Sri Lanka’s banking sector bracing for tough operating conditions: Fitch

• Rating agency says sector will face earnings pressure, moderate asset quality in 2018 

Fitch Ratings last week said Sri Lanka’s banking sector is bracing for some tough operating conditions in 2018 with muted loan growth and moderate asset quality, which could put pressure on profits.  As a result Fitch, one of top three global rating agencies, is maintaining a negative outlook on the sector as operating conditions are likely to remain challenging. Sri Lanka’s banks currently face muted demand for new loans, particularly in the consumption related lending, as the economic growth slowed in response to a stabilization programme instituted by the International Monetary Fund in return for a three-year loan package.  In 2015, Sri Lanka’s growth story transitioned from a State-led, 

 construction-driven model to a private consumer-led one as the new regime triggered an unsustainable credit boom by keeping interest rates artificially low through heavy money printing.  

Banks made phenomenal growth and profits during 2015 and 2016 as they made hay with loans extended on consumption—personal loans, credit cards, vehicle leasing and housing to a certain degree—by lending money over and above the deposits they raised. 

The party did not last long as defaults rose. Interest rates were increased and taxes were slapped making servicing loans a tough task.

During the process, many conglomerates, which had been accumulating cheap bank debt to fund major deals including mergers and acquisitions found themselves trapped in a web of debt as they were seen weighing heavily on their bottomlines with the rising cost of borrowing. 

The economic growth slowed to 3.1 percent in 2017—lowest in 16 years— and the loan growth slowed to 16 percent in 2017 from 18 percent in 2016 and 21 percent in 2015. 

Sector NPLs rose 13 percent in 2017, reversing from back-to-back contractions in the last three years and continued to rise in 1Q18 as reflected in the banks’ reported results, Fitch said in their banking sector dashboard authored by its two key banking sector analysts. 

In a further deterioration of the banking sector asset quality, the gross NPL ratio ticked up to 3.0 percent from 2.5 percent in 2017 December-end, which marginally improved with some recoveries and/or write-offs in 4Q17. 

Meanwhile, this weaker asset quality and higher credit costs stemming from the implementation of International Financial Reporting Standard 09, which increases the impairment provisions, will boil down to lower profits in the sector. 

Some banks have already disclosed their estimated impact on incremental impairment provision to be between 35 percent and 45 percent, which is substantial. 
Fitch also suspects the new levy imposed on the sector from the budget to dent the profit further should it come into effect. 

Net profit growth was subdued at 10 percent in 2017 (2016: 25 percent) due to higher credit costs and the full- year impact of the higher financial VAT introduced in November 2016 – both of which resulted in stagnant sector return on assets, they said. 

Meanwhile, the rating agency also expects the banking sector to remain fairly liquid in 2018 due to expectation of moderating in lending and healthy 
deposit growth. 

Deposits were the main source of funding for Sri Lankan banks consisting of 80 percent of the funding mix. 

However, the low-cost deposits have come under pressure recently due to current and savings account base depleting to 34 percent in 2017 from 36 percent due to term deposits increasing in response to higher interest rates. 

In a special report released last week on the sector, Fitch said Sri Lanka’s large banks—mainly the state banks—face a Rs.19 billion capital shortfall in the run up to the higher capital ratios under the BASEL III regime coming into full effect in 2019. 

But capital levels of the banks improved notably during 2017 and 2018 as banks made several capital calls to beef up their capital levels before the BASEL III full implementation.