ICRA Lanka worried over move to allow banks to draw down from additional capital buffers

ICRA Lanka cautioned that the capital reprieve afforded to banks by allowing them to draw down from additional capital buffers could make such buffers thin, exacerbating the future capital pressures banks may face, particularly in the current year where economic conditions are going to be much tougher. Reviving a pandemic era playbook, the Central Bank in May allowed flexibility to banks to draw down from what is referred to as the Capital Conservation Buffer (CCB) up to maximum of 2.5 percent, linked to the extent to which banks retain their earnings, considering the potential stress that could befall on their capital from the higher impairments from foreign currency assets and possible bad loans. 

However, even those who will make use of the CCB are required to present the Central Bank a capital enhancement plan within 21 days since the draw down showing how they would rebuild the buffers. 

“ICRA Lanka takes note of the measures implemented by the CBSL to support the banking sector which include the flexibility to draw down the Capital Conservation Buffer (CCB) up to a maximum of 2.5 percent. However, the same would diminish the capital buffers available for future use especially in the current year wherein the economy is expected to face challenges from worsening macro parameters,” they said in a rating report yesterday. 

The CCB is an additional capital buffer over an above their typical Tier I and Tier II capital levels, necessitated under BASEL III rules with the prime intention of promoting capital building during good times, to be utilised during stressed times.

As of late, many analysts sounded cautious on the potential stresses on the banking sector capital and liquidity buffers from the worsening macro-economic conditions which will result in elevated loss provisions on account of their foreign currency denominated investments and the loan books. 

While banks have already provided substantially against foreign currency assets anticipating a potential default of sovereign credit, another wave of provisions against loan losses could bring additional pressure on their capital. 
But, others are of the view that the muted or potential de-growth in new loans due to economic contraction could offset the pressure coming from earnings compression and thereby could hold up the capital adequacy levels. 

ICRA Lanka yesterday cut Bank of Ceylon’s rating to AA with a Negative outlook from AAA on watch with Negative implications over the aforementioned intensified risks in Sri Lanka’s banking sector and the envisaged rise in slippages from the forgoing quarter due to the business disruptions caused by fuel shortages, power cuts and other macro challenges. 

“While the mark-to-market impact from the sharp interest rate hike by 700 bps in April 2022 and 100 bps in July 2022 is limited on the bank’s treasury investment portfolio, ICRA Lanka expects the core margins to be affected due to deposit repricing,” the rating agency said.

Fitch Ratings in June cautioned that Bank of Ceylon might run into capital deficiencies from having to absorb losses from foreign currency denominated investments and thus requiring capital injection.  

However, ICRA Lanka does not expect much capital support to the bank from the government, given its stretched 
fiscal outlook.