The Sri Lanka banking sector is a vital cog in the economic wheels of the country as it accounts for 37pct of the stock market capitalization (Table-1). A shock in the banking sector could spell deeper repercussions.
The Sri Lanka Banking Report published by the Central Bank indicated that the banking sector is in a dire situation with non-performing loans (NPL) rapidly rising given the shift in monetary policy towards a tightening stance. Businesses across all sectors have therefore seen their cost of debt increase by 100% as interest rates shifted from 7pct to 14pct during the three year period. The data therefore indicates that the large blue chips and SME sectors are running into significant difficulties in meeting their loan obligations, such actions could have an adverse impact on bank risk capital (Figure-1). The bad news is that apart from the SME the other sectors too will find it hard to manage their working capital with payments been delayed and their financial costs escalating.
Tighter monetary policy
The Central Bank of Sri Lanka has continued its tight monetary policy stance for almost 3 years. The 2018 year end inflation points to real interest rates of around 10 pct. Private sector credit growth has slowed down to 13pct over around 22pct two years ago.
The decline in banking sector profits is widespread and is reflected in the negative business sentiments. The spill off is also visible in the banking sector NPLs which increased from 22pct in Q1 to 27.4pct in Q3 and is of great concern, for banks will be forced to cut out lending to interrelated sectors until such time balance sheets are re-structured and the profit story materializes. The Central Bank has highlighted that the overall gross NPL ratio of the banking sector increased to a three year high.
High adjustment costs on the economy
On top of tighter monetary policy (Figure-1) NPLs too have significantly risen due to the lower and slower growth rates in the economy since 2015, higher fuel price adjustments, and lack of credit being extended by banks, while the 19.5pct rupee depreciation has negatively impacted real sector profits. The rupee depreciation has not had much of a positive impact on the export sector as it too is badly impacted, given higher interest rates needed for working capital. Trading companies and SMEs too have found no respite to the declining rates of profits. The use of foreign supplier’s credit for the import and export business has lost its attraction, given higher and volatile exchange rates. Similarly, the agricultural sector continues to struggle as it was hampered due to inadequate fertilizer supplies, adverse weather conditions witnessed until 2018, Q3 low producer pricing and marketing related issues.
Construction worst hit
The construction sector was particularly affected due to the government lagging on its loan repayments for most of the ongoing construction projects, which is estimated to be LKR 80 billion. On top of the delays in payment by the government, the rupee depreciation of 19.5pct has pushed raw material prices higher, eroding profits further. Therefore the bad news for the banking sector in the coming months would be the NPL’s continuing to follow the rising trend, along with contraction in banking sector profits.
Taxes suppress demand
Ironically profits earned by banks too will be subject to an effective taxation 57pct, thereby making any concessionary funding to the struggling economy even more remote. Due to these challenges faced by the business environment, consumption related loan exposure impairments and regulatory implications, banks, and with it the real economy will face significant head winds in the months ahead.
The banking sector is facing two other challenges, namely, the new accounting standards on loan loss provisioning (IFRS-9) and the introduction of new capital adequacy regulations by the Central Bank.
The new capital regulation ties in both credit loan loss provisioning (IFRS-9) and capital requirements (Basel -3) have made it compulsory for banks to provide for credit losses, and calls on banks with assets less than LKR 500 billion to maintain a capital i.e. common equity, Tier 1 (CET1) of at least 7.0pct, an increase by 21pct from its previous 5.75pct of their Risk-Weighted Assets (RWAs), while banks with an asset base above LKR 500 billion would be compelled to maintain a minimum Tier 1 capital of at least 8.5pct, an increase of 36pct from its previous requiring of 6.5pct. These credit provisioning and capital requirements must be in place, thereby adding more to the stress on to the total cost of capital as capital i.e. Tier 1 and Tier 2 capital, should at least be 12.5pct. The rules of credit and capital requirements should in place by January 2019. Similar to the rest of the economy the banking sector also sees higher associated costs due to the credit risk factors, and the higher default probabilities impacting the balance sheets of banks.
Focus on compliance at cost of relationship building
It is not surprising that under these stress conditions and compression in net profits Sri Lanka’s banking sector is now more focused on compliance and less focused on banking relationship building (i.e. managing the business cycle), as they are forced to consider supplementing their capital base further with the existing loan/risk assets and clients. The general perception is that banking will shift from relationship building to compliance building with the new capital rules and provisioning rules of accounting (IFRS-9).The end result is that these rules would be that customers will merely be a numeric value as tighter credit rules require banks to inject incremental capital in a highly costly monetary environment and not be seen as a business cycle/human activity.
Relevance of development banking
Sri Lanka does not have a development bank to help out in long term capital formation, and this shortfall is widely felt by industries. Both DFCC and NDB are now modeled in the traditional banking mold and has shied away from providing development assistance. Sri Lankan born Prof. Howard Nicholas was in fact critical of the government for privatizing both development banks (DFCC and NDB). He voiced his displeasure at the Sri Lanka Inc. economic forum where he stated, “One of the worst things that was ever done in Sri Lanka is the privatization of the NDB & DFCC. And the reason is that all these countries, all the successful countries I mentioned, had one policy and one policy only, that was development banking, state development banking”. For development banks are more accommodative in their credit assessments and more balanced in their shareholders objectives, thus development banks are able to balance growth needs and business cycle outcomes.
Thus the high cost of capital will only negatively impact banking sector earnings/net profits(Figure-2) and will make credit growth impossible with the new loan loss accounting standards forcing banks to move away from Knowing Your Customer to unknowing their customers. It is therefore safe to say that further loan impairments would only increase due to the reluctance by banks to restructure loans of ailing businesses that are already hemorrhaging from higher debt servicing. While their own operating costs are escalating, and stringent accounting rules push them to a point of freezing new credit. It is therefore safe to say that higher cost of capital, fear of credit and the weakness in the economy is making banking on banks extremely remote under these conditions. The final assessment is that it is plausible that the banking sector could manifest into one destructive force if the current trend of risk averse banking takes place unaddressed and slips past the government’s attention, which could eventually increase the NPL ratios in 2019 beyond that of 2018.
By Dr Kenneth De Zilwa