Fitch Ratings revises Sri Lankan banks’ outlook to ‘negative’ as operating conditions turn challengi

Fitch Ratings revised its outlook on Sri Lanka’s banking sector to ‘negative’ from ‘stable’ as the rating agency foresees more challenging operating conditions with higher bad loans  and mounting pressures on capital and bottom-lines. 
Sri Lankan banks’ rating is generally capped at the sovereign rating which was downgraded to B+ in February this year from BB- and the outlook was also revised to ‘negative’ from ‘stable’ demonstrating challenging operating conditions, hence the rating actions on banks largely reflects the change in sovereign outlook. 
“This is because bank credit profiles are sensitive to the sovereign’s credit profile, and also to risks stemming from the operating environment in the absence of a build-up of adequate loss-absorption buffers,” Fitch said in its Asia Pacific Banks outlook for 2017. 
Fitch expects the 3 - year deal with the International Monetary Fund (IMF) struck in June this year to dampen the economic performance due to a host of economic adjustments which are currently being made. 
According to them this could exert downward pressure on growth in the short term which will slow the economic growth to around 5.0 percent, slightly above the IMF’s 4.8 percent target for 2017. 
“ Fitch expects rising macroeconomic pressure to strain banks’ credit metrics, in particular asset quality,” Fitch added. 
Meanwhile the global rating agency expects the banking sector asset quality to deteriorate as the banking sector lent to more susceptible segments during the recent past. 
While the recent gradual improvement in the banking sector asset quality to historically best as demonstrated by the gross Non-Performing Loan (NPL) ratio falling to 2.9 percent in October, Fitch said this decrease was mostly reflective of the reduction in NPLs from gold-backed lending, “ and this is not expected to continue to mask incremental NPL formation for the sector,” they said. 
Further the rapid credit growth seen during the last 2 - years will also become moderate in 2017 when the monetary tightening measures taken so far by the Central Bank taking full effect and the dampening consumption demand due to higher taxes. 

It was only last week the IMF expressed their serious concerns of the still strong credit growth and asked the authorities to stand ready for further tightening by way of interest rate increases or loan-to-value ratios on selected sectors unless the 
situation moderates. 
Meanwhile the capital adequacy level of the Sri Lankan banks has remained a significant issue in the sector and Fitch warns of challenges when raising Tier I capital going forward. 
“There has not been much Tier 1 capital-raising, and banks could face challenges in raising capital”, they noted. 
Fitch highlighted the thin capitalisation levels of State banks and diminishing capitalisation levels of most of non-State banks. The BASEL III demands higher capital adequacy buffers and raising fresh capital could become an uphill task for the banks with reduced returns and lackluster capital market prevailing in 
Sri Lanka. 
It is expected the Central Bank would issue directive on BASEL III in early part of 2017 with transition period from the current BASEL II rules. 
In an earlier note, Fitch blamed the regulatory forbearance for under-capitalisation in some of Sri Lankan small and 
mid-sized banks.  
Meanwhile the rating agency also expected a slight decrease in profitability as potential increase in credit costs could offset the benefit of a possible improvement in net 
interest margin. 
Further Fitch’s report also highlighted the upward pressure on funding cost in recent times both in response to rising interest rates and lack of liquidity in 
the market. 
As a result the competition for deposits has increased but Fitch believes that a stable deposit base should continue to support bank’s liquidity. Customer deposits comprise the bulk of banks’ funding, at about 68 percent of assets. Despite being susceptible to economic cycles, Sri Lanka’s banking sector has continued to deliver consistent returns to 
its shareholders.