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Sri Lanka Banks Report Card 2020

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Sri Lanka Banks Report Card 2020 Financial Institutions Banks Sri Lanka Sri Lanka Banks Report Card 2020 Loan Growth Profitability Adverse Environment Continues to Pressure Banks' Profiles Gross loans growth - Fitch rated banks NIMs (LHS) Gross loan growth - excl. state banks Operating profit/RWA (LHS) Fitch Ratings expects the economic fallout from the coronavirus pandemic and the weakening ROA (LHS) State banks' contribution to incremental lending sovereign credit profile to continue to weigh on the Sri Lankan banking sector in 2021. We expect (%) (%) Credit costs as a % PPOP (RHS) (%) banks' ability to generate new business and revenue to be broadly similar to that experienced in 100 6 50 2020, with significant downside risks. Sri Lankan banks entered 2020 with their credit profiles 80 40 4 already under pressure following a long period of poor economic growth due to adverse weather 60 30 conditions, political turmoil and the 2019 Easter attacks. 40 20 2 Fitch expects Sri Lanka's real GDP to contract by 6.7% in 2020 before expanding by 4.9% in 2021, 20 10 albeit off a low base. Our forecasts are subject to a high degree of uncertainty regarding the 0 0 0 evolution of the pandemic globally and in Sri Lanka. 2016 2017 2018 2019 9M20 2016 2017 2018 2019 9M20 Weakening Operating Environment: The operating environment (OE) score for Sri Lankan banks Source: Fitch Ratings, Fitch Solutions, Banks Source: Fitch Ratings, Fitch Solutions, Banks has been progressively lowered alongside the downgrade of the sovereign rating, which is a key Asset Quality Capitalisation & Leverage factor in our assessment of the banks' OE, given the strong linkage between the sovereign credit Regulatory gross NPL ratio - sector CET 1 ratio (LHS) profile and the banks' operating conditions. This linkage further strengthens during periods of stress Impaired loans (stage 3) ratioª Equity/assets (LHS) (%) Impaired loans (stage 3) ratio - excl. state banksª Unimpaired loans/CET1 (RHS) as selected banks, in particular state-owned banks, are expected to support the state's relief (%) (%) 12 initiatives and policy objectives. 13 60 10 55 8 11 In December 2020, Fitch lowered the assessment on the OE to 'ccc' from 'b-' following the 50 6 downgrade of the sovereign rating to 'CCC'. The OE score was similarly lowered to 'b-' from 'b' in 9 45 4 May 2020 after a sovereign rating downgrade. We expect Sri Lankan banks' financial profiles to be 40 2 7 under pressure from a more challenging operating environment, particularly in terms of their access 35 0 to foreign-currency funding, asset quality and profitability, than previously envisaged. 5 30 2016 2017 2018 2019 9M20 2016 2017 2018 2019 9M20 Intrinsic Creditworthiness Drives Ratings: All domestic Sri Lankan bank ratings are driven by their a Fitch rated banks standalone strength, except for Cargills Bank Limited (CBL). Fitch believes that extraordinary Source: Fitch Ratings, Fitch Solutions, Banks Source: Fitch Ratings, Fitch Solutions, Banks sovereign support cannot be relied upon for any bank, including the two large state banks - Bank of Funding & Liquidity Loan Composition by Industry - 9M20 Ceylon (BOC) and People's Bank (PB), mainly due to the state's sharply weakened ability to provide Loans to deposits ratioª (LHS) Wholesale & retail trade Tourism support, even though its propensity to support remains unchanged. The state's weak credit profile Consumption Manufacturing FC deposits as a % of total funding - sector (RHS) Construction Others also affects domestic banks' ratings, including on the national rating scale. Lending to treasury FC borrowings as a % of total funding - sector (% of loans) Financial Profiles Affected the Most: We believe that high OE-related risks will translate into (%) (RHS) (%) weaker financial profiles for banks despite an anticipated economic recovery. This is evident from 96 15 Private banks their rising impaired loan (stage 3) ratios and below-average profitability. Sourcing non-deposit 94 10 foreign-currency funding could also be challenging, both in terms of accessibility and pricing, due to 92 State banks 5 a weaker sovereign credit profile. 90 88 0 0% 20% 40% 60% 80% 100% 2016 2017 2018 2019 9M20 (Lower risk) a Fitch rated banks (Higher risk) Source: Fitch Ratings, Fitch Solutions, Banks Source: Fitch Ratings, Fitch Solutions, Banks Special Report │ 18 December 2020 1 Financial Institutions Banks Sri Lanka Financial Profile Sri Lankan Banks Market Shares By assets By deposits State Banks to Gain More Market Share (%) Fitch expects state banks to gain more market share in the near to medium term as their asset 25 growth outpaces the sector's due to increased state lending. Muted growth among the private 20 banks has resulted in their market shares declining marginally in 9M20. 