Sustainability of above-average loan expansion in doubt – Fitch

Fitch expects the profitability of the Sri Lankan banking sector to benefit from manageable credit costs in line with the expectation for asset quality

While Fitch expects all banks to benefit from better lending prospects through 2012, the two largest and state-owned banks are likely to continue to dominate, given their presence across the country and ability to source business from the state sector (state and state-owned entities)

Fitch Ratings expects the ear nings of Sri Lankan banks to continue to benefit from strong lending prospects in the post-civil war period (since 2009). Real GDP is forecast by the agency to increase by 8% per annum in 2012, driving strong credit demand. Licensed commercial banks, accounting for about 45% of financial system assets, are in Fitch’s view the best placed to meet this demand. The agency expects a policy response from the authorities to rein in credit demand should inflation increase.

Manageable Asset Quality:

Fitch remains concerned about the Sri Lankan banking system’s ability to manage a sustained level of above-average loan expansion. Sri Lanka’s Macro Prudential Index (MPI) – an indicator of potential stress in the banking system – was revised to ‘3’ (high) from ‘1’ (low) in December 2011. The knock-on effects of a still uncertain global economic environment could affect asset quality. However, the agency believes that asset quality may not immediately deteriorate to the levels reached in 2008 and 2009.

Sustained Healthy Profitability:

Fitch expects net interest margins (NIMS) to continue to come under pressure due to intensifying competition. The agency believes that healthy profitability could continue to be delivered in 2012, supported by strong loan demand, manageable credit costs and reduced taxes.

Increased Non-deposit Funding: Fitch believes that loans/ deposits ratios (LDRS) will continue to increase to 85%-90%. The agency notes that heightened competition and diminishing liquidity are being reflected in rising interest rates on deposits. Supported by their domestic franchises, deposits will remain the main source of funding for Sri Lankan banks, although strong lending could result in a rising share of non

deposit funding.

Capital Planning Important:

Fitch believes that the capital ratios of Sri Lankan banks could come under pressure through continued strong credit growth. The agency recognises that capital conservation to maintain an adequate buffer is important in light of loan growth levels, credit concentrations, the just adequate level of loan-loss reserve coverage and exposure to macroeconomic volatilities. What Could Change the Outlook?

Capital Impairment:

A significant reversal of policy direction and/or macroeconomic shocks, and/or rapid lending that puts pressure on liquidity, earnings or asset quality resulting in substantial capital impairment could be negative for the outlooks and/or ratings of Sri Lankan banks.

Structural Changes:

Structural changes such as improvements to risk management, particularly for those banks venturing into new customer segments, and enhanced capital buffers could be positive for the outlooks and/or ratings.

Strong loan expansion to continue

The Sri Lankan banking sector experienced strong loan growth of about 24% (annualized) in 6M11 and Fitch forecasts loan growth to remain above 25% in 2012 supported by strong economic growth. The loans to GDP ratio increased marginally in H111 to 36% from 35% at end-2010, which is still below the 41% average from 2006-2008.

Fitch expects the focus to remain on lending to SMES and the consumer/retail se gment in search of higher NIMS. Although this could deliver greater diversification of loan books to more granular exposures, there could be challenges in ter ms of the need for improvement in risk management processes and systems, particularly for those banks that are relatively new to lending to this segment. Credit concentrations to cor porate customers are likely to continue in the absence of a developed corporate debt market.

While Fitch expects all banks to benefit from better lending prospects through 2012, the two largest and state-owned banks are likely to continue to dominate, given their presence across the country and ability to source business from the state sector (state and state-owned entities).

Asset quality manageable

Fitch expects the asset quality of Sri Lankan banks to remain manageable through 2012. While NPL accretion could result from sustained rapid loan growth, the agency believes that asset quality of the system may not immediately deteriorate to the levels reached in 2008 and 2009. While policy rates have remained steady since January 2011 to support credit growth, Fitch expects a policy response from the authorities to high credit demand should inflation increase. However, the agency notes that this may take the form of another increase in the statutory reserve ratio rather than an increase in policy rates.

Fitch notes that asset quality, particularly of export- and tourism-related segments, could feel the knock-on effects of a still volatile global economic environment. Hence, the agency recognizes banks’ need to enhance their loss absorption capacity by increasing their Tier 1 capital buffers.

