Volatile and deteriorating liquidity and interest rates and the depreciating currency have challenged banks in 2022. Besides these, the economic challenges have crippled businesses and personal finances of families. It’s forecast that struggling creditors will result in banking industry bad loans rising to 15 percent levels over 2023, putting severe pressure on bank capital.

Banks themselves and the Central Bank, which regulates the financial sector, have been conducting stress tests to understand how deeply the sector might be impacted. Besides the challenges from volatility and rising loan loss provisions, banks hold over 30% of Sri Lanka’s commercial foreign currency debt which will now be restructured. The depth of the financial fallout from this has not been fully reflected in their balance sheets.

Echelon hosted Commercial Bank of Ceylon, Chief Executive Sanath Manatunge, NDB Bank, Chief Executive, Dimantha Seneviratne and Ranjith Kodituwakku, who was the Chief Executive of People’s Bank when this panel discussion took place at Echelon studios in December 2022. They discussed the challenges and possible approaches for the industry.

How have the balance sheets; the assets and liabilities of commercial banks been impacted by the current economic challenges?

Manatunge: We’ve been hit by a triple whammy; liquidity issues, interest rates and a sharp currency depreciation. These three variables create significant risks for banks. Issues at the banks ultimately boil down to the economy.

The dollar liquidity decline has deprived the general economy of a significant part of the 2 billion dollars needed for goods and services imports each month. As banks we face two challenges, one is dollar liquidity and the second is rupee liquidity. When the economy is shrinking, ultimately borrowers face issues like lower turnover and the challenges caused by social unrest. Everything ultimately ends up in the banks. They have to service the borrowing at these high interest rates.

In the meantime, inflation and the shrinking economy have made loan servicing challenging for customers. We expect our loan portfolios to be under stress from the present circumstances. But the actual level of stress caused by the past hasn’t fully manifested in our portfolios yet.

One could argue that everybody is feeling the impact of the economic crisis. Why are banks given importance?

Seneviratne: Let me make just one point before I answer your question. With the steep depreciation of the rupee another challenge banks face is capital. Most banks have dollar assets of between 25% to 30%. When the rupee depreciated the value of those assets in dollar terms almost doubled as the rupee depreciated almost 100 percent. But our capital is in rupees and as a result everyone had a massive impact on the capital adequacy ratio. We need that capital to support economic revival and growth.

In addition to the three challenges that Sanath Manatunge pointed out, I would add the strain on capital the banks face to that list.

A country’s economic revival depends on how strong its banking sector is. We are an intermediary, mobilising deposits and funding businesses in need of capital through our lending. Bear in mind, Sri Lanka’s banking sector holds nearly 15 trillion in deposits and has 19 trillion in assets. Banks drive the economy forward. Altogether we have 3,500 branches and over 56,000 are employed by the banks.

Regulators realise this and have provided some forbearance on capital for banks, especially to deal with the impacts of the rupee depreciation, they have come up with a capital conservation buffer. In good times banks build up that conservation buffer. Our minimum capital ratio is 8.5% and the regulator has provided a 2% leeway for lower level of capital for three years. So far none of the banks have used it, which shows the resilience of the banking sector so far. But that might change when the sovereign debt restructuring happens.

The worst of the economic crisis has yet to be reflected in your balance sheets and P&Ls. What of these will be the first wave of stresses to hit the banks of the ones we have identified; liquidity, capital, interest rates and currency depreciation?

Kodituwakku: From a liquidity sense, we’ve already felt some stress. Exchange rates have stabilised so there won’t be any new pressure from the exchange rates going forward. Non performing loans are going to be the biggest challenge on the bank balance sheets the way I see it, starting in 2023 when the moratoriums are over next year. At the end of October 2022 stage 3 loans were 11%. Of 19.3 trillion in assets stage three loans are 1.2 trillion rupees right now.

Could you define what a stage three loan is?

Kodituwakku: It’s an IFRS9 classification and in that stage three loans are a classification for potential risk. NonPerforming Loans (NPLs) are based on historical data, once the incident happens you classify it as NPL. In terms of IFRS9 it’s based on potential risk. Stage three loans in this classification are at 11 percent currently, and they are expected to rise to 15 percent in the coming months. It will have a considerable impact on banks’ tierone capital due to higher provisioning.

