Sri Lankan banks' bearish outlook to extend until end-2019

The country is still reeling from the aftermath of the Easter Sunday attack last April.

Sri Lanka’s banking sector is expected to remain under pressure in the short-term amidst a tough operating environment due to deteriorating asset quality and subdued economic activity, according to a report by Fitch Ratings.

For the first six months of 2018, Sri Lankan banks’ net profits slipped 15% YoY to LKR41b (US$230m) from LKR56m (US$310m) in H1 2018. Profits were impacted by slower loan growth, increased credit costs and higher effective taxes. The lending rate cap may also have a limited impact on banks’ net interest margins in the near term.

Sector loan growth contracted 0.5% YoY in H1 2019 after strong loan expansion from 2015-2018, reflecting weaker borrowing sentiment and subdued economic activity. The sector’s non-performing loans (NPL) also rapidly rose in H1 2019, up by 39% and 46% for 8M19, with the increase in absolute terms exceeding the entire increase in 2018.

Notably, the country is still feeling the effects of the Easter Sunday attack last April, of which the services sector--in particular the tourism sector--was the most impacted. As a result, gross domestic product (GDP) growth slowed to 2.6% in the first six months of 2019, compared with 4.2% over the same period last year. The Central Bank of Sri Lanka (CBSL) also offered concessions to the tourism sector in the form of a moratorium until March 2020.

In addition, the lending rate cap may have a limited impact on banks’ net interest margins in the near term, although profit could come under pressure based on our expectation of subdued loan demand.

Loan growth is also expected to remain muted in the near-term until after the upcoming election cycle in 2020.

Further, the lending rate cap imposed recently by the Central Bank of Sri Lanka (CBSL) on rupee-denominated loans may not be enough to support an improvement in lending in the short term.

Asset quality is expected to remain weak as a result of the rising number of rescheduled loans and defaults in gold-backed loans, which in turn led to a high NPL ratio in the sector: 4.8% in H1 2019 from 4.2% in Q1 and 3.4% in end-2018.

However, Fitch Ratings believes that Sri Lanka’s banking sector is headed for recovery by end-2020. GDP is expected to improve to 3.3% next year. The imposition of a minimum net stable funding ratio of 90% in H1 and 100% in H2 should also push banks towards more stable funding sources, added Fitch Ratings. Currently, Sri Lankan banks are expected to rely on deposits as the main source of funding, making up 73% of of assets by the end of June.