Fitch says govt.’s DDO plan eases banking sector uncertainty, but risks persist

• Says if the plan does not get foreign creditor approval, risk of further domestic debt restructuring could linger, impacting banks’ stability 

Fitch Ratings yesterday said the government’s Domestic Debt Optimisation (DDO) plan is a significant step towards resolving uncertainty regarding the country’s banking sector, but stressed that many risks remain.
“The Sri Lankan government’s proposal for treatment of domestic debt marks a significant step towards resolving uncertainties around the impact of the sovereign’s debt restructuring on the local banking sector, but complications may arise from a number of factors,” Fitch Ratings said.
Highlighting the risks, the agency pointed out that it is still unclear whether the government’s proposal has received the support of the country’s external creditors. “If not, the risk of further domestic debt restructuring could linger, resulting in further instability for the banking sector.”

The DDO plan approved by parliament last Saturday excludes banks’ holdings of Sri Lankan rupee denominated treasury securities, which according to Fitch, will alleviate some of the pressure on their already stressed capital positions from weakening loan quality and the rupee’s depreciation.
The rating agency said its base case did not expect treasury bills held by banks to be subject to restructuring but assumed banks’ treasury bond holdings would be.
“Bank holdings of Sri Lanka Development Bonds (SLDBs), which are foreign-currency denominated but governed by local law, will be affected, as we had anticipated, and we still expect an impact on international sovereign bonds (ISBs) as well.

However, these together account for only about 5.5 percent of banks’ combined assets, a much smaller share than treasury securities (26.4 percent for Fitch-rated domestic banks). The proposal also includes a restructuring of foreign-currency bank loans to the government (less than 1 percent of combined assets for Fitch-rated banks), though without detailed plans,” the rating agency said.
The government has outlined three treatment options for SLDBs. Fitch expect banks will generally opt for the choice involving conversion of such debt into local currency-denominated instruments.
Banks have so far opted to convert maturing SLDBs to rupee-denominated treasury bonds since the announcement of suspension of foreign debt servicing in April 2022. 

According to Fitch, provisioning should help to moderate the hit to bank capital from the debt treatment. 
Fitch-rated Sri Lankan banks have already made provisions of 35 percent or higher for ISBs, with SLDBs being subject to lower provisioning due to the possibility of obtaining rupee-denominated treasuries.
Nonetheless, worsening impaired loans, which stood at 13.3 percent by the end of May 2023 compared to 8.4 percent by the end of first quarter in 2022, in line with the economic stress associated with the sovereign default and the unwinding of forbearance provided during the Covid-19 pandemic are already exerting pressure on banks’ thin capital buffers.

Fitch does not believe that a restructuring of Sri Lanka’s local currency obligations is likely to trigger a loss of depositor confidence in the banking system, based on the proposed plans. However, funding stress remains a negative sensitivity for bank ratings, Fitch noted.
Fitch-rated banks’ national ratings remain on Rating Watch Negative (RWN) to reflect the potential for the banks’ creditworthiness relative to other entities on the Sri Lankan national ratings scale to deteriorate. This reflects heightened near-term downside risks to credit profiles from capital and funding stress.

Meanwhile, Fitch said a downgrade of the sovereign’s ‘CC’ Long-Term Local currency Issuer Default Rating would not automatically drive a downgrade in Sri Lankan bank ratings.
“To resolve the RWN on these ratings, we will need to assess the impact to the banks’ capital once debt treatment terms are finalised, including the effects of any present value reductions from an exchange of bonds and those of any regulatory or accounting forbearance. 
We may resolve and affirm the banks’ ratings if we think risks from fundingcapital stresses have abated, at both the individual bank and the sector level, to the extent that we believe the banks’ ability to service obligations in local and foreign currency is not hindered and/or banks are able to continue as going concern and avoid failure,” Fitch noted.