Capital position of state banks questioned

Fitch Ratings last week raised its concern over the capital position of state banks as a follow up to similar sentiments expressed by the International Monetary Fund (IMF).

The country’s banking system is dominated by two state-owned banks, Bank of Ceylon (‘AA(lka)’) and People’s Bank (‘A–(lka)’), which account for 33% of system assets.

“According to the IMF December 2007 Financial System Stability Update on Sri Lanka, the capital position of the state banks ‘undermines both the credibility of banking supervision and soundness of the banking system’, and suggests “regulatory forbearance” stands in the way of fair competition between public and private banks,” Fitch said last week in its credit analysis report on Sri Lanka.

It noted that the state banks are considered to be of strategic importance in Sri Lanka, and are thus the responsibility of the Strategic Enterprise Management Agency (SEMA), which is charged with instilling commercial principles in a range of state companies. At this time, there is no intention of privatising either state bank, and they face considerable structural challenges.

According to Fitch the capital position of People’s Bank remains a concern. The government has undertaken to inject capital in what was to have been a plan backed by the Asian Development Bank (ADB). ADB conditions and financialsector reform milestones were not met, however, leaving the government to provide Rs. 3.5bn beginning in October 2007.

In Fitch’s most recent Bank Systemic Risk report, published in September 2007, Sri Lanka’s Banking System Indicator (BSI) remained at ‘E’ and its MacroPrudential Indicator (MPI) was unchanged at ‘1’.

Along with Vietnam (‘BB–’), Sri Lanka has the lowest BSI in Asia. From a sovereign credit perspective, the weakness of the banking system is of some concern, but there are two mitigating factors.

The BSI is based on banks’ Individual Ratings assigned by Fitch, and is intended to measure system quality or strength on a scale from ‘A’ (very high) to ‘E’ (very low). The MPI is intended to capture the vulnerability to macroeconomic circumstances that have been shown to anticipate banking system stress, and does so on a scale of ‘1’ (low vulnerability) to ‘3’ (high level of vulnerability).

Fitch also said Sri Lanka’s banking system is small, with private credit equivalent to only 33% of GDP, which is less than half that of Vietnam. Second, Sri Lanka’s MPI is in the highest category, indicating that the macroeconomic environment is not characterised by developments in private credit growth, equity markets, property prices or the real exchange rate that are seriously misaligned with trend, and thus at risk of a large correction.

The system-wide non-performing loan (NPL) ratio was 5.1% in mid2007, down sharply from 14% in 2002. Mid2007 loan loss provisions amounted to 67% of system NPLs.

According to the Monetary Survey (which includes overseas banking units (OBUs)), domestic credit growth peaked in December 2006 at 34%, and declined steadily last year, reaching 16% in December. Credit extended to the government made up 23% of total credit, but it has accounted for much of the volatility in credit growth over the last two years.

Private sector credit growth has been much steadier, declining slowly from 29% in mid2006 to 19% in December 2007. In real terms (using the New Colombo Consumers’ Price Index), the drop in private credit growth has been much more dramatic. In November and December 2007, real private credit growth was zero, its lowest since 2002.

According to Fitch while private credit growth has been slowing in general, some components grew rapidly last year, warranting additional monitoring. Lending for private consumption grew particularly quickly, expanding by nearly 60% in the first quarter of 2007.

Loans for housing were up by 45% in the same period. In response to the rapid expansion of certain segments of the credit market, the CBSL advised banks of the risks in lending for consumption and introduced a general provision equivalent to 1% of loans and advances. Lending rates have not kept pace with price increases in Sri Lanka, and the prime lending rate averaged slightly less than inflation in both 2006 and 2007. Marginally negative real interest rates almost certainly contributed to the increase in privatesector borrowing for consumption.