Special regulatory reserve somewhat weakens State lenders’ capital: Fitch

The capital ratios of Sri Lanka’s two state lenders are expected to continue to be weaker than their private sector counterparts despite their significantly higher profitability, Fitch Ratings said in a commentary issued last week.

This weakness, however, stems from a special reserve maintained by the state banks, into which a large portion of their profits is allocated but does not become part of the capital adequacy calculations.

The Central Bank has required the banks to establish this special reserve to minimise the settlement risk of restructured foreign currency loans to the government, which include both loans and step-up sovereign bonds.

The reserve is set at 15 percent of the outstanding exposure via foreign currency loans and sovereign bonds to the government and is effective for six months from the end of 2024.

Despite being set up for six months, Fitch expects continued regulatory risk mitigation, which will impact the capital of the banks.

Fitch estimates that the state lending giants, Bank of Ceylon (BOC) and People’s Bank, had allocated 72 percent of their combined profits, or 2.2 percent of their combined risk-weighted assets, to this special reserve by the end of 2024.

“We expect BOC to allocate more in 2025 to meet the 15 percent requirement,” Fitch said.

In contrast to the state lenders, the other systemically important private commercial banks, such as Commercial Bank of Ceylon PLC and Hatton National Bank PLC, have allocated only 19 percent of their combined profits and 0.7 percent of their risk-weighted assets, respectively.

This special reserve for state banks mainly arises from foreign currency-denominated loans to a state-owned entity, amounting to around 15 percent and 7 percent of their combined loans and assets, respectively, with two-thirds held by BOC.

These loans were restructured in 2024 as part of the sovereign debt restructuring.

Despite Fitch identifying the state banks’ capital as vulnerable, it also estimates that their capital ratios would have risen by about 2 percentage points without this reserve.

Meanwhile, the larger private sector commercial banks have smaller exposure to the government via international sovereign bonds, representing 3.2 percent of assets, which results in a much less significant impact from the special reserve.

Sovereign bonds restructured in December are classified as Stage 2 assets with risk weights of 20 percent.

However, Fitch estimates that if these risk weights were to be applied to these bonds, their reported Common Equity Tier I ratios could fall below 10 percent from their current 11.97 percent and 10.43 percent for BOC and People’s Bank, respectively.

“This decrease would be modestly larger if non-restructured foreign-currency loans to the state and state-owned entities are included, highlighting the vulnerability of state banks’ capitalisation to sovereign risks,” Fitch added.

The rating agency also expects the expansion in private sector credit, which usually carries higher risk weights, to further exert pressure on the capital positions of these banks.

Sri Lanka’s banks have been lending at a relatively faster pace since the second half of 2024, recovering from a significant contraction in loans in 2023 as interest rates have fallen to levels that make borrowing feasible for most individuals and businesses.

Although the current high exposure to the state (more than half of their assets) is expected to moderate in the medium term as private sector lending picks up,

 “... state exposure will remain a major factor influencing the risk profile,” Fitch added.