FINANCE COMPANIES FACE A GLUT OF NEW RULES. WILL THESE ALSO FORCE MERGERS?

A NEW ACCOUNTING RULE ON CREDIT LOSSES FOR FINANCE COMPANIES WILL MAKE LENDING AND PROFITS CHOPPIER. WILL IT ALSO FORCE THE WEAKEST TO MERGE?

Rule tightening over 30 years hasn’t stopped Sri Lankan finance companies from falling off the cliff at least once every few years. In just the last few years, half a dozen lenders including Central Investments & Finance,  The Standard Credit Finance, City Finance Corporation, ETI Finance and Swarnamahal Financial Services all have gone bust or were sold due to serious liquidity challenges.

Another, The Finance Company, originally of the now defunct Ceylinco Group, was barred from accepting new deposits, with restrictions placed on withdrawals and lending in February 2019 by the regulator, a clear sign that its liquidity challenges have deteriorated.

However, large finance companies like Central Finance and those controlled by LOLC or People’s Leasing are exceptions. These are larger than some commercial banks, and their risks are professionally managed.

Finance companies are essentially deposit taking and lending businesses in Sri Lanka that cannot access the payments and settlements system that commercial banks use to settle interbank transactions. As a result, finance companies cannot open checking accounts (current accounts), which require access to a settlements system. There are other differences too between them and banks, but this is the significant one.

Finance companies play a critical economic role as they mostly lend to subprime customers who are ignored by banks. Their reach is also rural, where most of Sri Lanka’s poor live.

Three decades after the first regulations were introduced by the Finance Companies Act of 1988, the revolution and the crisis rumble on in parallel.

“The performance of some finance companies is very weak,” observes credit ratings agency Standard & Poor’s Banking Country Risk Assessment report of January 2019. Sri Lanka’s 43 finance companies and five leasing companies accounted for 13% of financial sector assets as of June 2018. Specialised leasing companies cannot accept public deposits.

Of course no regulator can hope to prevent every structural weakness. But frequent finance company collapses putting at risk billions of rupees in savings call into question what more regulators can do – and if their efforts are indeed adequate.

FINANCE COMPANIES MOSTLY LEND TO SUBPRIME CUSTOMERS WHO ARE IGNORED BY BANKS

Steering most of the other 43 finance companies away from the cliff ’s edge has fallen on the non-bank regulator (finance company regulator) the Central Bank. It has introduced a blizzard of rules kicking in periodically, including a six-fold minimum capital increase and variable capital to match risks.

In addition to Central Bank regulations, a new accounting rule, IFRS 9, introduced under Sri Lanka’s almost automatic adopting of global accounting standards (International Financial Reporting Standards), kicking in from the 2019 accounting year, demands timelier provisions for credit losses.

IFRS 9, higher minimum capital and risk capital regulations similar to BASEL rules applying to banks will have the combined effect of upticks in equity requirements for finance companies. Seven companies, representing 5.7% of licensed finance company assets, were not compliant with the minimum capital requirements at June 2018.

Sri Lanka’s finance companies are an oddity by international standards for two reasons. First, in many countries, lenders that are not banks aren’t allowed to accept deposits to fund their business. In Sri Lanka and only a few other countries are finance companies accepting deposits, Central Bank’s Assistant Governor J P R Karunaratne pointed out during an interview.

When public deposits aren’t available, lending must be financed with shareholder or borrowed capital.

Second, Sri Lanka has a large number of finance companies, many of which have eroding market positions and their lacking scale makes them uncompetitive. By 2014, there were 60 licensed finance and leasing companies. A Central Bank policy forcing companies to merge reduced this number in the next year, and by 2018, there were 43 finance companies and five leasing companies. Sri Lanka also has 26 commercial banks and 7 specialised banks.

The rational that led to Sri Lanka’s 60 finance & leasing companies isn’t clear. However, Karunaratne says, “As the banking sector was not catering to rural masses, we thought this sector would be an ideal substitute.” In 2005, there were 20 specialised leasing companies (SLCs). Now, there are only five as many SLCs had obtained finance company licenses, so they can fund lending with deposits.

Borrowers with blemished credit histories are offered loans at higher rates by subprime lenders. Anyone can give subprime loans. In rural poor areas, lenders willing to take the risk are often the village money lender, a company providing micro loans or licensed finance companies. Banks are much less tolerant of patchy credit records and irregular income.

1Addressing the lobby group for the finance companies, the Finance Houses Association (FHA) in December 2018, Karunaratne was critical of their poor risk management.

