Implications of COVID-19 on bank lending

By Jagath Gamanayake 

The pandemic together with depressed global setting has impacted the economy and the financial sector in particular, having to respond carefully and indeed strategically, if it is to obviate or perhaps, avert the inevitable impacts on it. By far the greatest and most complex impact of COVID-19 for banks will be on credit management.

Emerging COVID-19 outbreak, in the credit business, have forced the banks to deal with many inevitable challenges. This article attempts to explain the positive and negative implications of the coronavirus pandemic on the banking credit businesses.

Being the main determinant of bank profitability, loans and advances act as the main contributor to the total assets of the financial sector which make up approximately Rs. 9.8 trillion out of the total asset base of Rs. 14.5 trillion, of which banks and licensed finance/specialised leasing companies (LFC/SLC) consist Rs. 8.5 trillion and Rs. 1.2 trillion respectively.

Growth in loans decreased significantly during the year 2019. The year-on-year growth of credit to the private sector decelerated to 4.3% by the end of December 2019 from 15.9% recorded at end 2018. In absolute terms, the expansion of credit to the private sector was Rs. 236.8 billion in 2019, compared to an expansion of Rs. 762.1 billion in 2018

The COVID-19 pandemic and the ensuing economic impact will lead bank credit growth to nosedive to a low level during 2020, as against the 5.8% achieved in the first four months of the year. CBSL revised down the private sector credit growth target for 2020 and forecasts 4% credit growth for this year to reflect pandemic caused the economic slowdown. The Central Bank, however, expects the private sector credit growth to accelerate to 10% in 2021 before matching its earlier 12-13% projections in the subsequent years.

Key risks for the Sri Lankan economy

The pandemic has left an unprecedented trail of both humanitarian and economic change in all countries while the containment measures adopted which have helped curb the outbreak, they have had a substantial negative impact on economic activity on the domestic front.

Global economic growth projected to contract by 3%. Several advanced economies such as the United States, the United Kingdom, the Eurozone, and Japan will experience contractions during 2020. Other key trading partners of Sri Lanka, including China and India, are also projected to experience a notable slowdown.

Across the globe, the World Trade Organization (WTO) forecasts that global merchandise trade can decline by as much as 32% in 2020. A significant decline in merchandise exports is probable, particularly to Sri Lanka’s key export destinations of Europe and the United States. In particular, exports of textiles and garments, are likely to experience a decline in the near future and it is expected to come down from $ 5.3 billion in 2019 to 4.3 billion in 2020.

The tourist sector and the remittance market which are two main contributors to the national income shall adversely impact the economy. It is also important to maintain sufficient foreign reserve ratio and it is expected to fall around $ 5.5 billion and Morgan Stanley predicted to $ 4.4 billion at the end of the year.

The accumulated debt of government over the years has reached very high proportions to the extent that debt servicing is a major challenge on top of this pandemic. Which will jeopardize the effects made by the government to bring normalcy to the country. Debt to GDP which was around 87% last year would go up to 93% this year and 100% next year. 

The Sri Lankan economy value to be maintained and remain at Rs. 15 trillion, we expect to maintain decent GDP growth, however, it has been revised to 1.5%.

De-risking the economy

The pandemic arose with uncertainty and implications on all aspects of business across the world. Despite Sri Lanka being ahead of most countries in being able to implement a proper action plan. Government and regulators have introduced extraordinary measures to alleviate the financial and economic impact of COVID-19. 

The relief measures include a range of different payment moratoriums, government guarantees, and concessions to pandemic hit businesses including self-employment, individuals and banks. 

Implications on banks

Profitability

The major short-term impact of COVID-19 on the retail and commercial banking industry would result in revenue compression from multiple sources. Due to difficult operating conditions, the performance of the banking sector and the NBFIs’ in particular, will be more challenging, affecting asset quality and profitability recovery. Introduction of debt moratoriums may reduce stress on businesses, but causes a bane for banks. Individual banks are now preparing probable loss in this respect.

