New NPL classification could reduce NBFI lending to MSMEs: AFC Chairperson

• Warns the move could push vulnerable borrowers towards informal sector and loan sharks

By Nishel Fernando 
Sri Lanka’s oldest non-bank financial institution (NBFI), Alliance Finance Company (AFC) PLC warns that the recent amendment with regard to the classification of non-performing loans (NPLs) in the NBFI sector would lead to a significant contraction in lending to the micro and emerging SME sector and push vulnerable borrowers to the informal lending sector including loan sharks. 

The Central Bank (CB) issuing a direction amended the classification of NPLs in the NBFI sector from 180 days to 120 days past due; moving towards placing it on par with the classification for the banking sector, with effect from July this year. 

“Sri Lanka’s NBFI sector is the leading lender to the most disadvantaged sectors of the economy and this regulation would force the NBFIs to adopt a stringent recovery process as stated above and curtail lending

to the micro and emerging SME sector whose cash flows are more variable and vulnerable than those of established SMEs and corporates serviced by the banks. 

The micro and emerging SME sector would hence be compelled to resort to informal borrowings facing adverse consequences detrimental to their economic wellbeing. This would in turn result in economic exclusion of them rather than the inclusion we strive for,” AFC Chairperson Tamara Dharmakirti Herath told shareholders of the company in its recently released annual report. 

By the end of last year, the gross NPLs of the sector rose to record 13.9 percent of total advances recording 3.3 percent hike over the previous year. However, it came down to 11.30 percent in the March quarter this year.

Due to subdued economic activity, the total asset base of the sector also contracted by 2.2 percent year-on-year to Rs. 1,402 billion. The total asset base further declined to Rs.1, 392 billion in the March quarter.

The asset base of the sector mainly consisted of loans and advances, which accounted for 74.2 percent of the total assets. The loans and advances declined to Rs.1, 061 billion in the March quarter compared to Rs.1, 0340 billion at end 2020 and Rs.1, 103 billion at end 2019.

Finance leases account for the major part of the loans and advances portfolio in NBFI sector, representing over 50 percent followed by other secured loans. However, Finance leases have been on a declining trend since last year while the loan segment showed a marginal recovery in the March quarter compared to December quarter.  In the meantime, real estate loans and pawning advances have shown a steady increase over the year. If the impending regulation is to come into effect in July as scheduled, NBFIs are expected to adjust their business models and undertake more stringent recovery processes.

“Consequently, the NBFIs will reduce the NBFI’s tolerance limit for past due age for termination of leases and would be reduced within the framework of all statutory provisions, to accelerate recovery of leased assets, its disposal and realization of its receivables, in order to minimize nonperforming lease portfolio,” Dharmakirti Herath elaborated.

Therefore, she urged the financial sector regulator to reconsider the move and consider a more suitable past due age tolerance limit for NPL classifications. She mooted a NPL classification based on the product risk and business model adopted by the NBFIs to accommodate the disadvantaged sectors of the economy, thereby facilitating the nation’s path to creating financial inclusivity and reducing economic disparities. 

As the Central Bank and the government policy is aimed at promoting lending to MSMEs to drive inclusive economic growth, she suggested policymakers to consider establishing SME guarantee scheme and appropriate credit insurance scheme for an interim period, which would support NBFIs to mitigate the risks associated with providing capital goods to SMEs while the NBFIs realign their business models focusing on new product offerings to SMEs.

In particular, she stressed on the need to diversify into other segments with new innovative products beyond the financing of motor vehicles, with regulator’s support.

“Firstly, to support the more established SMEs to access capital goods to enhance their productivity and efficiency. This requires the industry to make a concerted effort to strengthen the technical skills and knowledge base and works with policy makers to have a more conducive legal accounting and tax framework needed to mitigate the inherent risks associated with these products.

Further, it is envisaged that the investment in capital goods will coincide with the growth in economic activity in the country which would lead to a gradual emergence of a secondary and third tier market for capital goods, to encourage NBFI’s to invest in capital goods,” she said.  Meanwhile, AFC remains alerted of the current bubble in second hand automobile prices, due to the current import restrictions imposed on new vehicles.

“A relaxing of the restrictions in the future would result in a sharp drop in vehicle prices in the second-hand market,” Dharmakirti Herath cautioned. 

Despite the turbulent conditions in the sector, it was able to maintain capital at healthy levels in 2020. 

The total regulatory capital levels improved by Rs. 36.9 billion in 2020, compared to 2019. The sector’s core capital to risk weighted assets and total regulated capital to risk weighted assets increased by 3.5 percent and 3.2 percent over 2019, to 14.5 percent and 15.7 percent respectively in 2020.Although, large MSMEs meet regulatory capital levels comfortably, several small NBFIs have been struggling to achieve these capital requirements.

Further, the NBFI sector deposit base also recovered to Rs. 757.8 billion in the March quarter, after declining to Rs.748.57 billion at end 2020 from Rs.756.68 billion in 2019.