Fitch Ratings’ outlook on Sri Lankan banks for 2017 remains negative, although the expected deterioration in the operating environment has so far been managed.
Challenges stemming from slow economic growth together with deteriorating asset quality and weak internal capital generation could put further pressure on capitalisation levels of banks. The operating environment is a key rating driver for the banking sector as it can affect the vulnerability of the banks’ financial profile.
Fitch believes the Sri Lankan banking sector faces challenges from a slowdown in economic growth despite the revision of the outlook on the sovereign’s rating to ‘B+’/Stable from ‘B+’/Negative in February 2017. Fitch estimates Sri Lanka’s real GDP growth to be just under 5% over 2017-2018, moderately lower than the authorities’ estimate of 5.5%-6.0%, as Fitch expects a greater drag on growth from tax hikes as well as slowing credit growth.
Fitch expects loan growth to moderate in 2017 following policy rate hikes in 2016 and early 2017 and a tax hike, which may reduce consumption demand.
However, increased credit demand from the state can push growth higher. Loan growth slowed to 17.5% in 2016 from 21.1% in 2015, but remains high in certain sectors such as construction (2016: 17.4% of sector loans and 2015: 16.7%), which could pose risk, if not well managed.
Absolute NPLs among Fitch-rated banks rose 7% in 1Q17, and could see further increase following aggressive lending in 2015/2016 into more susceptible segments such as retail and SME and the effects of the recent floods.
However, we do not expect a significant deviation in the sector NPL ratio due to the moderate loan book growth expected.
Fitch sees capitalisation as a key issue facing the sector, stemming from thin capitalisation across state banks and diminishing capitalisation across most private banks.
The state banks’ internal capital generation has been weak, with substantial dividend pay-outs to the government.
In 2016, the three largest state banks paid 76% of their profits as dividends.
Stronger capital buffers are desirable to counterbalance structural balance-sheet issues and to absorb unexpected losses.
The Central Bank of Sri Lanka has issued local Basel III capital requirements that banks are expected to comply with from July 1, 2017. Whilst Fitch believes that banks are likely to be compliant on the July 1, 2017 requirement, most banks would need to raise capital to meet the new Tier 1 levels by 2019.
The new rules also include higher risk weights for foreign-currency lending to the state and gold-backed loans, which the old rules did not have.
The government in 2016 proposed an increase in the minimum capital of licensed commercial banks to Rs 20 billion from Rs10 billion, and that of licensed specialised banks to Rs 7.5 billion from Rs5 billion.
Six small and mid-sized banks rated by Fitch did not meet this requirement based on reported core capital as of end-2016.
Sector profitability may decline as net interest margins (NIMs) are likely to narrow due to higher funding costs, which could outpace the rise in lending rates due to higher funding costs. This could be compounded by an increase in credit costs if asset quality were to worsen alongside the implementation of IFRS 9 due in early 2018.
Fitch-rated banks account for around 88% of the sector’s assets. Fitch-rated state banks’ market share had declined to 43% by end-2016 from 47% in 2013 due to aggressive growth by private banks.
Loan growth has been high despite contractionary monetary policy.
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