Equity Analysis /
Sri Lanka

Sri Lanka banks: Muted profitability, but limited systemic pressure

  • Regulations eased; banks directed to absorb the economic shock partially

  • Credit growth to trend lower on weak economic sentiment

  • Profitability to remain under pressure in CY 20

Asia Securities
16 April 2020
Published byAsia Securities

In this report, we highlight the pressing current themes around the banking sector. Overall, majority of SL government’s key support measures for the economy are implemented through the banking system, and the banks are expected to absorb the economic shock partially. In return, banks have received several concessions to maintain the systemic stability. We expect sector profitability to be muted in CY20E, with 1) weak credit growth, 2) contracting margins, 3) lower supplementary income (low fee income and trading gains) and 4) no reduction in cost of risk as earlier expected. In addition to the concessions offered to the banks, we note that the CBSL has increased available market liquidity through an SRR cut in mid-March along with injecting funds through increasing CBSL’s bond holdings. With a drawdown allowed from the capital buffers to increase lending, we do not see major pressure on capitalisation.

Regulations eased; banks directed to absorb the economic shock partially

In the last few weeks, the CBSL has instructed the banks to provide several measures to ease the economic burden of borrowers affected by Covid-19. Broadly, these measures could be grouped into 1) payment holidays, 2) discounted loan rates and 3) temporary suspension of foreclosures. In return, the CBSL eased banking regulations in terms of 1) NPL recognition 2) lower SRR and 3) lower capital requirements (a detailed list of the measures is provided in Appendix 1 in the full report).

Profitability to remain under pressure in CY 20

These measures, in our view offer much-needed support for the businesses to tide over the short-term shock coming from the lockdowns. Most of the measures are in place for six months, which means that the implications for financial institutions would last for a large part of 2020. Overall, we downgrade our bank net profit estimates by 21.1%, with a 3ppt drop in ROE, compared to our previous estimates. This is underpinned by 1) weak credit growth, 2) contracting margins, 3) lower supplementary income (low fee income and trading gains) and 4) no reduction in cost of risk as earlier expected. We believe these will offset the benefit coming from the removal of NBT and DRL. In our base case, we also believe that the corporate tax reduction which was proposed in January would not go ahead given the already weak government revenue position. Given the state of flux, we believe that these estimates could naturally see further revisions in the coming months.

Credit growth to trend lower on weak economic sentiment 

We believe the credit demand will remain muted throughout CY20, underpinned by the extremely weak economic conditions. This is despite the 100bps policy rate cut initiated in 2020 so far (50bps in January, 25bps in March and 25bps in April). In CY19 gross loans in the banking sector grew only marginally by 5.6% on the back of weak sentiment driven by Easter attacks and elections. Private sector credit growth in CY19 was 4.5% YoY, and we believe this to trend at 3.5%-4.0% for CY20E at this stage. 

Retail lending, which was expected to grow substantially in CY20 would likely be subdued, as a significant part of the workforce would see their income being impacted. Business loans – largely expansion-related borrowing – would be put on hold, both at corporate and SME level. In addition, banks would turn extremely cautious in the current environment given the asset quality concerns experienced over 2018 and 2019.