Financial Institutions Banks

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 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 a (Higher risk) (Lower risk) Fitch rated banks Source: Fitch Ratings, Fitch Solutions, Banks Source: Fitch Ratings, Fitch Solutions, Banks

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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

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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. 14 15 12 10 10 State banks, like BOC and PB, are the most vulnerable to potential capital impairment risks given 8 their already thin capitalisation, despite lower risks weights on some exposures. Capital buffers 5 6 4 could further shrink should the banks opt to draw down their capital-conservation buffers (CCB) by 0 2

1%. In contrast, most large private banks have sufficient loss-absorption buffers, mainly in the form PB

UB

CBL

SDB

NTB

BOC

HNB NDB

PABC

DFCC SAMP

of healthy PPOP. Only three banks, COMB, SDB and NDB, raised or are planning to raise equity in HDFC

Seylan

COMB Amana 2020, but we expect some of the smaller banks to raise capital in 2021 to reach the minimum capital State banks Large private banks Small and mid-sized banks level of LKR20 billion ahead of the extended regulatory deadline of end-2022. Source: Fitch Ratings, Fitch Solutions, Banks Sovereign Profile Poses Threat to Foreign-Currency Funding Funding & Liquidity The main risk for banks' funding profiles is from foreign-currency funding, which accounted for 21% Loans to deposit ratio 2019 (LHS) 9M20 (LHS) Liquidity coverage ratio - bank level - 9M20 (RHS) of the Fitch-rated banks' funding at end-3Q20, comprising 14% in deposits and 7% in borrowings. (%) (%) However, of the two components, Fitch believes the latter could be harder to come by or more 130 450 120 400 costly as increasing risks to the sovereign credit profile could deter foreign lenders. 110 350 100 300 Domestic funding should broadly remain intact with banks continuing to benefit from a deposit 90 250 80 200 influx driven by lower consumption and possible flight to quality. This, together with subdued credit 70 150 growth, should lower banks' loans/deposits ratios in 2020, but we expect a slight pick-up in 2021 as 60 100 50 50

credit growth resumes.

PB

UB

CBL

SDB

NTB

BOC

HNB NDB

PABC

DFCC

SAMP

HDFC

Seylan COMB We believe that liquidity pressure from the extension of the loan moratorium to March 2021 should Amana be mostly manageable for the Fitch-rated banks due to their high liquidity coverage ratios and the State banks Large private banks Small and mid-sized banks central bank's continued accommodative monetary stance. Source: Fitch Ratings, Fitch Solutions, Banks

Special Report │ 18 December 2020 3

Financial Institutions Banks Sri Lanka

Appendix

Relief Measures Announced by the Central Bank of Sri Lanka (CBSL) Fitch Rated Banks and Ratings as of 18 December 2020 Accommodative monetary policy The CBSL reduced policy rates by 250bp, the statutory reserve ratio by Bank name Acronym National Rating/Outlook stance 300bp and the bank rate by 650bp in 2020 Bank of Ceylona BOC AA+(lka)/Negative Working capital financing Financial institutions provided working-capital facilities under a special People's Bank PB AA+(lka)/Negative scheme introduced by the CBSL at a concessionary interest rate of 4% with a grace period of 6 months, which was later extended to 9 months. A Commercial PLC COMB AA+(lka)/Negative total of LKR178 billion has been disbursed under this scheme. The CBSL PLC HNB AA+(lka)/Negative will subsidise interest cost up to 4% for licensed banks and up to 7% for PLC SAMP AA-(lka)/Stable other financial institutions via a rebate. National Development Bank PLC NDB A+(lka)/Stable Capital relief for banks Domestic systemically important banks (D-SIBs) and non D-SIBs permitted to draw down their capital conservation buffers by 100bp and PLC Seylan A(lka)/Stable 50bp, respectively, out of the total 250bp. DFCC Bank PLC DFCC A+(lka)/Stable

Nations Trust Bank NTB A(lka)/Stable Enhancement of capital for licensed banks that are yet to meet the minimum capital requirement at end-2020 deferred until end-2022. Pan Asia Banking Corporation PLC PABC BBB-(lka)/Stable Union Bank of PLC UB BBB-(lka)/Stable Restrict cash dividend distribution to 25% of distributable profits in the Housing Development Finance Corporation Bank of Sri HDFC BB+(lka)/Stable financial years 2019 and 2020 to build up capital Lanka Liquidity relief for banks Computation of statutory liquid assets ratio relaxed until 30 June 2021 PLC SDB BB+(lka)/Stable

Minimum requirement for liquidity coverage ratio and net stable funding PLC Amana BB+(lka)/Stable ratio lowered to 90% from 100% Limited CBL A+(lka)/Stable Amendments to SLFRS 9/impaired Allow banks to consider all changes made to payment terms and loan a Bank of Ceylon is also rated on the international rating scale at 'CCC'. It is the only bank with a public international rating. loans recognition contracts from 16 March 2020 to end-June 2020 due to virus outbreak as "modifications" to loans and advances instead of classifying these loans as Source: Fitch Ratings "restructured loans" for loan classification and impairment purposes.

Allow banks to exercise judgment on case-by-case basis, to determine

whether to classify facilities as Stage 3 facilities or not (the current guidelines require that facilities restructured more than twice be considered as Stage 3)

Licensed banks shall use forecasts and projections published by the CBSL when adjusting credit provisioning models to reflect the economic conditions and forecasts, on a consistent basis Interest rate caps on lending Maximum interest rates were introduced on pawning, credit cards, products temporary overdrafts, and housing loans

Source: Fitch Ratings

Special Report │ 18 December 2020 4

Financial Institutions Banks Sri Lanka

Analysts Jeewanthi Malagala +94112541900 [email protected]

Rukshana Thalgodapitiya +94112541900 [email protected]

Special Report │ 18 December 2020 5

Financial Institutions Banks Sri Lanka

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Special Report │ 18 December 2020 6