On top of that we have already seen that bank balance sheets are also affected by international sovereign bonds to which most of us have some exposure. Banks will be affected by the inevitable haircut. If you have seen the published financial statements of the banks they have taken considerable provisioning of around 30 percent to absorb these losses. But the impacts could go beyond as there is an expectation that the haircut might go up to 40 percent.

Banks are undergoing liquidity stress on both the Rupee and Dollar sides, but it’s a matter of how we can best manage liquidity while conserving and augmenting capital to face these challenges.

Have the provisions been done for the 11 percent of loans classified as stage three impaired under IFRS9?

Kodituwakku: Most of the banks have already made the provisions. At the end of quarter three of 2022/23 financial year, substantial provisions have been made by the banks to absorb these losses, which shows the proactive measures taken by the banks.

Is it accurate to say a haircut or reprofiling of ISBs would be the next major challenge banks will face?

Manatunge: Although practically unavoidable, banks are against a haircut on the international commercial debt. That’s our position. Although we have made provisions, we are not talking about the haircut, its an expected loss provision. We have retained a financial advisor and a legal advisor. I’m not sure how successful we will be in preventing a haircut on the debt. I don’t think that’s practically possible, but our position is that the banking sector needs to be resilient.

The creditors understand for the restructured bonds to be serviceable in the future the economy must be resilient and the banking sector should support the economy. With that view we are talking with the lawyers and financial advisors to negotiate with relevant parties on this restructuring, to obtain the best solution possible. As a consortium of banks we are negotiating for the best solution possible. On the advice of auditors all the banks have provisioned for potential losses.

Seneviratne: We aim to find different solutions for different creditors rather than restructuring. There isn’t one solution to every problem and providing alternatives helps ensure that the debt is sustainable once restructured. Even the IMF is keen on us building a sustainable debt service

To understand this clearly, the Sri Lankan banks holding government issued foreign currency debt have appointed their own lawyers and financial advisers to negotiate with the government?

Seneviratne: Correct. This is our first such negotiation here. But our advisors are far more experienced with such negotiations around the world. A settlement is not a rejection of a haircut. We need a few solutions, some attractive to external creditors and others for us in the banking sector and everyone around the table is keen to see sustainable debt servicing in the future.

What are the preferred options from your point of view?

Manatunge: What we are proposing is that the treatment should not be the same for Sri Lankan banks. Sri Lankan bank capital adequacy is under stress. Our ability to absorb a haircut is limited. One possible option is for banks holding ISBs to be given a tradable bond to cover the impact of the haircut. This approach is attractive to a local bank but unattractive for an investor outside the country. That way, there is compensation through another instrument which is an asset. Otherwise, it would directly impact the P&L statements. The experience of other countries suggests there are six or seven such alternate solutions to the creditors.

But all this is contingent on the future. Banks can’t predict anything, but they have prepared. All the banks have done their stress testing, and capital augmentation plans are in place. I think the banking sector as a whole is resilient.

We are talking with the lawyers and financial advisors to negotiate with relevant parties on this restructuring, to obtain the best solution possible

Seneviratne: The banks here are holding between 12% to 14% of the ISBs outstanding. That is why the banking sector figured it needed its own advisors. The government is working with Lazard and the banks have appointed Baker McKenzie as legal advisor and Newstate Partners as the financial advisor, keeping the central bank informed of these developments.

The IMF will indicate the required gross financial needs and provide targets to achieve. Within that, how you restructure your debt is a negotiation with Paris Club and non Paris Club creditors, private creditors and banking sector creditors in Sri Lanka. We need sustainability and should not have to repeatedly restructure debt, like Argentina. That’s why we have engaged our own lawyers and financial advisors.

The commercial debt has to be restructured. For the banks is there a preferred option?

