Sri Lanka’s NBFIs pressured by weak economic growth and vehicle sales

Mar 21, 2019 (LBO) – Fitch Ratings expects Sri Lankan non-banking financial institutions (NBFI) to continue to face pressure on asset quality and profitability in the medium term.

The ratings agency says a slowdown in Sri Lanka’s economic activities and lacklustre growth in the sector’s core vehicle-financing segment continue to 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.’

Muted Growth Prospects: 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 9.0% by end-2018 from a high of 31.0% in 2015, due to the imposition of tighter loan-to-value ratios on vehicle-financing by the Central Bank of Sri Lanka (CBSL).

Heightened Risk Appetite: 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.

Rising NPLs: The sector’s NPL ratio (overdue by more than 180 days) spiked to 7.7% by end2018 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.

Ongoing Capitalisation Challenges: Among the Fitch rated-NBFIs, six (Fintrex, Ideal, Bimputh, AFP, DF and Serendib) need additional capital to meet the enhanced capital requirement of LKR2.5 billion by 1 January 2021, while others may require external capital to support loan growth and meet the higher capital adequacy ratio requirement (see Related Research).

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.

Pressure on Profitability: 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 reprice, due to their predominant fixed-rate lending practices.

Increase in Deposit Funding: 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.