NBFIs under pressure from asset quality and profitability: Fitch

• New scorecard from Fitch Ratings says slow growth and higher taxes on vehicles hurting biz 
• Higher taxes on financial institutions and enhanced capital requirements also challenging 
• Leasing makes up 53% of biz but loan growth slowed to 9% in 2018
• NPLs grow to 7.7% from 5.9% in 2017

Fitch Ratings expects Sri Lankan non-banking financial institutions (NBFI) to continue to face pressure on asset quality and profitability in the medium term, given slowing growth and movement away from vehicle financing, which was earlier a core segment.  

Releasing its latest scorecard for local NBFIs, Fitch Ratings said a slowdown in Sri Lanka’s economic activities and lacklustre growth in the sector’s core vehicle-financing segment will weigh on NBFI’s financial profiles. Furthermore, higher taxes on financial institutions would pose an additional threat on smaller NBFIs in meeting enhanced capital requirements, due to a further weakening in internal capital generation. 

Macro-prudential policy measures taken by the authorities since 2015 to curb imports, and stringent rules on vehicle financing, could continue to dampen growth prospects. Leasing and hire purchases made up the largest proportion of sector loans, with 53% at end-December 2018.

Loan growth year-on-year had already slowed to 9% by end-2018 from a high of 31% in 2015, due to the imposition of tighter loan-to-value ratios on vehicle-financing by the Central Bank of Sri Lanka (CBSL).

“NBFIs’ risk appetite is likely to remain high in light of their rising exposure to risker non-core lending segments outside of vehicle financing that they aggressively expanded during 2015-2017. We view these non-core segments as risky due to larger ticket sizes, poor collateral protection, and a lack of experience in these segments. Nonetheless, we expect NBFIs to scale down growing into these risky segments in the medium term, reflecting the increased pressure on their asset quality and capitalisation,” the report said. 

The sector’s Non-Performing Loans (NPLs) ratio (overdue by more than 180 days) spiked to 7.7% by end-2018 from 5.9% at end-2017, with the target customer base suffering from the economic slowdown. Fitch-rated NBFIs’ median NPL ratio of 4.7% at end-September 2018 was far below than that of the sector, driven mainly by better ratios at larger companies. Fitch-rated large NBFIs generally possess better franchises with more sophisticated risk management. 

Among the Fitch rated-NBFIs, six (Fintrex, Ideal, Bimputh, AFP, DF and Serendib) need additional capital to meet the enhanced capital requirement of Rs. 2.5 billion by 1 January 2021, while others may require external capital to support loan growth and meet the higher capital adequacy ratio requirement.

Fitch witnessed an average reduction in the Tier I ratio of 200bp among Fitch-rated NBFIs with the new capital adequacy framework, stemming mainly from risk weights for operational risk. 

However, the impact on specific companies varies, based on their exposure to unsecured retail claims such as microfinance – of which risk-weights have increased by 25% under the new methodology.

The profitability of Fitch-rated Sri Lankan NBFIs is likely to remain under pressure due to rising credit and funding costs amid high taxes. Fitch-rated peers’ average return-on-assets declined – a trend witnessed across the sector – but continued to remain better than that of the sector. NBFIs’ net interest margins are also affected by the companies’ inability to re-price, due to their predominant fixed-rate lending practices.

Fitch-rated NBFIs are funded mainly through deposits, the share of which had increased to 61.9% by FYE18 from 55.3% at FYE16, a trend seen across the sector. Nevertheless, a highly concentrated and pricing-sensitive deposit base is susceptible to market events and less reliable in situations of market stress.

Sri Lankan NBFI sector loan growth has slowed down considerably since end-2015 with tightened regulation on vehicle financing and increased tariffs on vehicle importation.

The five largest companies accounted for around 48% of sector assets at end-September 2018, while the remainder is distributed among 43 companies. Fitch-rated NBFIs represented 42% of the sector assets at end September 2018.  The sector’s return-on-assets ratio had declined to 2.7% by end-2018, which is below its four-year average of 3.2% over 2014-2017. Ability to absorb credit-cost shocks have weakened in FY18 for most of the Fitch-rated-NBFIs, due mainly to rising credit costs.

Elevated funding and credit costs exerted pressure on most of the Fitch-rated NBFIs’ profitability. As with the sector in general, deterioration in asset quality was evident across Fitch-rated NBFIs in recent years, mainly as a result of difficult operating conditions. 

Reserves coverage of NPLs of most of the Fitch-rated NBFIs has declined due to acute deterioration of asset quality. This has raised these NBFIs’ exposure to changes in the market value of underlying collateral. The average debt-to-equity ratio of the Fitch-rated NBFIs stood at 4.6x at FYE18, which is below that of the sector’s 6.7x.

Regulatory capital ratios of Fitch rated NBFIs witnessed a moderate decline at end-September 2018 with the adoption of the new capital adequacy framework. Bimputh and HFL suffered the biggest impact under the new capital-adequacy ratio calculations of around a 600bp reduction, due to their significant exposure to microfinancing which is to be risk weighted at 125%.