Tougher capitalisation requirements, NPLs to add pressure on already battered finance firms

Sri Lanka’s finance and leasing company (FLC) sector will face added pressure for consolidation as the deadlines for the implementation of tougher capitalisation requirements approach in 2021, said Fitch Ratings. 

“We view further consolidation of the sector as positive for financial sector stability in Sri Lanka but the process could be impeded by a challenging operating environment,” the rating agency said.

The gross loan growth for Sri Lanka’s FLCs had slowed sharply in a sluggish economy, coming in at only 0.5 percent year-on-year (YoY) at end-September 2019, against 12.9 percent on average between end-2015 and end-2018. 

“The capacity of some of the smaller FLCs to withstand the asset-quality pressures stemming from this more challenging environment has been weak, owing in part to thin capital buffers,” Fitch noted. The Central Bank figures indicate that FLCs accounted for 7.6 percent of total financial system assets at end-2018, so developments in the sector are significant for the overall stability of the financial sector. 

The top 10 FLCs accounted for 69 percent of the sector assets at end-September 2019, with 33 smaller FLCs representing the remaining 31 percent. 

The Central Bank has sought to reduce risks by raising capital thresholds to encourage consolidation. The FLCs are required to meet an enhanced Rs.2.5 billion absolute capital requirement by January 1, 2021, up from Rs.2 billion at present. 

The minimum Tier I capital ratio for the FLCs will also rise from 6.5 percent to 7 percent, on July 1, 2020, before increasing further to 8.5 percent, from July 1, 2021,
“We believe the CBSL is unlikely to delay the deadlines for raising capital thresholds. It has already taken action against several FLCs that failed to meet the capital requirements,” the rating agency noted. 

In 2019, the regulator cancelled the licences held by TKS Finance and issued a notice of cancellation for the licence held by The Finance Company and Sinhaputhra Finance. The Central Bank has provided the latter an opportunity to implement a capital augmentation plan within a stipulated time frame, despite the notice of cancellation). 

Among the Fitch-rated FLCs, the regulator has also imposed a deposit cap on Dialog Finance (AA(lka)/Stable), Bimputh Finance (BB-(lka)/Stable), Ideal Finance (B+(lka)/RWP) and Abans Finance (BB+(lka)/Stable), due to their non-compliance with the interim thresholds.

“The FLCs may face difficulty improving their profitability, as we expect economic growth to remain subdued. This could impede efforts to meet enhanced regulatory capital requirements by generating capital internally or by raising capital externally. 

We believe this risk will be higher for smaller standalone finance companies,” Fitch noted. 

“Those FLCs that have raised external capital recently, as part of efforts to meet the higher capitalisation standards, have benefited mainly from the support from their major shareholders. 
The tough operating environment may also impede consolidation, as asset-quality issues and limited near-term growth prospects for the sector could make M&A less attractive. 

We estimate that the Fitch-rated FLCs would require additional equity capital of around Rs.5.5 billion (US $ 30 million) to meet the absolute regulatory capital thresholds by January 1, 2021. 

We believe that generating this internally through profits may be difficult and therefore might require additional external capital raising. Capitalisation factors are likely to remain a prominent rating sensitivity for most of our rated standalone FLCs,” Fitch added.