Possibility of increasing NPL

The six-month debt moratorium and other measures imposed by the government is expected to soften the impact to individuals and businesses but will increase non-performing loans and is expected to weigh heavily on banks’ asset quality and to increase overall gross NPL percentage during 2020 to7.2%. However, the increasing trend in NPL, continuing from 2019, 3.4% at the end of 2018 to 4.7% mainly due to the adverse business conditions which prevailed during the year. Accordingly, total NPLs of the banking sector increased by Rs. 118.5 billion in 2019 compared to the increase of Rs. 102.5 billion in 2018. LFCs and SLCs Sector gross non-performing advances (NPA) ratio increased to 10.6% at end-December 2019, from 7.7% reported at end-December 2018, as well. The NPLs of the banking sector increased by Rs. 52.8 billion during the first four months of the current year. 

Pressure on Net Interest Margin

Emergency interest rate cuts to stimulate the economy may lead to net new lending, and will also compress banks’ net interest margin in many markets. Lending rates are expected to decline to single digits in the period ahead commensurate to the policy rate deductions and with the other policy measures.

Fee-based income

All financial institutions have been instructed not to charge for cheque returns, stop payments, late payment fees on all credit cards and other credit facilities during the period up to 30.09. 2020. No additional interest will be charged on the capital and/or interest instalments deferred under the concessions granted. Further, the transaction cost of foreign remittances to be waived for a period of 6 months to provide them relief. 

Workers’ remittances are also likely to be impacted by low international oil prices as well as the direct impact of the COVID-19 outbreak. World Bank forecasts a 19% decline in remittances to Sri Lanka, accordingly from $ 6.7 billion in 2019 to $ 5.4 billion in 2020. (Sri Lanka has about 1.7 m migrant workers and 5 m beneficiaries)

Indirect advances

A decrease in off-balance sheet exposures was reported in 2019 and this will further decline, reflecting the slowdown in business activities that are going to take place during the year. Directions were issued to licensed banks to suspend the facilitation of importation of several categories of motor vehicles and other non-essential goods, other than those approved by the Trade and Tariff Policy Committee, which has a direct impact on LC opening and guarantees.

Credit cost

The challenge for many banks will be how to operationalise these moratoriums and other programs. Many core banking and loan accounting systems are just not set up for this type of operational flexibility at scale. Many banks have some experience of these types of loan modification programs from the aftermath of the 2019 Easter Sunday attack but this time the loan programs requiring modification may be much more expansive, the timeline to get it done is much shorter, and the resulting operational complexity much higher. 

Cyber security 

While banks are providing more flexible customer access, they also need to ramp up their cyber-security and anti-fraud teams. As more staff work from home and therefore open new threat vectors (Ransomware implications). This will also create the risk of sensitive information flowing outside the organisation, which should be managed appropriately. Due to increased usage of internet banking, an environment of increased exposure to financial crime have resulted in increased possibilities of cyber risk. 

Relationships with customers

This is an ideal opportunity for the banks to combat competition. Building trust and confidence is of paramount importance to any bank. This enables the banks to show that they understand their customers’ plight and are committed to supporting them through the crisis. Clients will remember for a long time how they were treated during the bad times. Therefore, banks need to give very careful consideration to their approach to credit resolution. 

New credit lines

Individual banks to look for new avenues of financing facility from Development Financial Intuitions. This could test the bank’s credibility and negotiating power. This type of credit lines might enable the financial system to release more credit to the economy in addition to other easing measures introduced by the regulators.

Operational issues

The inability of the existing rating models to capture the effect of COVID-19, as existing models may not be geared to assess the impact of this nature and magnitude. Existing stress testing scenarios used to assess the credit risk stress may not be capable of capturing the effects of the existing pandemic requiring to closely monitor the funding and recovery plan of the bank.

