Understanding Standard & Poor’s BICRA Assessment Of Sri Lanka

Standard & Poor’s Ratings Services recently assigned Sri Lanka to its Banking Industry Country Risk Assessment (BICRA) group ‘8’.  That was S&P’s first assessment of Sri Lanka’s banking industry under its BICRA methodology. This article addresses questions investors and market participants may have about S&P’s rationale for assigning Sri Lanka to BICRA group ‘8’. S&P’s also assess what this means for banks operating in Sri Lanka.

Q: What is BICRA? What does it communicate?

A: The strengths and weaknesses of an economy and its banking industry are critical factors that underpin the creditworthiness of a country’s financial institutions. Under our criteria, we distill this analysis into a single measure called BICRA. The BICRA framework is designed to evaluate and compare global banking systems on a relative scale. It is not an absolute measure of evaluation of any banking system. A BICRA analysis for a country covers rated and unrated financial institutions. It incorporates the entire financial system of a country by considering the relationship of the banking industry to the financial system as a whole.

A BICRA is scored on a scale from 1 to 10, where group 1 is assigned to lowest-risk banking systems and group 10 is assigned to the highest-risk banking systems.

Contributing to these overall scores are our assessments of economic risk and industry risk, which are the two main elements of the BICRA. The rating methodology for banks uses the economic and industry scores produced by the BICRA analysis to determine an anchor, which acts as a starting point for determining a bank’s stand-alone credit profile. Our risk-adjusted capital framework methodology also uses the BICRA score and the economic score of a country to determine the risk weight of its various asset classes (namely financial sector, corporate sector, retail sector etc).

Q: What are the factors behind  assigning the Sri Lanka banking system to  BICRA group ‘8’?

A: The following factors underpin our assessment of Sri Lanka’s BICRA:

A large proportion of highly stable core customer deposits mainly drive funding in Sri Lanka’s banking system.The banking industry is therefore less dependent on wholesale or external debt.

Economic imbalances have started to build up in Sri Lanka with the recent pickup in growth of private sector credit (28% annually for the past two years). High loan growth, coupled with rising competition; a slow foreclosure process except for mortgages, pawning, and hire purchase; and evolving risk management practices could expose the sector to increased credit risk.

Banking regulations and supervision are improving and the regulator has an adequate record of managing the financial sector. However, the regulation of finance companies is somewhat lax.

Sri Lanka is a low income economy with per capita GDP of about US$2,750. However, its economic growth prospects have improved following the end of the civil war and a subsequent shift in the government’s focus toward boosting the economy and diversifying sources of growth.

Additionally, the Sri Lankan government is “supportive” of the banking industry and is committed to maintaining financial system stability and market confidence.

(For more details, see “Sri Lanka Banking System Assigned Group ‘8’ Banking Industry Country Risk Assessment,” published June 19, 2012, on RatingsDirect on the Global Credit Portal).

Q: Does Standard & Poor’s view the Sri Lankan banking sector as “very high risk”?

A: We have assigned Sri Lanka to BICRA group ‘8’ to reflect the banking industry’s risk profile relative to banking systems in other countries. BICRA is not an absolute measure of risk in any banking system. We scored Sri Lanka on various factors and sub-factors as per our BICRA methodology. Our assessment on these factors is on a pre-defined set of descriptors--such as “very low risk”, “low risk”, “intermediate risk”, “high risk”, “very high risk”, and “extremely high risk”--to reflect relativities in a globally consistent manner. Our criteria use these descriptors to enhance transparency and provide a basis for comparability among banking systems (see “Banking Industry Country Risk Assessment Methodology And Assumptions,” published Nov. 9, 2011).

Q: What does assignment of Sri Lanka to BICRA group ‘8’ mean for the credit ratings on banks operating in Sri Lanka?

A: A BICRA score provides an anchor to bank ratings as per Standard & Poor’s bank rating methodology (see “Banks: Rating Methodology And Assumptions,” published Nov. 9, 2011). For Sri Lankan banks, based on the economic risk score of ‘8’ and industry risk score of ‘7’, the anchor would be ‘bb-’, which is one notch higher than the sovereign rating on Sri Lanka (B+/Stable/B). That means the starting point for our rating analysis of each bank operating only in Sri Lanka is ‘bb-’. The stand-alone credit profile of a bank could either be higher or lower than the anchor, depending on bank-specific factors, specifically its business position, capital and earnings, risk position, and funding and liquidity.

Q: Does S&P’s assignment of BICRA group ‘8’ for Sri Lanka suggest the performance trend of the country’s banking industry?

A: We have just initiated our coverage on the Sri Lankan banking industry. The score of ‘8’ is not a reflection of either the deterioration or an improvement in performance of the banking industry. Instead, it reflects our opinion of where the Sri Lankan banking industry stands relative to other banking industries globally. Our BICRA assessment is a combination of the economic and banking industry risks that determine the operating environment to which banks in Sri Lanka are exposed.

Our economic risk assessment is based on: the structure and stability of the country’s economy; the central government’s macroeconomic policy flexibility; actual or potential imbalances in the economy; and the credit risk of economic participants--mainly households and enterprises.

Our industry risk assessment is based on: the quality and effectiveness of bank regulation and the record of regulators in reducing vulnerability to financial crises; the competitiveness of a country’s banking industry—including the industry’s risk appetite, structure and performance; and possible distortions in the market. Industry risk also assesses the range and stability of funding options available to banks, including the role of the central bank and government.

Q: How does the BICRA score of ‘8’ for Sri Lanka compare with that of other banking systems in emerging Asia?

A:The relevant peers to compare Sri Lanka’s banking system with are banking systems in emerging markets. Within Asia, Sri Lanka’s peers are Indonesia, Philippines, Cambodia, and Mongolia. Indonesia and Philippines are in group ‘7’, Sri Lanka is in group ‘8’, Cambodia and Mongolia are in group ‘9’, and Vietnam is group ‘10’  . It is common and understandable for banking industries of emerging markets to rank lower on the BICRA than banking industries in developed countries. Typically, emerging economies have low income levels (per capita GDP of less than US$5,000) and their economic structure has many structural weaknesses. These economies also have underdeveloped institutions. These factors make them vulnerable to adverse developments, such as external shocks or internal imbalances.

Q: With regards to the central bank’s oversight of the Employees’ Provident Fund (EPF), why does Standard & Poor’s hold the view that there is a potential conflict of interest?

A:The monetary board of the Central Bank of Sri Lanka oversees EPF investments as well as policy formulation and supervision of banks (See the organization structure of the central bank at its website http://www.cbsl.gov.lk/pics_n_docs/03_about/_docs/organisation_chart.pdf for more details). The EPF is also a large investor in Sri Lankan banking stocks. For these reasons, we think the central bank is exposed to a potential conflict of interest, although we have no information of any specific incidences occurring. We expect the central bank to have mechanisms to limit this risk. However, in our globally consistent assessment, we assess systems without such potential conflicts of interest as relatively less risky than those with.