Budget proposal to spark M&A wave in finance and leasing company sector: Fitch

• Says budget proposal to give tax credit for FLC sector mergers to drive the wave
• Says at least 20 FLC sector companies currently facing capital challenges
• FLC sector accounted for 8% of financial sector assets at the end of 2019 

The budget proposal to effect consolidation in the highly fragmented finance and leasing company (FLC) sector is expected to spark a wave of mergers and acquisitions (M&A) during the next two years, as the government proposed to give tax credit to those who marry each other. 

The budget presented last week proposed to merge subsidiary finance companies with their parent companies and finance companies operating as subsidiaries of banks to be absorbed by the latter to strengthen the sector beset by thin capitalisation and challenge to provide effective oversight. 

“We expect significant increase in M&A activity within the FLC sector in next 12-24 months, even among standalone small FLCs, as there are at least 20 that are currently facing capital challenges, either on an absolute basis or to meet the regulatory capital ratios,” Fitch Ratings said in a note yesterday.  

Several FLCs have already announced potential mergers, while several smaller finance companies have begun their search for merger partners. 

While Fitch does not think the mergers between finance and leasing companies with their parent banks to have an immediate impact on banks’ current ratings, they think consolidation in the sector is positive for its long-term stability, although it may not necessarily ease their near term challenges. 

“We believe banks will be reluctant to absorb their FLCs due to the significant difference between their risk profiles and underwriting practices, leading to elevated challenges in achieving effective management,” the rating agency noted. “FLCs typically cater to sub-prime customers, which banks have very little appetite for. However, if the proposed mergers are enforced, we expect the risk appetite of the amalgamated bank to be lower than the simple aggregated risk appetite of the parent and the FLC subsidiary, as the FLC business is unlikely to be a core business line for the parent,” it added. 

The consolidation in the sector is nothing new but is a continuation of the previous policy by the then Rajapaksa administration that was in office till January 8, 2015. 

At that time, several banks acquired FLCs including the acquisition of HNB Finance (then Prime Grameen Micro Finance Limited) by Hatton National Bank and Serendib Finance (then Indra Finance Limited) by Commercial Bank of Ceylon.

The budget proposal affects five Fitch-rated banks with FLCs as subsidiaries including the aforementioned two. The others are, Sampath Bank due to its ownership in Siyapatha Finance PLC, Bank of Ceylon which owns Merchant Bank of Sri Lanka & Finance PLC and People’s Bank, which owns People’s Leasing & Finance PLC. 
According to Fitch, there are 44 FLCs, out of which 33 at the lower end, which account for 33 percent of sector assets, have posed challenges to the Sri Lanka’s financial sector stability, despite the sector’s moderate 8 percent share of the financial sector assets at the end of 2019. 

The finance and leasing sector woes run deep and far, with its growth faltering for nearly five years largely due to lack of access to capital, muted income generation and weaker asset quality despite the regulatory moratoriums for stressed loans.