Jan 11, 2009 (LBO) - Sri Lanka's finance company profits would pick up in 2010 as deposit rates falls, helping offset some credit losses, but asset quality may remain until the economy strengthens, Fitch Ratings has said.
A recent sharp fall in bank deposit and lending rates had now started to spread to the finance company sector.
"The agency expects the consequent decline in funding costs and the resultant benefit to net interest margin, to offset the high credit costs," Fitch said in a statement on central bank registered finance and leasing companies in Sri Lanka.
"However Fitch notes that the recovery of the industry’s current weak asset quality could lag the positive macroeconomic trends seen at present, underlining the severity of the recent economic downturn and the higher‐risk nature of the industry’s client base."
Liquidity problems at finance companies and leasing firms have "eased somewhat" since a Fitch comment in September 2008 which then intensified after the collapse of several unregulated financial firms.
During the period finance companies had to give higher risk premiums compared to commercial banks.
held for regulatory liquidity purposes have been carried at negative interest.
"The resultant pressure on profitability was magnified due to the proportionate increase in treasury investments amid slow credit growth," Fitch said.
"These factors, combined with high credit costs stemming from continued weak asset quality, stifled RFC (registered finance company) sector profitability further in 2009."
The average return on assets (ROA) of five large RFCs was at 1.8 percent by end-June 2009, compared with 3.2 percent at end-March 2008.
Fitch said lack of private sector credit demand and monetary easing pushed Treasury yields down with one year maturities falling over 900 basis points.
"However the pass-through effects of these rate reductions into the deposit and lending rates of commercial banks were initially slower than Fitch expected," Fitch said.
"This was driven by the relatively slow revisions of deposit rates at the three largest state banks in the first nine months of 2009, possibly due to the high funding requirements of the state during this period, as the government’s primary account deficit deteriorated to unprecedented levels.
"These banks have historically been the de facto rate-setters on system-wide deposits."
When high yielding treasury securities at commercial banks matured, private commercial banks had cut deposit rates ahead of state banks.
27 October 2009 the president as finance minister directed that state banks to reduce average lending rates across a broad cross section of loans, to between 8 percent and 12 percent, to push up credit growth.
This compared to an average interest yield of about 15 percent for Fitch rated banks for the June quarter.
Fitch says the state directive triggered a steeper, more rapid revision of deposit rates across the banking system (200bp–400bp in the first three days post-directive) than would otherwise have been likely to occur.
This allowed most finance companies to engage in similarly sharp reduction in deposit rates.
"Such a pass-through of reduced deposit rates, together with a possible normalising of private sector credit demand, should improve the RFCs’ profitability over 2010," the rating agency said.
"Fitch expects the improvement to be more rapid for higher-rated RFCs which generally have stronger capital positions and better deposit franchises."
But Fitch says that a protraction of the high risk premiums, or a prolonged inability to overcome weak asset quality levels, could result in a loss of market share for weaker entities and a deterioration of credit profiles.
This could trigger rating actions on a case-by-case basis.
Leasing firms which had funding from institutional lenders had benefitted faster from falling market rates. With lending rates on existing loans remaining fixe, interest margins widened.
Finance companies, which have public deposits experienced slower falls in deposit rates.
The rating agency says the risk premium from banks to better established and higher rate finance companies have remained intact or reduced in some case in recent months.
As a result, the profitability of such SLCs has broadly improved since March 2009, as improvements to net interest margins have outstripped high credit costs.
But smaller SLCs (whose risk management systems and controls are generally weaker) could continue to face profitability pressures over the medium term, if banks continue to limit exposure to this segment, Fitch said.
The ratings of the smaller SLCs that Fitch rates, such as People’s Merchant Bank PLC (‘BBB−’/Negative Watch) and Ceylease Financial Services Ltd (‘BBB−’/Stable Outlook), derived comfort from shareholder support.
Fitch says this could limit possible rating actions over the medium term.
The rate of deterioration in non performing loans for larger, more established finance and leasing firms had shown early signs of easing during the September 2009 quarter, after an apparent peak in the June quarter.
But Fitch says sector asset quality is unlikely to return to its historical best levels seen in 2006 at least until 2011, despite structural improvements to collections and recovery mechanisms implemented by companies over the past 24 months.