The research arm of the Sri Lanka’s First Capital PlC (FC) group expects the banking sector to experience tough circumstances in 2022 as worsening macro-economic conditions are expected to spill over into the banking sector.

“Weaker economic activity, rising inflation and higher interest rates are expected to depress borrowers creating sharp deterioration in asset quality as reflected in the banking system’s stage-3 loans which were high at 7.6% as at December-21, FC stated in its latest banking sector equity research report.

“Moreover, sector is also expected to face added asset-quality pressure from their government securities holdings, particularly those denominated in foreign currency. Additionally, increase in VAT rate from 8.0% to 12.0% with immediate effect and corporate tax rate from 24.0%-30.0% with effect from 1 October 2022 are expected to dampen the profitability of the sector.”

According to FC observations Net Interest Margins (NIMs)  expansion due to rising interest rates to be offset by subdued credit growth despite the fact that sharp rise in lending rates (AWPR surged by 1,218bps to 22.62% as at 1  July ‘22 since 8 April ‘22 policy rates hike) leading to higher margins for banks, weak macro- economic conditions, along with the proposed series of other measures such as removal of caps imposed on credit cards, pre-arranged temporary overdrafts, and pawning facilities are expected to significantly slow down the real domestic credit growth for 2022.

Furthermore, though the sharp depreciation of Sri Lankan rupee  since Mar 2022 has resulted in significant swell in credit in rupee terms in March and April 2022 (11.07% 5M YTD) real growth in credit is expected to be marginal over the deteriorating economic conditions.

Consequently, while taking into account potential settlements especially in credit cards during 2nd half of 2022, FC estimates credit growth for 2022 to hover around 13.0%-14.0%. In 2023, FC expects private sector credit growth to hover in the range of 5.0%-7.0% led by the gradual recovery in the economy in the midst of completion of debt restructuring process.

Constant liquidity pressure creates further risks

Post sovereign default, banks are facing extremely high liquidity risk as there is a loss of appetite in international markets for Sri Lanka which is also likely to create banks having limited access to cross-border funding.

“This trend is expected to persist until the sovereign’s external situation stabilises, which is expected to take few months. Accordingly, rupee crunch as well as risk stemming from constrained access to foreign currency funding is expected to create a stress situation in the sector” FC stated.

Impaired profitability to result in capital deficiencies

Impaired profitability is likely to create pressure on the capital adequacy ratios of the bank demanding capital rising in the future. Considering this impact banks have already been authorised to drawdown capital conservation buffers up to 2.5% to cope with the mark-to-market losses from the fall in prices and interest payments on sovereign bonds. Consequently, impaired profitability is likely to expose banks to capital deficiencies requiring further capital raising in the future, the report concluded.