Seneviratne: There are various permutations and combinations in reprofiling the debt. We have to bear in mind that the banking sector is important for the revival. A majority of the foreign creditors are represented by the financial services group Rothschild, and they also agree on the need for banking sector stability to anchor the economic revival. So we need a different treatment for the local banks as was already mentioned here.

Manatunge: In IFRS terms, between the time the restructuring is announced there will be an adjustment, a provision. The bonds may materialise later. The day one adjustment should come with some regulatory forbearance, because the banking sector will not be able to absorb this adjustment, depending on the amounts, in the first year. If there is a day one adjustment the accountants and auditors need to make a call on how to spread it over a period. These are extreme situations. Accounting standards have been designed for general business conditions.

If there is a rupee security given to the banks to cover some of the losses arising from the foreign currency commercial debt they hold, you don’t anticipate it will fully cover any ‘day one’ adjustment?

Manatunge: Depends on how it will be structured. If the entire amount of the haircut is replaced by a 20 year bond, for instance, then there won’t be an adjustment. Of course the interest rate of that bond too matters.

How will adding bonds to the balance sheet impact your capital?

Manatunge: We are getting compensated by another instrument, which is an asset. So the haircut will be reduced by a similar amount. Otherwise it will hit the P&L fully and also erode the capital. The interest rate and the maturity period of the restructured bonds also matter, because on the IFRS it is always the NPV, and the cashflow that matter.

Capital is currently very expensive. Is now the time to raise capital?

Seneviratne: The cost of capital, especially tier-one capital is very high, and there are a lot of uncertainties. I personally think this is not the time to raise new capital.

Once the IMF programme is announced, and there is confidence in debt sustainability is when banks should ideally tap into the market to increase their tier-one level capital. But to maintain capital ratios, tier-two capital is being raised, at a cost.

How should we approach addressing Sri Lanka’s rupee debt which amounts to about half of the country’s outstanding debt? There are questions about its sustainability and the need for restructuring rupee debt too.

Kodituwakku: Serious consideration is needed when considering a reprofiling or a haircut on the local debt. It will have a devastating impact on the banking sector. Other countries in similar circumstances have undertaken a reprofiling rather than a haircut. Although we’ve had several discussions with the IMF and relevant authorities here, there is still very little information we know about what will happen.

If you look at IFRS 9, expected losses are based on ‘informed supporting evidence’. Right now we lack that. The challenge is when we try to do necessary provisioning or try to forecast our future business and balance sheet, since there is no concrete evidence of what will happen.

Manatunge: As the banking sector we want to say that we have zero tolerance on rupee debt haircuts. One of the reasons banks are against a rupee debt haircut is because a haircut already took place with the currency’s depreciation by around 80% in 2022. So the foreign currency value of the rupee bonds we hold have fallen by 80%. Already a haircut has been taken by the rupee bond holders.

Also, the largest bondholders include the EPF, which holds these bonds on behalf of the public. It could have a significant impact on people’s future and the economy. By promoting these rupee haircuts we create unnecessary panic in the economy. Maybe through such an action the foreign creditors are trying to get a bigger share of the settlement. We should not agree to rupee debt haircuts; that’s the view of the banking sector.

Is differential treatment an option on rupee debt. Spare the banks of a haircut but enforce it on other creditors?

Manatunge: Unlikely, and if you see, this is the public’s savings in these bonds. So any hit will also be a hit on the economy.

Although we currently have high interest rates in bonds, those will come down in the future. This debt servicing formula is all about assumptions. If we arrive at a formula with more positive assumptions for the future, we should be able to avoid rupee haircuts.

Seneviratne: It’s all based on Gross Financial Needs (GFN). Of the assumptions, interest rates are an important one. At the current interest rate the sustainability of debt may be challenging. If we can bring interest rates down and stabilise it at around 15 percent, we can avoid any domestic debt restructuring. By creating doubt about the rupee debt sustainability we have added a premium for that to bonds already.

Of the 100 sovereign debt restructuring that took place over the last few decades, 29 countries also restructured their domestic debt. In 10 of those 29 countries, the banking sector collapsed. That’s the gravity of this. Whoever is entertaining these thoughts must be mindful of the repercussions.

