Banks may withstand debt restructuring pressure– Acuity

• Cautions on heightened risks from deteriorating asset quality as rates soar, economy deteriorates

While Sri Lanka’s banks may get affected by the impending debt restructuring, Acuity Stockbrokers believes that the sector may not need additional capital infusions in the short term but cautioned that the fallout from the deteriorating economic conditions on the asset quality would remain a significant risk. 

Analysing the exposure to debt – both foreign currency and locally-denominated – of Commercial Bank of Ceylon, Hatton National Bank and Sampath Bank – under three different scenarios, the research arm of the stockbroking house said it expects the current capital to provide them with sufficient buffers to withstand the impact that could stem from debt restructuring.

“We find that the majority of banking stocks within our coverage are capitalised sufficiently to absorb a reasonable level of provisioning for ISBs and SLDBs, which reduces the likelihood that the banks would need to raise additional regulatory capital in the short term,” it said.

Thus, it maintained its ‘overweight’ rating on the banking sector counters, signalling it is wiser for the investors to accumulate shares in banks.

While announcing that Sri Lanka would default on its foreign currency debt, the Central Bank made clear that the Sri Lanka Development Bonds (SLDBs) and rupee bonds would not be subjected to restructuring.
While this assurance helped to diffuse anxiety in bankers, if the restructuring would be extended to their SLDB portfolio, it remains to be seen if the other creditors led by the International Monetary Fund (IMF) would agree on any restructuring, unconditional on restructuring the SLDBs, which in an extreme case could extend up to rupee-denominated debt.

However, Acuity doesn’t believe restructuring could come to that level, although it considered it as its third scenario.

“However, the IMF and creditors would consider a restructuring of the LKR debt as a last resort, given the enormous stress on the financial system, which could do more harm than good. We therefore believe this scenario is unlikely,” the research team at Acuity said.

“We also believe that Sri Lanka’s current economic crisis is largely due to a shortfall of tax revenues and that primarily revenue-based fiscal consolidation along with restructuring of the foreign debt would suffice to generate primary balance surpluses to bring about debt sustainability,” it added.

Acuity’s second scenario assumes a 20 percent haircut on the SLDB on top of the total marked down of the ISBs into market value. And the first assumes only the ISBs are subjected to restructuring.  The banks since 2020 onwards have been making provisions against the ISBs and SLDBs, due to repeated downgrading of the country’s sovereign credit rating by every rating agency.

“However, based on the ongoing negotiations with creditors, if higher levels of haircuts on ISBs and SLDBs are deemed to be necessary, it would necessitate correspondingly higher levels of provisioning, which could erode the capital buffers beyond our stress scenarios,” Acuity said.   At the same time, Acuity raised serious concerns about the “higher NPAs arising from the deteriorating economic situation in Sri Lanka in 2022” but said “margin expansion in a rising interest rate environment will help to absorb incremental NPAs to some extent”.