Banks, Fitch Ratings, NPLs & Impairments!

By Rusiripala Tennakoon –

Rusiripala Tennakoon

Global economy is in a decline mummifying all activities, virtually halting the growth prospects, due to the Covid-19 Pandemic spreading at alarming speed, signaling signs of a worst economic shock the world is destined to experience as the deepest recession after several decades. Attention of the financial circles throughout the world remain heavily focused on the performance of the banking sector and their asset quality associated with this conundrum. Key words interacting corelated to the on going discussion are Fitch ratings, Non-performing loans (NPL), impairment, loan loss provisions (LLPs), equity capital and the credit risks etc.. 

In a background of major Financial catastrophes such as the Great Financial Crisis of 2007 followed by other localized more recent happenings including those in Cyprus and Greece, loan portfolios of banks have become serious concerns of those focusing on early recognition of credit losses and transparent disclosures. Regulatory and accounting treatment of bank assets occupy an important position under these.

Recent Fitch Rating assessments about the current state of loans and lending has caused  alarm in the local banking scenario. Particularly in association with unprecedented lowering of ratings there is a compelling need for a closer and careful scrutiny of the overall position. A recent news flash states that, combined impaired loan ratio of BOC & PB is at 9.8% by end of September from 10.4% end 2019 while impaired loan ratio at private banks increases 10.1% from 8.8%. Fitch ratings went on to qualify their reference by further stating that, ‘the pressure on asset quality was more evident in the privately owned banks, and a rise in impaired loan ratios in both State and private banks could become crystalized from the second or third quarter of next year as the moratorium would hide the true nature of the loans under stress at present” 

However, Fitch ratings are highly skeptical about the true position of this difference in the shift and how the picture would look applied to all Banks once the moratorium granted by the CBSL { initially for six months from April last year and further extended by another 6 months lasting in March 2021}, ends. One significant factor Fitch ratings may have overlooked could be the degree of uniformity in the application of the moratorium as allowed by the CBSL in the State and Private sectors. With less political pressure the private sector banks apparently are engaged to regularize borrowings and set aside adequate provisions without dramatically increasing the risk of write offs as a safety measure against an unpredictable environment in the future. This sounds more sensible and a safe measure helping in the long term to reduce the need to raise equity in the event of a crisis. Even if the number of NPLs decline, it is more prudent and realistic to apply higher impairment losses to loans in the category of reasonable suspicion of default. There cannot be any controversy about the number of risky loans growing at an increasing rate according to the prevailing conditions. 

State Banks are blessed with a ready source for capital augmentation as we have seen in the past, the Treasury. So, they do not have to take pains in chasing the borrowers to reduce their obligations and /or bring them into the regular fold by following other possible steps such as rescheduling. 

The composition of the Loan portfolio is another  factor for the two State Banks to keep their combined loan impairment figures low. Approximately about 52% of their total loans are either direct to the State or to the SOEs. Application of general impairment rules are relaxed extensively and there is a great deal of leeway available to the State banks in respect of advances to the State sector despite their default status. Even the Regulatory controls seems to be applied in an offhand manner. An example of this practice can be elaborated by referring to how the very large defaulted outstanding amounts of Sri Lankan Airlines is treated by the two leading State Banks. In one bank the loan is continued in the current section while the other bank has applied the regulatory criteria and transferred it to NPL category. A namesake guarantee provided by the Treasury in the form of a letter of Comfort issued to authorize the lending is regarded by the former to treat it as a fully secured facility while the latter has applied other obvious criteria such as the balance sheet positions and the net-worth of the entity in assessing it’s asset quality as sub-standard or doubtful despite the cover available under similar letters of comfort. The NPL in one bank remains low whereas LLP balance and the loan impairment losses in the other shows an increase. Accordingly, when the statistical values are combined and averaged it gives a distorted picture. This makes an accurate comparing unrealistic and impossible. To that extent the assumptions of Fitch ratings become debatable.

According to the above State Bank practices, there are two possibilities of misrepresentation. The first is  one bank applies different criteria for the application of regulatory standards for the continuation of public sector loans classified in the performing category and the other treats the same type of lending categorized as sub-standard or doubtful. Then the combined effect gives a completely wry version. 

