Lankan banking sector resilience weak, asset quality to deteriorate further: S&P

• Says fallout of past aggressive growth and adverse weather 
• Expects no sharp decline in asset quality going forward 

Sri Lanka’s banking sector’s strength to withstand cyclical economic shocks remains weak and is affected by the country’s low income levels, said Standard & Poor’s, while revising the country’s economic risk trend to ‘stable’ from ‘negative’. 

 
Issuing the latest banking industry country risk assessment (BICRA) for 2018, the global rating agency headquartered in the United States said Sri Lanka’s banking sector is facing higher credit risk driven by relaxed lending, underwriting standards and evolving risk management practices. 
After years of cheap bank lending, Sri Lanka’s banking sector asset quality took a beating in 2018 with gross non-performing loans spiking during the first two months of the year as the economy slowed overall in response to higher borrowing cost and taxes. 

The reported non-performing loan (NPL) ratio of the banking sector hit a high of 3.0 percent in February 2018, up from 2.8 percent in January and 2.5 percent in December 2017.

The rating agency cautioned that the NPL situation could continue to deteriorate in 2018 but said it is unlikely to be sharp as Sri Lanka’s growth prospects remain favourable. 

“This is a fallout of banks’ aggressive growth in the past few years and Sri Lanka’s drought in 2016 and flooding in 2017, which disturbed the agriculture sector and agro-based industrial activity,” S&P said.

The rating agency’s decision to revise Sri Lanka’s economic risk trend to ‘stable’ from ‘negative’ comes amid expectations of benign macroeconomic conditions as the economic imbalances from aggressive growth in the past are expected to recede going forward. 

Following the end of the 30-year civil war in 2009, the Central Bank reduced interest rates to stimulate economic growth through cheap bank credit. But the artificial push only resulted in creating credit and asset bubbles.

Further, the country was plunged into balance of payment and the rupee weakened from around Rs.110 to Rs.157 against the US dollar. “While we expect loan growth to remain higher than nominal GDP growth, the gap has narrowed, reducing risks of a further build-up of economic imbalances. Moreover, the sovereign external position continues to stabilize,” the rating agency added.  Sri Lanka’s private credit has eased now and is rising at around 14.6 percent levels, coming down from around 22 percent a year ago.

Commenting on the funding profile, the rating agency said it would continue to be supported “from a good level of stable core customer deposits”. 
Meanwhile, at a time when the consensus is building up towards banking sector consolidation, S&P doesn’t think that a large number of banks relative to the economy’s size has led to a significant instability in the competitive environment. 

“We believe that larger banks with strong franchises will continue to dominate the sector. 

However, the dominance of government-owned banks and directed lending to the agricultural sector somewhat distort the competitive environment, in our view.” 

Commenting on the regulatory environment, S&P said although the Central Bank’s regulatory oversight has improved over the years, they remain weaker than that of international peers.  As the Central Bank has recently doubled the minimum capital of licensed bank by 2020, S&P confided that these measures would ensure stronger banking system by way of good capital buffers to absorb unexpected losses. 
In this journey, S&P expects the Sri Lankan banks to step up capital issuances – including hybrid instruments.