Competition to cause NIMS to contract

The NIMS of Sri Lankan banks have already be gun to contract due to rising funding costs, which are the result of competition for deposits amidst diminishing liquidity. Fitch expects the impact on NIMS to differ across banks, although there is a limit to the extent to which higher deposit costs can be passed on. It is likely that those banks with more mature deposit franchises such as the older and larger banks that have a higher share of current and savings accounts (CASA) in their deposit mix (See Figure 4) will weather the pressure on NIMS better. While the focus will remain on garnering low cost CASA, it is likely that there will be a shift towards higher yielding ter m deposits. The agency expects banks to support net interest income through robust lending to counter contracting NIMS.

Manageable credit costs and taxes to support profitability

Fitch expects the profitability of the Sri Lankan banking sector to benefit from manageable credit costs in line with the expectation for asset quality. The agency notes that while declining NIMS have already begun to take their toll on banks’ pre-tax retur n on assets, the impact on overall retur n on assets (ROA) is being shielded by lower tax rates.

Declining liquidity through rising LDRS

The LDR of the Sri Lankan Banking sector is likely to increase amid strong loan expansion ahead of that of deposits. Fitch notes that the LDRS of those banks that have less mature deposit franchises are fast approaching 100% or more, and believes that the major banks that have strong franchises are better positioned to compete for customer deposits as liquidity diminishes. Overall for the sector, the agency expects the LDR to be in the range of 85%-90% in 2012, with an increasing share of non-deposit funding required to fund growth.

The system’s foreign-currency LDR has remained lower than its local-currency LDR. Banks have generally been more cautious on foreign-cur rency lending which is generally funded by foreign-currency deposits. While liquid assets held largely in the for m of gover nment securities are gradually channelled into lending, Fitch notes that banks will still need to comply with minimum regulatory liquid asset ratios of 20% of its total liabilities (excluding liabilities to the central bank and shareholders).

Profit retention and capital raising to counter capital dilution

While the Tier 1 ratios of Sri Lankan banks have remained above the 5% regulatory minimum (See Figure 5), Fitch believes that profit retention and capital raising will be needed to support strong loan growth. The sector’s Tier 1 ratio stood at 13.4% at end-q211. Assuming annual growth of 20% in the sector’s risk-weighted assets in 2010-2014, the agency estimates that about LKR75BN (USD0.66BN) would be required over the next three years to maintain a comfortable capital adequacy ratio (CAR) of 9%. While a substantial portion of this could be raised via profit retention, further capital raising would be required in view of current growth.

Fitch notes that some banks have raised Tier I capital through share issues, while more have raised Tier 2 capital through issues of subordinated debentures. While the quality of capital is likely to remain good, capital conservation would be required to ensure that an adequate buffer is maintained in view of the strong loan growth being experienced, high credit concentrations, low level of loan loss reserves and exposure to macroeconomic volatility.

Year 2011 review

The rating outlooks for the majority of Sri Lankan banks is stable, due to improved earnings prospects of banks supported by the post-war growth in the domestic economy as well as the government’s capacity to support the banking system. However, the rapid pace of loan growth that began in mid2010, if continued, will test banks’ risk management systems and funding profiles.

Fitch upgraded the ratings of Bank of Ceylon (‘Aa+(lka)’/ Stable) and People’s Bank (Sri Lanka) (‘Aa(lka)’/stable) in view of the government’s increased capacity to support the banks if required following the upgrade of Sri Lanka’s IDR to ‘BB−’ from ‘B+’ in July 2011. The Positive Outlook on Sampath Bank Plc (‘Aa−’(lka)/positive) reflects the continuous improvement in the bank’s credit metrics and the ongoing structural improvements since 2009 as well as its growing franchise and market share. The Negative Outlook on Union Bank of Colombo Plc (‘Bb+(lka)’/ Negative) reflects operational risks, given the nature of its disparate IT systems, weak operational branch procedures, and high loan growth of 56.5% in nine months ended September 2011 (9M11).

In December 2011, Sri Lanka’s Macro Prudential Index (MPI) – an indicator of potential stress in the banking system was revised to ‘3’ (high) from ‘1’ (low). The MPI identifies the build-up of potential stress in banking systems due to rapid credit growth associated with bubbles in housing or equity markets or appreciated real exchange rates. Credit growth in Sri Lanka in 2010 and 2011 has been amongst the highest in emerging markets, and together with an increase in equity prices, has triggered the increase in the MPI.