• Says downgrade done in May closely linked to sovereign rating downgrade 
• Slow growth and high debt also contributed to score  
• Expects credit growth 5.1% in 1Q 2020 but COVID-19 expected to mute demand

Fitch Ratings, releasing its latest report yesterday, said it has revised down the operating environment (OE) score for Sri Lankan banks to ‘B-’ from ‘B’ after the sovereign rating was downgraded to ‘B-’ in April 2020. 

The Outlook on Sri Lanka’s Long-Term Issuer Default Rating (IDR) is Negative, as is the outlook on the OE score. The downgrading was done in May. 

The change in the OE score followed a revision in the outlook on the score to Negative from stable in January, which came on the heels of a revision in the Outlook on Sri Lanka ‘B’ sovereign is rating to Negative from Stable in December 2019. 

“These actions show that the OE score for banks is usually constrained by the sovereign rating. The OE score change also reflects Fitch’s assessment that the risk of doing business in Sri Lanka could rise in the medium term. The current OE assessment factors in the pressure arising from the coronavirus pandemic and the possibility of further risk if the pandemic worsens or lingers,” the ratings agency said in the report. 

The assigned OE score is consistent with the implied score for Sri Lankan banks, which is at the lower end of the ‘B’ range. This reflects a GDP per capita of around $ 4,000 and a 48.2 percentile ranking under the World Bank’s Ease of Doing Business index for 2019.

Fitch also considers qualitative aspects when assigning the OE score, such as the sovereign rating, macroeconomic stability, size and structure of the economy, economic performance, the level and growth of credit, financial market development, regulatory and legal framework and international operations.

Fitch’s Macro Prudential Risk Indicator (MPI) of 2 for Sri Lanka indicates that there is moderate vulnerability to potential stress in the banking system and the broader economy.

The ratings of the Sri Lankan banks are also on a negative outlook, reflecting the sovereign rating outlook for those that are support driven and the negative outlook of the OE and some financial profile factors for those that are driven by their standalone profiles.

The OE for Sri Lankan banks has a high influence on the banks’ ratings, as it is likely to constrain their intrinsic credit profiles through its effect on financial and non-financial key rating factors, despite regulatory reliefs, the report said. 

“Fitch believes that there is a strong link between the sovereign credit profile and the operating conditions for banks in Sri Lanka. This is because our forecast 1.3% GDP contraction in 2020 will constrain the banks’ growth and recovery prospects and the increased risk of sovereign debt distress will limit banks’ access to and cost of foreign funding.”

Sri Lankan commercial banks also have significant exposure to the State mostly through investments in Government securities. Total exposure was over 25% at end-2019. This underscores Fitch’s view that it is unlikely that a domestic bank would be rated above the sovereign rating.

“We believe that should the sovereign credit profile deteriorate further, the operating environment will also worsen, including weakening of public- and private-sector balance sheets, funding market dislocations and macroeconomic volatility.” 

Fitch believes that the Sri Lankan economy is more susceptible to negative shocks after having previously experienced significant volatility in economic variables, such as interest rates and exchange rates in times of stress.

Sri Lanka’s five-year average real GDP growth is below the median for ‘B’ rated countries. The economy grew by 2.3% in 2019, slower than the 3.2% in 2018, mainly due to weak growth in the services sector after the April 2019 Easter attacks. Private sector credit, which grew by 16% in 2018, expanded by only 3.9% in 2019.

As a result, lending by Sri Lankan banks has grown more slowly and asset quality has deteriorated. Loan growth picked up in the last quarter of 2019 to 5.6%, after a contraction in the first half of 2019, but remained below the 17.5% average over 2015-2018. 

Loan growth was 5.1% in the first quarter of 2020, but Fitch expects loan growth in the rest of 2020 to be muted due to the pandemic.

“The sector’s non-performing loan (NPL) ratio continued to rise rapidly and reached 4.7% by end-2019 and 5.1% by end-March. We expect the accumulation of potential credit stress, even though the banks are likely to report a lower stock of NPLs and Stage 3 loans in the near term than might otherwise have been the case due to relief measures.” 

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