COVID-19 pressures likely to hit bank profitability: Fitch

• Says NPL ratios likely to rise, virus to worsen  operating environment, outcomes deeply linked to macroeconomic performance

 Fitch Ratings has downgraded in May three Sri Lankan banks' Issuer Default Ratings after it downgraded Sri Lanka's sovereign rating to ‘B-‘ with a Negative Outlook and revised down its assessment of the banks' operating environment, both of which reflect the escalating impact of COVID-19 pandemic on the country's economy. 

Fitch also maintained a Negative Outlook on the banks' ratings, as it believes the sovereign's credit profile could constrain their ratings and to reflect the pandemic's effect on banks' intrinsic profiles.

The affected banks are – Bank of Ceylon (B-/Negative), National Savings Bank (NSB, B-/Negative) and DFCC Bank PLC (B-/Negative).

Fitch expects Sri Lanka's economy to contract by 1.0% in 2020, from 2.3% growth in 2019, due to the impact of the coronavirus pandemic. 

The regulator has granted a spate of concessions for businesses and individuals affected by the pandemic, including for the banking sector, which is acting as the intermediary for the relief measures, the ratings agency said in a statement yesterday.  

“We expect banks' financial profiles to come under stress from the increased challenges in the operating environment, and their key credit metrics are likely to be weaker than our previous expectations, notwithstanding regulatory actions. This led Fitch to revise its outlook for Sri Lanka's banking sector to negative in March.” 

“We have also revised our assessment of Sri Lankan banks' operating environment to ‘B-’/negative, from ‘B’/negative. We expect the pandemic to continue to pressure the banks' already-weak operating environment coming into the crisis. There is a possibility of further downside risk to the economy if the pandemic becomes more pronounced or lingers, notwithstanding the support measures that could benefit banks.”

The operating environment continues to have a high influence on bank ratings as it affects financial and non-financial rating factors. This is reflected in negative outlooks assigned to all of the financial metrics' midpoint scores.

Fitch expects the accumulation of potential credit stress, even though the banks are likely to report a lower stock of non-performing and Stage 3 loans in the near term than might otherwise have been the case due to the relief measures. It also expects a spike in the impaired-loan ratio for the Fitch-rated banks excluding NSB to just over 13% in 2021, from 9.4% at end-2019, once these relief measures are lifted.

“We also expect the banks' earning and profitability to come under pressure from continued slow loan growth, narrower net-interest margins due to low interest rates, reduced non-interest income and higher credit costs.

“The resulting impact on banks' operating profitability could offset the benefit from the reduction in taxes announced in 2019. We expect pre-provision operating profit/average loans to fall from the current low of 3.9%, while provisions/average loans, which we expect to rise, was 1.1%, leaving a buffer of only 2.9%.” 

Sri Lankan banks have been raising their capital buffers in response to regulatory requirements – resulting in a core equity Tier 1 ratio of 12.6% at end-2019 for the Fitch-rated banks excluding NSB, but the capital buffers remain thin at some banks, including at some domestic systemically important banks. 

“There is potential for capital impairment should the downturn from the pandemic prove significantly worse than we expect. We believe the banks' funding and liquidity profiles could come under pressure if access to foreign-currency funding becomes more challenging given the deterioration in the sovereign credit profile, or if there is a flight to quality, which could affect banks with weaker domestic franchises.”

Excess liquidity built up in 2019, muted lending prospects and potential liquidity support from the Central Bank of Sri Lanka could help banks to manage the impact from the deferment of loan repayments through the regulatory moratorium and other rescheduling and restructuring.

A revision of rating Outlook on the three banks would most likely result from positive rating action on the sovereign and if the assessment of the operating environment is improved (other than for NSB).

However, Fitch said it does not believe this is probable in the near term in light of the pressure on the sovereign rating and operating environment. The banks' ratings could be downgraded if there is a sovereign downgrade or if the operating environment deteriorates beyond our expectation, further weakening the banks' key credit metrics.

Fitch will also review the effect of the pandemic on Sri Lankan banks' National Ratings.