15 10 Relief Measures Mask True Asset-Quality Deterioration 5 We expect Sri Lankan banks to face significant risks to underlying asset quality once relief measures 0 are phased out. However, these risks will not be apparent in reported performance in the near term. 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 2019 9M20 9M20 9M20 9M20 9M20 9M20 9M20 9M20 9M20 9M20 9M20 9M20 9M20 9M20 The extension of the debt moratorium by six months to end-March 2021 gives banks more flexibility 9M20 to defer recognising stressed loans as impaired, which should, in our view, limit the potential rise in BOC PB COMB HNB SAMP NDB Seylan DFCC NTB PABC UB HDFC SDB Amana CBL stage 3 loans (impaired loans). As such, the expected rise in impaired-loan ratios is unlikely to Source: Fitch Ratings, Fitch Solutions, Banks crystallise in full till 2Q21 or 3Q21, instead of 4Q20 or 1Q21 as previously anticipated. Asset Quality These measures to provide affected borrowers more time are not unexpected, and are not out of Regulatory gross NPL ratio - bank level - 2019 Regulatory gross NPL ratio - bank level - 9M20 line with initiatives in other emerging markets in the region. Sri Lankan banks face the risk of a sharp (%) Impaired loans ratio - 2019 rise in impaired loans if borrowers are unable to resume repayments once the moratorium ends, 30 25 with potential deterioration highly correlated with the pace and quality of economic recovery. 20 15 Fitch estimates that at least 26% of loans of Fitch-rated banks were under the first phase of the 10 regulatory moratorium at end-June 2020. Banks have been restructuring loans of their own accord, 5 even before the onset of the pandemic. 0 PB UB CBL SDB NTB BOC NDB Asset-quality risk also stems from banks' non-loan exposures. Fitch estimates that at least 6% of HNB PABC DFCC SAMP HDFC Seylan COMB banks' assets at end-9M20 comprised foreign-currency denominated instruments of the sovereign Amana (Sri Lanka Development Bonds and international sovereign bonds), which are likely to attract higher State banks Large private banks Small and mid-sized banks credit costs. Source: Fitch Ratings, Fitch Solutions, Banks Gross Loan Growth During 9M20, the combined impaired-loan ratio of the two large state banks fell to 9.8% from 10.4% at end-2019, but this was mainly due to high loan growth (state banks' loan growth in 9M20: 22%). (%) 2018 2019 9M20 Fitch rated banks - 9M20 The pressure on asset quality was more evident for private banks, whose impaired-loan ratio 30 increased to 10.1% from 8.8% at end-2019. 20 10 State Banks to Drive Loan Growth 0 Fitch expects moderately higher loan growth in 2021, driven by increased private-sector credit -10 demand. We still expect state banks, driven by lending to the state or state-related entities, to PB UB CBL SDB NTB BOC NDB HNB PABC DFCC SAMP account for a sizeable share of the incremental lending, though lower than in 2020. Fitch-rated HDFC Seylan COMB Amana banks' loans rose by 11.4% in 9M20, of which the two large state banks accounted for 83% of the State banks Large private banks Small and mid-sized banks incremental lending. Source: Fitch Ratings, Fitch Solutions, Banks Special Report │ 18 December 2020 2 Financial Institutions Banks Sri Lanka Credit Costs to Drive Profitability Profitability We estimate that Fitch-rated banks' operating profit/risk-weighted assets will fall sharply in 2020 (PPOP/average loans - credit costs/average loans) 2019 9M20 Operating profit/RWA - 9M20 as a result of increased credit costs and muted lending. However, we expect most banks to remain (%) 5 profitable, with the exception of CBL. We expect profitability to improve in 2021 as the rise in credit 4 3 costs decelerates due to slower impaired-loan accretion, with some banks opting to front load credit 2 1 costs in 2020, and a pick-up in lending. We estimate banks to charge at least 50%-60% of their pre- 0 -1 provision operating profits (PPOP) as credit costs for 2020 (9M20: 47% of PPOP, 2019: 27%), but a -2 -3 sharper-than-expected deterioration in asset quality could lead to sustained high credit costs and -4 depress profitability for longer. PB UB CBL SDB NTB BOC NDB HNB PABC DFCC SAMP HDFC Seylan COMB High Capital Impairment Risk, But Manageable Amana Fitch believes that pressure on Sri Lankan banks' capital buffers is mostly manageable. Muted State banks Large private banks Small and mid-sized banks lending prospects are likely to be outpaced by earnings retention, which should provide stability to Source: Fitch Ratings, Fitch Solutions, Banks common equity Tier 1 (CET1) ratios, despite the earnings pressure and credit weakening. Capitalisation at End-9M20 CET1 ratio (LHS) Tier 1 capital ratio (LHS) Total capital ratio (LHS) Leverage ratio (RHS) However, risks to capital buffers could increase, should the downturn be much worse than our base (%) case. The net impaired loans/CET1 ratio for Fitch-rated banks has already risen to 51% by end- 25 20 9M20 from 45% at end-2019, but we believe that the availability of tangible collateral in most cases 18 20 16 could reduce potential losses.
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