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SL’s banking sector faces asset quality issues amidst higher bad loans

Sri Lanka’s banking sector, already facing pandemic-related asset quality challenges, has been further hit by its increasing exposure to the sovereign debts, several banking and finance analysts claimed.

With no access to external funds since 2020, the government has had to depend solely on domestic markets and the central bank to finance the fiscal deficit, they pointed out.

The increasing risk of domestic debt restructuring has reduced foreign investors’ appetite for sovereign debt (T-bills and T-bonds).

This has increased the burden on domestic banks – especially state-owned banks – to buy government paper, tightening their liquidity position.

Meanwhile, foreign banks are parking their excess liquidity with the central bank, as stricter counterparty limits due to sovereign-related risks have made them reluctant to lend to liquidity-deficient domestic banks

Banking-system profitability likely weakened in 2022 due to increases in provisioning, though slower credit growth likely kept banks’ capitalization stable, SL banking sector analytical report revealed.

Given the banking system’s large exposure to the sovereign (more than 40% of assets), a sovereign domestic debt restructuring would have to be accompanied by regulatory forbearance for domestic banks to mitigate capital erosion from NPV losses.

However, even if such forbearance was provided, the loss of interest revenues due to coupon cuts would erode most of the sector’s profitability, creating growth and lending challenges for banks.

Maturity extension would also lead to a further liquidity squeeze in the sector, reducing banks’ ability to support economic growth, they predicted.

Sri Lanka’s banks are facing higher bad loans as interest rates rise and the economy contracts, the central bank said as the country faces the worst currency crisis in the history of the intermediate regime monetary authority.

Stage 3 bad loans had reached 10.6 percent of loans, while banks were also hit by mark to market losses and possible re-structuring losses.

Sri Lanka’s rupee collapsed from 200 to 360 to the US dollar in 2022 after two years of money printing blew the balance of payments apart and interest rates shot up to 30 percent and the economy is expected to contract more than 8 percent this year.

“The financial sector is likely to encounter significant challenges in the face of the current economic environment with the contraction in economic output, sovereign debt restructuring, high interest rate environment, tax revisions and high exposure of the banking sector to SOBEs,” the central bank said in a report.

“Asset quality of the sector deteriorated in terms of stage 3 loans to total loans ratio. Stage 3 loans increased by Rs. 475.1 billion, recording a growth of 56.9 % and reached Rs. 1.3 trillion as at end August 2022,” the central bank said.

“Furthermore, stage 3 loans to total loans ratio increased to 10.6 % by end August 2022 from 7.6 % as at end 2021 induced by the increase in stage 3 loans and lower growth in credit.

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