CB’s regulatory forbearance has contributed to bank under-capitalization: Fitch

The regulatory forbearance or Central Bank’s failure to strictly enforce minimum capital rules has led to the under-capitalization of some of the small and mid-sized banks in Sri Lanka, and this could undermine the authorities’ objective of industry consolidation, according to a leading global credit rating agency. According to Fitch Ratings, six Lankan banks out of 15 rated by them fell short of meeting the proposed minimum capital requirements in the 2017 budget while 3 out of these six even do not meet the existing minimum capital requirements.

The Central Bank in December 2014 sent directives to all licensed commercial banks to double its minimum core capital level from Rs.5.0 billion to Rs.10.0 billion from January 1, 2016. But those few, who were unable to meet the requirement, were granted time till January 1, 2018 with interim targets. “Fitch believes that such regulatory forbearance has contributed to bank under-capitalization and could undermine the authorities’ objective of consolidation,” the rating agency said in a special note. In the budget for fiscal 2017, the country’s belligerent finance minister proposed to raise the minimum core capital requirement up to Rs.20.0 billion – doubling from the existing requirement of Rs.10.0 billion and of licensed special banks’ to Rs.7.5 billion from Rs.5.0 billion. While the budget speech was silent on the timelines, the enforcement of such capital requirements is likely to come into force from January 1, 2018. Fitch Ratings hailed the proposal as such would “help to strengthen the capitalization of some banks and appear aimed at bringing about consolidation in the banking sector, which should raise systemic stability of the sector in the long term”.

However, Mirror Business learns that the Central Bank Governor Dr.Indrajit Coomaraswamy has not endorsed this proposal yet and in any case a final ruling on minimum capital levels of the banks in the country has to come from the Monetary Board. The rapid expansion of credit during the last two years led to the capitalization of most banks to deplete and most of them failed to replenish core capital through capital infusions from shareholders. However, raising capital, even going forward, will not be easy for banks as the country’s operating conditions remain challenging. “Fitch believes banks could face challenges in raising capital, particularly as the operating conditions in Sri Lanka remain difficult, as signalled by Negative Outlook on the sovereign rating, which was downgraded to ‘B+’ from ‘BB-’ in February 2016,” the rating agency noted. Many in the banking industry consider budget 2017 as industry-negative, as a number of proposals in the budget, according to them, hurt the growth of the country’s banking sector.

They also detest treating the banking sector as a cash cow, which can be milked to the hilt, to meet the government’s fiscal objectives. Meanwhile, the forthcoming full implementation of BASEL III rules, which demand additional capital requirements, could further dent operating conditions for many banks, especially those who operate with limited capital buffers. The Lankan banks are now in a period of transition towards BASEL III rules, which will come in to full effect from early 2019. The banks have been given with interim capital targets and the regulator has also begun to periodically monitor some of the capital and liquidity matrices under the new BASEL III rules in order to ensure full compliance from 2019. “Fitch believes that this could pose a challenge to some of the banks that do meet the enhanced minimum capital requirements because they would need to have sufficient capital to fulfill additional requirements,” the rating agency added. Unlike under BASEL II, where some of the exposures such as gold-backed loans which do not attract capital charge, will see a capital charge under BASEL III, leading to further capital related challenges for the sector. The Central Bank is set to announce its road map for the economy and the financial system either in December or early January 2017, which may address some of the pertinent issues. Commenting on the state banking sector, Fitch said the level of capitalization of major state banks remains thin when adjusted. While the scope for internal capital generation remains limited due to dividend payments to the government, fresh capital infusion could also become largely a tall order considering the shallow coffers of the state.