Significant capital requirements for Lankan banks with move to Basel III: Fitch

Fitch said yesterday that Sri Lankan banks will see an increase in capital raising as they transition towards the full implementation of Basel III requirements.

Fitch said the new minimum Tier 1 and total capital ratios have increased to at least 8.5% and 12.5%, respectively, from 5% and 10% under Basel II. The full implementation of Basel III requirements is scheduled for 2019, prompting several banks to raise capital via share issues or debentures in the domestic market.

Large Sri Lankan banks raised Rs. 42 billion in equity and Rs. 11 billion in Basel III-compliant Tier 2 capital in 2017. Still, Fitch estimates the large Sri Lankan banks will have a Rs. 19 billion capital shortfall against the Basel III requirements based on bank-specific assumptions, with state banks accounting for 72% of the shortfall. 

The impact of SLFRS 9 has not been factored in, but Fitch believes its impact on banks’ regulatory capital ratios could be spread across several years.

Loss-severity risk is higher for Tier 2 instruments than for senior debt. Fitch’s approach is to rate the instrument one notch below the anchor rating in cases of below-average recoveries, and two notches lower in the case of poor recoveries - such as when there is a significant risk of full contractual write-down. The anchor rating is the bank’s standalone rating except in the case of some select banks with strong state linkages that are systemically important – where the anchor rating could be the support-driven rating.

Sri Lankan banks have not issued Basel III Tier 1 instruments. Fitch’s usual approach is to rate hybrid instruments that have core features of deep subordination and full discretionary coupon omission at least three notches (two notches for loss severity risk and one notch for non-performance risk) below the anchor rating if the anchor rating is an Issuer Default Rating/Viability Rating of ‘B’/’b’ or below, as per our global criteria. This is most likely to be Fitch’s approach to rating such instruments of Sri Lankan banks that have these features.

Loss severity is high because Tier 1 instruments, based on the Central Bank’s directive, should be subordinated to the claims of depositors, creditors and holders of Tier 2 capital instruments issued by the bank. Non-performance risk arises from the discretion that banks have in cancelling distributions or payments.

Fitch believes there is a case for factoring in extraordinary sovereign support into the anchor ratings of Basel III Tier 2 instruments for some select banks with strong state linkages and systemic importance, as the state is likely to have a strong interest in supporting the instruments of these banks before loss absorption features are triggered. The anchor rating of these banks is their support-driven National Long-Term Rating, as in the case of Bank of Ceylon’s (AA+ (lka)) proposed issuance.

Fitch generally does not factor extraordinary sovereign support into the ratings of hybrid securities that have going-concern loss-absorption features and contain mechanisms that can be activated while a bank is still viable. However, in the case of a policy bank or select banks that have government sponsorship, linkage or ownership, Fitch may use the support-driven rating as the anchor for assigning ratings to hybrid securities to reflect situations where state support may be extended to a hybrid security to neutralise the non-performance risk.

Large Sri Lankan banks include Bank of Ceylon, People’s Bank (Sri Lanka), National Savings Bank, Commercial Bank of Ceylon PLC, Hatton National Bank PLC, DFCC Bank PLC, Sampath Bank PLC, National Development Bank PLC and Seylan Bank PLC.