FINANCE COMPANIES CONTINUE TO SLIDE

Non-bank subprime lenders in Sri Lanka have had a tough couple of years leading up to the COVID-19 outbreak. And things are looking worse. Rating agency Fitch is forecasting a 4% decline in economic output in 2020 – compared to a previous negative 1.3% forecast – as a second coronavirus wave threatens to drown the island, with harmful repercussions for finance and leasing companies (FLCs). “The risk of a second coronavirus wave, together with weak borrower sentiment in an already fragile operating environment, would put further stress on credit profiles of Sri Lankan finance and leasing companies. Adding to existing pressures on asset quality and profitability,” Fitch said in an October 2020 Report ‘Pandemic Exacerbates Downside Risks to FLC Loss Absorbing Buffers’.

These risks will test the loss-absorbing capacities of subprime lenders. But Fitch says it believes that capital and profit buffers of most LFCs will be adequate to cushion against moderate asset-quality shocks. “Fitch expects Sri Lanka’s real GDP to contract by 3.7% in 2020 due to the pandemic. The economic fallout has pressured finance and leasing company asset quality with the six-months past due non-performing loans (NPLs) ratio spiking to 14.1% by end-June 2020. Also, sector-wide return on assets turned negative to -2.3% due to high credit costs,” the rating agency said. The FLC sector has several growth challenges ahead. A ban on auto imports and a surge in prices for used vehicles will likely hamper medium-term growth. Sector loans contracted by 0.2% yearon-year in the June 2020 quarter (after growing 12% annually over 2015-2020), and leasing and hire purchases accounted for 55% of all lending, Fitch said.

Credit growth which peaked at 32% in 2015 has steadily declined to a negative 3% in 2019. The trend will continue with credit growth falling further to a negative 10% in 2020 and will return to positive growth territory only in 2022, according to First Capital Research. The credit market share of LFCs will decline to 6% in 2022, compared to a 9% average over the last three years. In April Fitch said a one- to six-month debt moratorium, depending on the type of credit line, would have negative first-order implications for FLCs. However, a reduction of the liquid-asset requirement for deposits and borrowings could reduce near-term liquidity shocks stemming mainly from non-payment of loan rentals. Fitch said the debt moratorium would exacerbate pressure on FLC profitability, which is already weakened and is likely to mask the extent of asset-quality deterioration. The worst is now taking form. According to Fitch Rating’s October report, underlying asset-quality pressure is building up due to the pandemic and become apparent from the September quarter onwards when a credit moratorium scheme introduced by the government ends. Regulatory relief in the form of loan-repayment moratoriums has temporarily halted the recognition of credit impairments for much of this year. Most borrowers will not emerge unscathed from the economic downturn because they are largely sub-prime. Non-performing loans have been rising steadily since 2017. Post moratoriums, NPL could peak to as much as 20%, according to First Capital Research, before easing to 14% by 2022, which is still a sixyear high since reaching 5% in 2017. Rising credit costs and slow loan book growth will reduce earnings and weaken the ability of FLCs to build capital buffers. This risk as more acute for smaller companies which already have weak profitability buffers, with credit costs consuming more than 70% of their pre-impairment operating profits, Fitch notes.

The sector reported its highest combined profit of Rs28 billion in 2017, up from 34% the previous year. Profitability has eroded since to Rs13 billion by 2020. The sector will report a combined loss of Rs29 billion in the current financial year to end March 2021, before recovering to an Rs8 billion profit the following year, according to First Capital Research. ROEs of listed LFCs combined peaked at 20% in 2017 and also declined steadily. ROEs of the sector will reach a negative 15% in 2020/21. In April, Fitch said that the timeline to comply with enhanced minimum core capital and minimum capital-adequacy ratio requirements has been extended by one year. This will provide some breathing space to FLCs that have not met the relevant thresholds due to dislocation of the capital markets, while significant near-term earnings pressure may weigh on FLCs’ capital buffers. Out of the Fitch-rated FLCs, five had not met the minimum core capital requirements of LKR2 billion by 1 January 2020.

By October, of the 38 licenced companies, nine were non-compliant with minimum capital requirements even by end-September 2020. The sector watchdog, the Central Bank, had had to grant extensions so that companies lagging can comply with the minimum capital requirements. The LFC industry must raise nearly Rs31 billion before 2022 to comply with Central Bank capital adequacy requirements, which is a tall ask under the current macroeconomic conditions. Most FLCs raise capital from bank borrowings. With banks reluctant to lend during the pandemic crisis, smaller FLCs’ exposure to liquidity risks has heightened. Small entities tend to rely more on bank funding, while large ones with better domestic franchises will underpin their liquidity profiles, Fitch said in its October 2020 statement.