Sri Lankan banking sector’s credit risk high, resilience weak: S&P

„Says regulatory oversight weaker, banks’ disclosures inadequate but improving

„Cautions escalation of political turmoil could spread to banking sector and cause funding stress

Credit risk in Sri Lanka’s banking sector has increased due to relaxed lending and lax credit underwriting standards which has heightened in recent times by the high growth in bank credit and the slowdown in the economic growth, said the global rating agency, Standard & Poor’s (S&P).

In its latest report on Sri Lanka’s banking sector country risk assessment, S&P said given these factors and the weak economic performance, the resilience in the Sri Lankan banking sector has also waned.

“In our view, the Sri Lankan banking sector’s resilience is weak and is affected by the country’s low income levels, with an estimated per capita GDP of about US $ 4,050 in 2018,” the rating agency said in a prelude to the report.

Since 2014, Sri Lankan banks have grown their loan books by double digits and this was amplified in 2015 by the artificially reduced interest rates, which led to multi sector economic imbalances.

The banks now face weaknesses in asset quality due to increased default rates as a result of the relaxed lending in earlier years.

In September 2018, the banking sector’s gross non-performing loans hit 3.6 percent of total loans of the sector assets from 2.5 percent in 2017. S&P estimates a further increase in non-performing assets.

The rating agency said the economic imbalances were further amplified in recent months due to the deterioration in the sovereign credit rating triggered by the political crisis stoking fresh risks on the country’s ability to refinance external debt.

“In a low-probability and high-impact downside scenario, if the political turmoil escalates or prolongs, uncertainty could spread to the banking sector and cause funding stress or liquidity outflows. We believe larger banks with strong franchises will continue to dominate the sector,” the rating agency said.

However, S&P is of the belief that the banks’ funding profile is benefited from the stable core customer deposits.

The proportion of external funding has declined, but the rating agency said such borrowings should increase again.

Meanwhile, S&P said the availability of a large number of banks in Sri Lanka had not led to any significant instability in the competitive environment.

“However, in our view, the dominance of governmentowned banks and directed lending to the agricultural sector somewhat distort the competitive environment,” they said.

However, they are of the opinion that regulatory oversight is weaker than the international standards, although the Central Bank has been taking several measures in recent times to rein in the possible risks in the system.

“In our opinion, banking regulations and supervision in Sri Lanka are weaker than international standards, and disclosures are still inadequate, though improving,” S&P added.

The Central Bank implemented BASEL III capital and leverage ratios on a staggered basis since mid 2017 and announced a raft of risk management and oversight measures on the banks and non-banks lately.

The tone of the Central Bank suggested that they are unlikely to be sympathetic toward any entity that falls short of the minimum capital rules stipulated by them.