Sri Lankan Banking Industry face ‘economic & Industry’ risk – S&P

Sri Lanka’s banking industry reflects a “very high risk”  assessment of economic resilience and credit risk in the economy, and a “high  risk” assessment of economic imbalances, says the Standards and Poor’s.

The Rating agency in its latest Banking Industry Country Risk Assessment, assigned Sri Lanka’s Banking sectors economic risk score of ‘8’ and an industry risk score of ‘7’ on a scale of 1 to 10.

Below we provide the rating review released by the S&P

OVERVIEW
•    We are assigning the Sri Lanka banking system to our group ‘8′ BICRA.
•    We are also assigning our economic risk score of ‘8′ and an industry risk
•    score of ‘7′.

BICRA ACTION

On June 19, 2012, Standard & Poor’s Ratings Services assigned Sri Lanka to its  Banking Industry Country Risk Assessment (BICRA) group ‘8′. At the same time,  we assigned an economic risk score of ‘8′ and an industry risk score of ‘7′.

RATIONALE

We have reviewed the banking sector of Sri Lanka (Democratic Socialist Republic of) (B+/Stable/B). The BICRA groups summarize our view of the risks  that a bank operating within a particular country and banking industry faces  relative to those in other banking industries. They range from group ‘1′ (the  lowest risk) to group ‘10′ (the highest risk). Other notable countries in  BICRA group ‘8′ are Nigeria, Tunisia, and Kazakhstan.

Our economic risk score of ‘8′ for Sri Lanka reflects a “very high risk”  assessment of economic resilience and credit risk in the economy, and a “high  risk” assessment of economic imbalances, as our criteria define those terms.

Our assessment of economic resilience reflects Sri Lanka’s status as a  low-income economy, as measured in terms of its per capita GDP, and the  inefficiencies in the economy. Nevertheless, Sri Lanka’s economic growth  prospects have improved following the end of the civil war and subsequent  shift in the government’s focus toward boosting the economy and diversifying  sources of growth.

Our assessment of economic imbalance factors in the recent pickup in growth of  private sector credit. The central bank’s recent directive to apply a ceiling  to the credit growth of banks should help to partially curb this risk.

Nevertheless, in our view, Sri Lanka’s economic imbalances could increase if  credit growth continues at the current pace. Sri Lanka’s external position,
which we consider to be moderately vulnerable, also affects the country’s  economic imbalance. Our assessment of Sri Lanka’s external position reflects  the country’s weak external liquidity, and moderately high and increasing  external debt.

Our view of credit risk in Sri Lanka takes into account moderate private  sector debt in the context of low income levels, relaxed lending practices and underwriting standards, as well as a weak payment culture and rule of law. The use of cash flow analysis for underwriting is limited in Sri Lanka, and some
exposures are concentrated. Moreover, risk management practices are evolving, in our view.

Our industry risk score of ‘7′ for Sri Lanka is based on our opinion that the  country faces “very high risk” in its institutional framework, “high risk” in its competitive dynamics, and “intermediate risk” in its system-wide funding.

We view the banking regulations in Sri Lanka as somewhat weaker than  international standards. Governance and transparency of banks are weak by global standards. Sri Lanka adopted a standardized approach of Basel II in  2008, with capital requirements higher than global requirements. The key
regulations for banks seem sufficient. However, finance companies are less  regulated, in our view. This is despite the December 2008 collapse of a  finance company triggering a run on a bank in that group.

Under the existing legislation, banks in Sri Lanka are subject to on-site  examinations by the banking sector regulator at least once every two years. We believe the frequency of on-site supervision may not be sufficient for the  regulator to quickly detect risk build-ups. Moreover, we see a potential  conflict of interest in the central bank’s role. In addition to policy  formulation and supervision of banks, the monetary board of the central bank  also oversees Employees’ Provident Fund investments. The fund is a large  investor in Sri Lankan banking stocks.

The banking sector’s risk appetite is “moderate,” in our view. Loan growth is  high. However, banks in Sri Lanka are mostly engaged in traditional lines of  business and most of their earnings come from traditional fund-based businesses.

Sri Lanka’s large number of banks relative to the small economy has not led to  any significant instability in the competitive environment. However, the  following factors have led to market distortions: (1) a significant market share (about 50%) of government-owned banks in the sector; (2) directed  lending requirements toward the agriculture sector; and (3) differential use of administrative controls; e.g. a recent cap on loan growth is applicable only to banks.

Sri Lanka’s large proportion of highly stable core customer deposits support system-wide funding. Such deposits reduce banks’ dependence on external debt. Nevertheless, we believe access to alternative domestic funding sources is limited because the domestic debt capital market is narrow and shallow.

In our view, the Sri Lankan government has “supportive” tendency towards private sector banks. We believe that the government is committed to maintaining financial system stability and market confidence. The government  has a record of supporting banks during periods of financial stress by encouraging market-led solutions. For instance, in the case of Ceylinco Group, the banking sector regulator stepped in and dissolved the board of directors of group entity, Seylan Bank PLC, and supported the sale of Seylan Merchant  Leasing PLC.