He said surveys of directors suggest that many finance companies aren’t focused enough on risk management. “Some were unaware if there was a risk management framework at all, while others said they were not very sure about it.”

“They are not expected to understand every nuance or overlook every transaction, but they are required to oversee the risk management framework and establish an effective monitoring mechanism.”

After April 2018, at the current accounting year’s start, many finance companies are looking a lot less profitable. IFRS 9 has forced higher credit loss provisions on almost all finance companies. Those with clients whose repayments are volatile will see the steepest bad loan provision rise during the first year of implementing the new standard.

The weight of the world’s most powerful countries, in the form of the G20, spurred the International Accounting Standards Board into replacing its existing credit losses standard for banks and other financial institutions.

It became apparent following the 2008 financial crisis that banks had done too little too late to recognise losses of their riskiest assets.

Under the previous standard, finance companies made a 50% credit loss provision when a loan had been overdue for six months, and a full provision made at one year.

Finance company gross bad loans grew to 7% in September 2018 from 5.7% a year earlier, driven by micro lending failures. Net non-performing loans (after netting off collateral of non-performing loans) was around 3%.

IFRS 9 expects banks and finance companies to provide for expected losses rather than wait for losses to be incurred.

It classifies loans into one of three stages. The industry calls these ‘buckets’. When a loan is made, a finance company or a bank must make a provision equivalent to the expected loss over the next 12 months. However small, this provision is unprecedented for finance companies, which previously didn’t have to make any provision until a borrower’s default extended to six consecutive months.

The loan will stay in the first bucket unless the probability of default increases significantly. For instance, this can happen when the government imposes a sugar tax on sweetened drinks. Sugary drink producers’ probability of default rises as rising prices will lower demand. This loan is then shifted to the second bucket, and the provision increased to reflect the higher expected loss over the life of the loan. Loans that had been in default in the past but have moved back to performing are also in the second bucket.

If a loan is currently in default, it’s moved to the third bucket. The provision is increased to 100% of the expected loss, and from then, the finance company books less interest revenue.

Estimates vary about loan loss provisions increase for finance companies, after IFRS 9 is adopted on the first day of the 2019 accounting year. Most finance companies start their accounting year on 1 April.

Sri Lankan banks, where the financial year starts in January, are expected to report a 30-35% rise in loan loss provisions due to IFRS 9.

Chairman of KPMG Middle East and South Asia Reyaz Mihular is guarded about forecasting. “Around 45-50% may be a safe estimate,” he ventures hesitantly.

One finance company estimated that its provisions will spike by around 60-65%.

After six months, it appears the estimates were too low.

Provisioning changes among 32 listed finance companies, based on the six months to their September 2018 quarter, showed the loan loss provision spike was over 70%. However, it’s not clear how much of this is on account of the IFRS 9-related spike.

The provisioning gulf between the banks and finance companies is due to their different risk appetites. Banks, for the most part, take lower risks and lend only to those with a good credit record. Bank bad loans are 3.6% of total loans in September 2018 despite weakening economic conditions, rising from 2.7% a year earlier. In theory, all these changes make perfect sense. The old provisioning rules have the effect of flattering performing loans. Without doubt some loans were going to default so it makes sense to recognise that.

PROVISIONING GULF BETWEEN BANKS AND FINANCE COMPANIES IS DUE TO DIFFERENT RISK APPETITES

It also brings parity. Interest rates reflect a borrower’s credit risk, however, the old systems provisions did not. As a result, loans to high-risk borrowers booked higher revenue without the corresponding provisions. This overstated profits.

A sweeping adjustment now will be challenging on at least four fronts for finance companies.

First, many finance companies don’t currently meet, or may fall short of minimum capital thresholds in the future. The Central Bank has regulated, and unrelated to IFRS 9, an annual minimum capital requirement rise by Rs500 million, to reach Rs2.5 billion by 2021.

Then IFRS 9’s timelier provisions will better reflect the risks, but also make it even more challenging for finance companies to attract good valuations, due to it eroding their short-term profits.

Their second challenge will be the profit volatility caused by IFRS 9. During an economy-wide or single industry slowdown, provisions can rise sharply, as finance companies move many loans to stage two from stage one. That may cause a freeze in lending due to capital constraints or until finance companies have more clarity, worsening any economic downturn.

Some finance companies serving niches of the poorest Sri Lankans highlight the high-profit volatility they face.

Volatility may also grow in the last part of the accounting year if finance companies and banks discourage their managers from lending, because booking the full expected loss rate reduces net income for the whole year.

