COVID-19 compounds stress on Sri Lankan banks: Fitch Ratings

• But says adequate capital buffers built over last 3 years to help withstand near term risks 
• Says temporary restrictions on declaring cash dividends to help banks’ capitalisation levels in near term

The adequate capital buffers built, specially during the last three years, will soften the negative impacts on the banking sector stemming from the new coronavirus-driven economic damage, which has made the operating environment for banks challenging amid pressure on asset quality and earnings, according to Fitch Ratings.

Sri Lanka’s banking sector, beset by the higher interest rates, hostile taxes, political and policy uncertainty, made significant gains during the first two and a half months of the year, the interim results released by the banks and other corporates showed. 

“The weakened operating environment will compound the existing threat to the banks’ financial profiles through elevated asset quality and earnings pressure although the sector’s adequate capital buffers should help it withstand the near-term risks,” Fitch Ratings yesterday said in a note on Sri Lanka’s banking sector. 

The rating agency cautioned that banks with already thin capital buffers against minimum regulatory capital requirements, would be significantly more vulnerable to capital-impairment risks, should the economic fallout from the pandemic worsen beyond their base-case expectations. 

Except for a couple of banks, Sri Lankan banks were racing to meet the elevated capital adequacy levels mandated by the BASEL III rules since mid 2017.Even those who couldn’t raise capital built internally generated capital via retained profits.  BASEL III rules came in as an extension to the BASEL II rules, after the global financial crisis during 2008/09, which resulted in high profile bank collapses, exposing their capital buffers, which were grossly inadequate to cover the losses stemming from the mortgage loans tied to housing market. 

Hence, the coronavirus-driven economic downturn is the first test the BASEL III is facing since the additional capital buffers were put in to place 10 years ago. 

In response to the virus-induced economic damage, the Central Bank earlier allowed the banks to draw down against their capital conservation buffers between 50 to 100 basis points, depending on whether the respective bank is a non-systematically important bank or a systematically important bank, in a bid to boost banks’ ability to lend. 

But Fitch Ratings does not think the banks’ lending activities would gather pace as a result of the relaxation in macro-prudential measures, which will in turn provide relief to banks’ capital ratios.

Fitch now forecasts a 1.3 percent contraction in the Sri Lankan economy in 2020 against the 1.0 percent contraction it forecast in April.  

“Temporary regulatory restrictions on declaring cash dividends will also help the banks’ capitalisation levels in the near term,” it added. 

However, the rating agency expects the ability to generate internal capital via profits could be impaired due to weaker margins and higher loan impairment charges amid the heightened operating environment risks. 

However, Fitch added that the reduction in the effective taxes of around 13 percent could ease some profitability pressure, although it will only be partially offset.

Despite Fitch’s expectation that new loans to remain muted during the remainder of the year, growth hungry banks were competing with each other to offer very attractive, single-digit, concessionary rate loans to existing and new SMEs and export-oriented firms in the post confinement period. 

Most of these loans are funded by foreign funds or re-financing lines secured from development financiers overseas who may be seeking higher returns from developing markets as safe haven treasury assets offer barely above zero percent return in the West.

Low rate loans to businesses will not only support their business revival from the coronavirus hit but will broadly reduce their cost of capital setting forth a revival in their output, making them competitive in the global market place, accelerating the economic growth which will be further aided by lower taxes, eased regulations and government patronage on development of domestic industries. 

However, Fitch in its report said access to foreign currency lines would be challenging due to weak sovereign credit profile, slowdown in foreign currency worker remittance inflows and worsening global funding conditions.

Meanwhile, the Central Bank’s liquidity support to banks and refinance schemes to provide assistance to affected businesses could also propel loan growth.  

“We believe there is less near-term pressure on local-currency liquidity due to the support measures taken by the CBSL, such as a reduction in regulatory liquidity-coverage ratios,” Fitch noted.