Finance companies recovering but challenges remain – RAM Ratings

The registered finance companies sector is recovering though challenges remain for a more robust performance, RAM Ratings Lanka has said.

The latest assessment from RAM is contained in its RFC sector update 2010 titled “Sailing forward after the storm.”

It noted that the registered-finance-company (“RFC”) sector has been gradually recovering from the weakened economic climate that prevailed in 2008 and 2009, and the confidence crisis triggered by the fall of an unregulated finance company. As opposed to the previous financial year, FYE 31 March 2010 (“FY Mar 2010”), and the ensuing 6 months ended 30 September 2010,

RFCs’ showed an acceleration in loan growth across the industry, supported by the opportunities of the post-war era and the more favourable macroeconomic conditions. The expansion in the loan base has resulted in the moderation of liquidity and capitalisation levels; however, these levels are adequate. Asset quality remains weaker than that of banks, as the sector caters to a high-risk segment; nevertheless, there has been increasing awareness among most RFCs to improve asset quality. Meanwhile, the sector has benefited from the falling interest rate scenario that has increased margins due to deposits repricing faster than loans.

With regard to the latter, lending by RFCs is generally long-term in nature at fixed interest rates; with hire-purchase and leases making up 64.73% of the industry’s loan portfolio as at end-September 2010. The broader margins, coupled with loan expansion and lower provisioning charges, have resulted in improving performance.

Going forward, RAM said asset quality is expected to improve amid the more favourable economic conditions. In addition, RFCs have taken steps to reduce the incidence of bad loans and rein in bad debts; together with the improving macroeconomic conditions, these steps are expected to aid asset quality improvement. In line with the improving asset quality and opportunities for RFCs following the post-war era and the easing of interest rates, performance is expected to ameliorate as well. The improving profitability is expected to increase capitalisation levels, going forward.

In addition, RFCs’ compliance with the regulatory listing requirements by June 2011 would also provide greater access to funds, thereby boosting capital levels. Meanwhile, the liquidity levels are expected to moderate but remain adequate as RFCs seek to expand their loan portfolios.

On a separate note, transparency and corporate governance are expected to see improvements. The more frequent quarterly financial reporting required by the Colombo Stock Exchange (“CSE”) and the proposed amendments to the Finance Business Act are expected to enhance the transparency and corporate governance of each player in the sector. The propositions include strengthening the regulatory aspects of the business, providing the Central Bank of Sri Lanka (“CBSL”) with greater authority to regulate RFCs and increased public disclosure by RFCs.

The RFC sector represents a small proportion of the Sri Lankan financial sector; as at end-December 2009, it constituted 3.30% of the total assets of the financial system and currently comprises 36 players in the sector with a total of 412 branches (as at end-December 2010). The sector has always played a crucial role in the development of the small and medium enterprise (“SME”) sector in the country as well as the growth of the micro-finance sector. RFCs have been involved in the provision of essentially hire purchase (“HP”) and leases, of which vehicle financing is their forte. However, the sector faces competition in the provision of these products from the banks. With the government increasing its emphasis on facilitating the flow of funds to the underserved sectors of the economy and with a law to regulate the micro-finance institutions to be enacted, the SME segment has become increasingly attractive to the banks.

“Nevertheless, we opine that the convenience in obtaining loans from the RFC sector and the less stringent underwriting would continue to appeal to the high risk segment,” RAM said.

The sector’s performance showed moderate improvement in FY Mar 2010, driven by recovering macroeconomic fundamentals and better business sentiments. Margins are expected to broaden for the sector as the funding costs continue to ease and there has been an increasing trend towards high-yielding 3-wheeler financing and pawn-broking, as is the case for the RFCs in our portfolio. Meanwhile, tax savings such as the easing of the financial value-added tax (“VAT”) based on the new budget are expected to render higher profits for the sector. That said, aggressive branch expansion of RFCs could take a toll on profits over the medium term as new branches grapple to break even amidst intensified competition.

Noting that the industry’s asset quality indicators weakened in FY Mar 2010, However RAM said it believes these indicators remain skewed by the weak asset quality of a few large, troubled RFCs. “We note an increasing awareness among RFCs with regard to asset quality; as such, some players have made initiatives to curtail lending to high-delinquency segments and boost recoveries. These initiatives are expected to pay off in the long term together with the improving macroeconomic conditions,” RAM added.

The capital adequacy ratios among the more established and sound RFCs moderated in FY Mar 2010 and 1H FY Mar 2011, on the back of resumed lending. However, as smaller RFCs infused capital to adhere to the minimum core capital regulatory requirement of LKR 200 million, capital adequacy levels for these companies ameliorated. The regulation requiring RFCs to list by June 2011 is expected to strengthen capitalisation levels further, going forward, for those who list by way of an initial public offering and the increased access to public funds thereafter.

Most of the RFCs in our portfolio have been able to maintain the minimum statutory liquid asset ratio of 10% as per CBSL regulations, and most companies that had curtailed lending last year had recorded liquidity ratios well above the regulatory minimum. However, as lending resumed, liquidity levels moderated. This is expected to continue into the future as companies seek to expand their loan portfolios. Deposits, on the other hand, remained the main funding source and demonstrated growth despite the run on deposits in FY Mar 2009. The industry is still exposed to funding risks due to the inherent mismatches in its long-term investments and shorter-tenured deposits. In this regard, its increased access to long-term banking lines will help mitigate these risks.