Many of Sri Lanka’s finance companies are specialists because they lend to niche areas like agriculture, and are regional lenders or specialise in micro lending. Their customers, often rural, poor and disadvantaged people, often fall behind on their installments. IFRS 9 would force banks and finance companies to make higher loan loss provisions at the time of granting these loans, and more provisions when they become overdue due to weather-related or other economic shocks borrowers face.

Finance companies with concentrated portfolios of small loans serving poor and rural communities suggest that their provisions rise and profit hit is challenging to address, unless they abandon long-term clients and their current business model.

A chief financial officer of a lender to farmers and rural SMEs, who did not want to be identified, said that poor weather often forces borrowers to fall behind on installments, ‘but they repay the loan albeit after rescheduling the instalments’. But IFRS 9 will classify these as non-performing loans.

In one provisioning sweep, most of a finance company’s capital may be wiped out, although its customers who have consistently been supported through crises by the lender will eventually pay. Addressing this lending concentration is the third challenge.

The Central Bank’s non-bank supervision department (the finance company regulating unit) realized that lending concentration will challenge companies.

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“In rural areas, loan demand comes from agriculture; it may be a lease but it will be for a tractor or a lorry, but still directly related to agriculture,” points out Central Bank’s Non-Bank Financial Institutions Supervision Department Director W Ranaweera.

A business in the Eastern province lending to rice farmers cannot suddenly start lending for home mortgages or shift operations to another part of the country.

During 2018, many finance companies providing micro loans reduced their portfolios and shrunk overall lending, due to reasons including the IFRS 9-led impacts on profitability. Weather vagaries will now require financial impact models.

“Droughts and floods were not taken into account earlier. Now they will have to model them in, instead of saying these factors are beyond our control,” Central Bank’s Karunaratne says.

A fourth challenge is that bank loans and debt market funding for finance company micro lending will tighten, driving up interest rates further for the poorest borrowers.

Despite non-bank financial institutions comprising just 7.9% financial system assets, of which those at risk are only a fraction, Central Bank Governor Indrajit Coomaraswamy says that even a small finance company failures will ripple across the financial landscape.

“There’s this long tale of rather vulnerable finance companies accounting for a small portion of total assets. Having said that, clearly there can be contagion effects if there is instability in some institutions,” he said at the Central Bank’s Monetary Policy Road Map for 2019.

Standard & Poor’s also raised concerns over contagion impact to banks, as 6.8% of their loans by end-September were to finance companies.

“Banks’ linkages with the non-bank financial sector are also rising and could be another source of vulnerability, in our view,” the ratings agency warned.

The Central Bank has directed finance companies to implement risk-based capital adequacy by 2021 of 10% shareholder capital and 14% total capital of risk-weighted assets. Principally, these are similar to the BASEL rules applying to banks. Currently, the requirement is 6% and 10%, respectively.

In the September quarter of 2018, the total capital ratio for finance companies came close to the minimum limit at 11.1%, the lowest since 2013.

Finance companies falling below the limit are blocked from distributing profits as dividends, or undertaking business that would decrease capital adequacy.

“IFRS 9 has the value of forcing people to make an assessment of the credit risk before lending, which is what lending is all about, and not like pawning or lending with a security to back. Finance companies must now do a proper project viability assessment before lending,” says Mihular.

Practically, however, finance companies will require high-quality data of their own lending risks, which only a few will have. “They have been running basic systems. The question is how will they get adequate data for proper risk assessment of the provision?”

Small finance companies suggest that the objectives of efficiency and risk-transparent financial intermediation, an aim of the regulations and accounting rule changes, may have unintended consequences.

The only consequences that Central Bank expects is that the speed of consolidation among finance companies will pick up. “In Sri Lanka, people won’t take action unless it’s forced,” Karunaratne says.

“We haven’t given up the idea that we have announced to the sector that we want a strong sector in the next five years that is resilient to any stress.”

The stakes are high. If regulations aiming to strengthen finance companies weaken them instead by reducing profitability, these companies will struggle to attract the new capital they so badly need. Unless potential financial sector investors look more favourably at smaller finance companies, the probability of their failure and depositor fury rise.

IFRS 9 WILL HAVE THE COMBINED EFFECT OF UPTICKS IN EQUITY REQUIREMENTS FOR FINANCE COMPANIES

Investors will charge a higher cost of capital from honest companies, whose loan loss provisions have wiped off profits, but must still meet regulatory risk and minimum capital hurdles.

Only substantial reform without unintended consequences of choking investment can unravel the finance companies.