S&P fires warning on Sri Lankan banking system; ranked along with Nigeria

Standard and Poor’s yesterday fired a fresh warning on Sri Lankan banking system, relegating it to a risk prone grouping that includes Nigeria.

Standard & Poor’s Ratings Services said it has assigned Sri Lanka to its Banking Industry Country Risk Assessment (BICRA) group ‘8’. At the same time, it assigned an economic risk score of ‘8’ and an industry risk score of ‘7’.

Explaining the rationale for the move, S&P said: “We have reviewed the banking sector of Sri Lanka (Democratic Socialist Republic of) (B+/Stable/B). The BICRA groups summarise our view of the risks that a bank operating within a particular country and banking industry faces relative to those in other banking industries. They range from group ‘1’ (the lowest risk) to group ‘10’ (the highest risk). Other notable countries in BICRA group ‘8’ are Nigeria, Tunisia, and Kazakhstan.”

“Our economic risk score of ‘8’ for Sri Lanka reflects a “very high risk”  assessment of economic resilience and credit risk in the economy, and a “high  risk” assessment of economic imbalances, as our criteria define those terms,” it added.

Following are excerpts from S&P’s announcement.

Our view of credit risk in Sri Lanka takes into account moderate private sector debt in the context of low income levels, relaxed lending practices and underwriting standards, as well as a weak payment culture and rule of law. The use of cash flow analysis for underwriting is limited in Sri Lanka, and some exposures are concentrated. Moreover, risk management practices are evolving, in our view.

Our industry risk score of ‘7’ for Sri Lanka is based on our opinion that the  country faces “very high risk” in its institutional framework, “high risk” in  its competitive dynamics, and “intermediate risk” in its system-wide funding.

We view the banking regulations in Sri Lanka as somewhat weaker than international standards. Governance and transparency of banks are weak by global standards. Sri Lanka adopted a standardized approach of Basel II in 2008, with capital requirements higher than global requirements. The key regulations for banks seem sufficient. However, finance companies are less regulated, in our view. This is despite the December 2008 collapse of a finance company triggering a run on a bank in that group.

Under the existing legislation, banks in Sri Lanka are subject to on-site examinations by the banking sector regulator at least once every two years. We believe the frequency of on-site supervision may not be sufficient for the regulator to quickly detect risk build-ups. Moreover, we see a potential conflict of interest in the central bank’s role. In addition to policy formulation and supervision of banks, the monetary board of the central bank also oversees Employees’ Provident Fund investments. The fund is a large investor in Sri Lankan banking stocks.

The banking sector’s risk appetite is “moderate,” in our view. Loan growth is high. However, banks in Sri Lanka are mostly engaged in traditional lines of business and most of their earnings come from traditional fund-based businesses.

Sri Lanka’s large number of banks relative to the small economy has not led to any significant instability in the competitive environment. However, the following factors have led to market distortions: (1) a significant market share (about 50%) of government-owned banks in the sector; (2) directed lending requirements toward the agriculture sector; and (3) differential use of administrative controls; e.g. a recent cap on loan growth is applicable only to banks.

Sri Lanka’s large proportion of highly stable core customer deposits support system-wide funding. Such deposits reduce banks’ dependence on external debt. Nevertheless, we believe access to alternative domestic funding sources is limited because the domestic debt capital market is narrow and shallow.

In our view, the Sri Lankan government has a “supportive” tendency towards private sector banks. We believe that the government is committed to maintaining financial system stability and market confidence. The government has a record of supporting banks during periods of financial stress by encouraging market-led solutions. For instance, in the case of Ceylinco Group, the banking sector regulator stepped in and dissolved the board of directors of group entity, Seylan Bank PLC, and supported the sale of Seylan Merchant Leasing PLC.

Our assessment of economic resilience reflects Sri Lanka’s status as a low-income economy, as measured in terms of its per capita GDP, and the inefficiencies in the economy. Nevertheless, Sri Lanka’s economic growth prospects have improved following the end of the civil war and subsequent shift in the government’s focus toward boosting the economy and diversifying sources of growth.

Our assessment of economic imbalance factors in the recent pickup in growth of private sector credit. The central bank’s recent directive to apply a ceiling to the credit growth of banks should help to partially curb this risk.

Nevertheless, in our view, Sri Lanka’s economic imbalances could increase if credit growth continues at the current pace. Sri Lanka’s external position, which we consider to be moderately vulnerable, also affects the country’s economic imbalance. Our assessment of Sri Lanka’s external position reflects the country’s weak external liquidity, and moderately high and increasing external debt.