The second is in relation to the broad comparison between the Private sector and the State sector banks. Rating agencies have made specific references to the high percentage of lending to Government in the loan portfolio of State banks. The biggest borrower from the State banks is the State itself and the SOEs under its control, with a percentage exceeding 50% of the total loan portfolio. This is in absolute contrast to the position in the Private sector banks where the loans are concentrated in the Private sector. In a situation where the Fitch ratings has down- graded our sovereign credit rating, attributing inter-alia doubts about the Nation’s  ability to meet its external debt service obligations, to ‘CCC’ level signifying a ‘a real possibility of default’, the application of impairment standards in respect of borrowings by the State should be more stringent in a realistic analysis. The application of macro-economic conditions become more appropriate therefore to the loans of the State banks than the private sector banks where the lending has been on a more secured basis.

The quality of the assets also represents other important features that have to be taken into consideration. Eg. The current outstanding amount due from Sri Lankan Airlines in one State bank is inclusive of the accumulated unpaid interest capitalized. Besides the compounded risk due to this exercise, the Bank has already absorbed unearned loan interests and shown as part of their profits already declared! 

It is evident that the rating agencies base their projections in a more conservative manner and there is a big variance between the statistical data presented by the Government and these agencies in several areas. They dispute the budget forecasts as highly speculative and ambitious and are critical about the targeted increase in spending and public investment. Government on the other hand estimates its GDP to grow and the projected investment to be of a higher percentage than estimated by the Fitch ratings. We remain baffled about these divergences and the associated challenges. However history has proven in many instances where the projections have gone astray as well as ignoring the predictions have caused economic calamities.

The references made regarding the failure of the Rating Agencies  and others to Forecast the American financial Crisis as highlighted in the Final report of the National Commission on the causes of the Financial and the Economic crisis in the U.S. is the best example for the former and the failure of our own  Financial wizards to take adequate notice of and follow the trends during the period preceding the Greece debacle before the impugned sovereign investments we made which caused heavy financial losses to the country is an example for the latter.

It has to be emphasized that the published accounts do not always reflect the true position at a glance. A much more careful and incisive approach is needed to understand the underlying controversial factors. As an example certain statistics announced in the published quarterly Statement of accounts of a State bank can be cited. (as at 30^th September 2020) 

Total Loans and advances to customres and others      1,602,074,504    (in billions of Rs.)

Total loans and advances to the State and SOEs              840,000,000    (inclusive of treasury borrowings)

Pawning  advances to customers (100% guilt edged )     160, 000,000

.: total loans to private sector                                                600,000,000

The statement shows a gross NPL ratio of 3.38

Hence the total NPL balance should be 54 Billion { 54/1600 X 100 = 54}        

Amounts in NPL o/a of SOEs approximately 2.3 Billion 

The NPL balance applicable to private sector 54- 2.3  =  51.7 Billion

This NPL as a ratio of total lending to private sector is 51.7/600 x100 =  8.61

Accordingly, the actual NPL ratio of this bank on account of its private sector lending has to be  8.61 and not 3.38.

Therefore, it will show an entirely different picture compared to the private sector bank NPL averages shown by the fitch ratings!

There have been instances previously where advances by one state bank reportedly  amounting to 30 Billion have been absorbed by the treasury by issuing interest bearing T.Bonds to that value which the bank in turn swapped with the EPF, thereby clearing their balance sheet to that extent.

This exercise may be resorted to in future too in the most probable situation of some of the advances to SOEs becoming unrecoverable! 

There are many aspects that do not fall within the investigative scope of rating agencies before their presumed projections, which they believe are realistic. The Sri Lanka situation and particularly the banking sector outlook are cases in point. Nevertheless, the consequences of the rating declarations are very serious and the stressful challenges we are facing to come out of a grave situation will be aggravated.

We have to strive to achieve realistic standards reflecting high asset management qualities and the performance of the State banks to be above board. The Fitch ratings already announced should be regarded as risk signals warranting immediate course corrections. The State has a duty to free the banks from political maneuvers as the industry remains virtually regulated by the Government through the CBSL and all major banks in the private sector too are operating with substantial capital inputs in their share holdings by the State in addition to the 100% owned state banks which perform the industry lead role.