Moody's: Sri Lankan banking system outlook negative; macroeconomic risks and worsening asset quality evident

Moody's Investors Service says that the outlook for Sri Lanka's banking system is negative, with both asset quality and profitability under pressure.

"The economy will only see a modest growth rebound as the government's fiscal constraints continue to limit public investment and private spending, despite stronger goods and services exports," says Srikanth Vadlamani, a Moody's Vice President and Senior Credit Officer.

Moody's conclusions are contained in its just-released "Banking System Outlook: Sri Lanka, Macroeconomic risks from weak fiscal position and deteriorating bank asset quality underpin negative outlook".

Moody's outlook assesses five key factors: operating environment, stable; asset risk and capital, deteriorating/stable; profitability and efficiency, deteriorating; funding and liquidity, stable; and government support, deteriorating.

"Credit growth was very high over the last two years, with the credit multiplier (credit growth/GDP growth) shooting up to an average of 2x over 2015 and 2016, up from 1x in 2014. As the loans made over this period start seasoning, asset quality will deteriorate. In addition, rising interest rates add to repayment burdens. However, increased loan loss reserves will provide some comfort," says Vadlamani

"In addition, profits will come under pressure as higher funding costs offset the benefits from higher loan rates, while credit costs move higher," adds Vadlamani.

At the same time, capital will remain stable as the banks are raising capital and reducing dividends to comply with Basel III requirements, though execution and market risks could derail fund-raising efforts. Under our baseline scenario analysis, capital, as defined by tangible common equity to risk weighted assets, will decrease to 7.6% at end-2018 from 7.8% at end-2016, without any additional equity raising.

The funding profiles of the banks are set to improve after weakening in recent quarters, as loan growth slows down.

Furthermore, Sri Lankan banks hold sizeable liquid assets to cover their liquidity needs and movements in deposits. The rated banks' liquid assets averaged around 30% of tangible banking assets as of December 2016, thereby providing considerable buffers against funding risks.

On the other hand, a high debt burden and contingent liabilities relating to state-owned enterprises restrict the government's capacity to support the banks.