will return to pre-crisis levels until at least 2025
• Banks will wait for economy to stabilise and consumer demand to pick up to re-open lending spigots 
• Until then banks will continue to earn the minimum risk-free rate, which shot up over 30% this year

Sri Lanka’s banking sector, which is usually resilient and generates consistent profits across economic cycles took a heavy beating this year, causing the sector to fall out of favour with the investor community.

The sector’s return on equity (RoE) plunged to multi-year low of 8.5 percent by the end of September, from 20.4 percent in March, amid sharp rise in interest rates in early April and the subsequent announcement by the government to default on its foreign currency loans.

Both had a massive impact on banking sector profits as banks had to fully provide for the share of international sovereign bonds and the development bonds they held as part of their financial assets portfolio. 

Meanwhile, the soaring rates put a significant damper on the asset quality of their loan portfolios prompting massive loss provisions against the profits. 

As a result, banks paused on their loan growth as they grew more cautious to lend in a declining economy where borrowers’ ability to service loans weakened considerably. 

The separate data for licensed commercial banks showed that the sector RoE stood at 8.9 percent by end-September compared to 20.4 percent at the end of March, while the specialised banks saw their ROE sinking to just 4.0 percent from 20.5 percent .

According to banking sector analysts, it is unlikely the sector profitability will return to its pre-crisis levels until at least 2025 as all projections point to a long-drawn recovery path for the economy.

 While there could be some relaxation in the monetary policy next year with the Central Bank pivoting to cut rates, it is unlikely to sway banks to reopen their lending spigots until they see credible evidence of the economy stabilising, particularly with demand conditions improving from their current depths. 

Strengthening consumer demand signals that people are comfortable loosening their purse strings to buy stuff they want and need, which will then prompt businesses to restart spending through their supply chains and capacity building to meet rising demand. 

Until such times, banks will continue to earn the minimum risk free rate, which shot up to over 30 percent this year, from the money they raise from by way of deposits.  Treasury bill rates continued their weeks-long descent this week but still remain a long way from investors beginning to re-allocate their funds into other growing sectors in the economy.