Liquidity issues

Financial sector liquidity will be impacted by the debt moratoriums although it shall be offset to some extent by the reduction in the liquidity requirements for financial institutions. There is a need to detect worsening liquidity positions of the banks as many institutes can be negatively impacted due to adverse liquidity. Stress testing of banks will also be of relevance and importance as we face uncertain events. Likelihood of adverse liquidity positions in the financial services sector due to credit relief offered to customers by deferring their payments and existing customers drawing additional facilities to manage the working capital and to revive their businesses.

Borrower by borrower approach

 Commercial, as well as individual consumers, will not be equally impacted by this pandemic. It follows that lenders should not be only doing sectoral modelling but also individual customer cashflow modelling (particularly where they have transaction account information). These analyses can then be used to proactively reach out to customers with tailored, relevant solution proposals. 

Cash flow-based lending into asset-based lending

Beyond performing interventions and messaging, banks also need to proactively consider alternative lending structures, particularly if there is a way to convert cash flow-based lending into asset-based lending.

People have been a cutting-edge factor

Bank employees’ professional role is becoming increasingly strategic and fast, flexible focused, on the spot decision making is important. The outbreak of the pandemic has encouraged people to learn new IT skills in a virtual office concept as a result employee should be an accelerator for one of the greatest workplace transformations and swiftly shift from “Rowing to Rafting world”

Drawdowns are expected to increase the lending capacity of banks

Reduction of Statutory Reserve Ratio (SRR), Lower capital conservation buffer requirements, and reduction of Liquidity Coverage Ratio and Net Stable Funding Ratio to 90% and other directions resulting in an injection of liquidity of around Rs. 700 billion to the market. 

More digital-savvy customers thereby reduction of operating cost 

Bankers can view this positively and digitalise most of their credit operations to ensure internal efficiency and external effectiveness through customer-centric enablers. Bankers face high internal and acquisition cost, hence digitalisation of end to end process would positively impact cost structure.

New business segments to give loans

The rapid adoption of online retailing facilities by the customers boosted an already booming online market in the country, specifically in relation to digital payments which saw a spike. This sector is not benefited due to lack of start-up support from the banks and now it provides a great opportunity to capitalise on the new market. 

Further, in the long term, the government focus on the development of health-related infrastructure can also give rise to newer lending opportunities. 

Business Continuity Plan (BCP)

This pandemic also gave an opportunity for banks to test the effectiveness of their BCP. These plans are usually designed to facilitate banks respond to localised threats, like fires, bombs, riots, flood and earthquakes, etc., Once the event has occurred, it is over and while the effects may linger, recovery can begin, but this COVID-19 totally new experience and unfolded global event. Therefore, this will require more than simply double-checking the soundness of existing bank BCP.

Mergers and acquisitions

Based on the PwC Global COVID-19 CFO Survey, the impact of the outbreak on mergers and acquisitions (M&A) strategies remain unclear at the moment. A majority of business leaders are still assessing whether or not to change their approach. However, 13% report an increased appetite for M&A. Therefore, the possibility of Leverage buyout.

Conclusion

Banks are preparing for the first wave of the pandemic now, but need to be agile as the crisis evolves. Banks must be both reactive and proactive in crisis response; risk mitigation actions taken now which can have a significant impact on the bank’s future years to come. In this unprecedented situation, each continues to bring new insights into how the market, consumers and companies are being impacted

On the other hand, market participants’ reliance on central banks to consistently intervene during difficult periods for economies and markets may have contributed to corporate behaviours that have driven up financial leverage in the system. 

Under these circumstances, the banks should adopt a flexible strategy when helping customers and the economy, while maintaining the trust of the depositors even at the scarification of some portion of the profits in these uncertain times. 

(The writer was the Senior Deputy General Manager at a leading State Bank, Vice President of the APB and a Senior Lecturer at the Institute of Bankers of Sri Lanka.)