By statute banks have to maintain a liquidity ratio and these investments in rupee sovereign debt are necessary. It’s the same for ISBs. Banks that have foreign currency liability (deposits) have to maintain liquid assets. The only liquid assets available for the Sri Lankan banks are the ISBs or the Sri Lanka Development Bonds. Otherwise you have to keep it in a NOSTRO account with no return. That’s why the banks were compelled to invest.

Manatunge: We must seek solutions which cater to Sri Lanka’s specific circumstances. Our situation is very different from the likes of Ghana or Lebanon. Ghana’s ISBs were only held by foreigners. Lebanon was a dollarised economy with only tourism as a major foreign exchange earner. But Lebanese banks had invested in dollar commercial debt. We must have the wisdom to come up with a solution that’s suitable for Sri Lanka.

We should also have the strength to say no, when foreign creditors propose conditions that are unsuitable for the economy.

Is enough being done to address these concerns in the forums where the negotiations are taking place?

Seneviratne: As an industry, that’s where we want to be. Which is why we have the services of our own financial advisor and legal advisor. When it comes to the local debt restructure too the banking industry should form a similar alliance. There will be broad IMF targets the country has to meet. But within that how we negotiate with the foreign creditors and about the rupee debt is up to each country.

Your question is whether we are doing enough. I think we should do more to ensure that as an industry we need to negotiate harder.

What sort of time frame are we looking at? Sri Lanka is desperate to have an IMF deal concluded, but that is contingent on having the creditors agree broadly on debt restructuring?

Kodituwakku: ISB restructuring in Q2 2023 will be the target. As far as I know, the IMF has never intervened in local debt restructuring. Any domestic debt restructuring or reprofiling is mostly up to the central bank, the government and banks. The IMF’s main concern is how we can restructure and serve our overseas debt, the ISBs.

The local debt restructuring is a topic discussed by people within Sri Lanka, in my opinion. The IMF is focused on debt sustainability before giving any sort of assistance to a country.

Manatunge: To move forward with the IMF, we first have to negotiate with our creditors such as the Paris Club, China, India etc and show them we have, in principle, an agreement with these countries. The 2.9 billion we will receive from the IMF is a form of bridging finance. In the first round of discussions the private creditors are not even being taken into consideration. The entire debt restructuring and the country regaining an investment-grade rating will take several years. Once the government to government debt restructuring is agreed then the negotiations can move to other categories.

At the moment Sri Lanka’s foreign currency bonds are trading at maybe $0.30 to the dollar, indicating that the markets are concerned about the restructuring. For the commercial sovereign debt restructuring to be concluded it will take one and a half to two years, in my estimate.

Kodituwakku: It’s going to be a long and arduous journey and we won’t be able to reach our previous economic state for a few years.

What other aspects of forbearance should regulators be considering?

Kodituwakku: There are some measures of regulatory forbearance in place already. For instance on capital augmentation, should we do it at the current high cost, or should we be allowed 12 to 18 months to raise capital to meet the standards. If you consider the state of the market, it’s not conducive for everybody to go out and raise capital at the same time, tier 1 or tier 2 capital. The current market will struggle to fulfil the entire sector’s requirement.

Seneviratne: Banks have been given a three year timeframe to come to the 8.5% tier one capital with the capital conservation buffer, so it’s already given.

Another aspect we need to consider is the tax contributions of the banking sector. With the new rates the affecting rate on banks is 55%. So whatever the earnings 55% comes to government revenue. That too is an important factor in future debt sustainability of the entire country.

The regulator has already unveiled a liquidity support facility, in case it is needed. Of course we have to pledge assets to the central bank to access this facility. No bank has utilized this so far.

The other aspect is the ‘day one’ impact in case there is an ISB restructuring or a domestic debt reprofiling. That’s where the regulator and the accounting standard setting chartered institute need to agree, on how we can mitigate some of the worst effects for a time.

Regulators have also been proactive in conducting diagnostic studies of the top 10 banks in the country to ascertain how they will perform under potential future market conditions. Hopefully, this data is already available and is being used during IMF talks. We should probably have measures to help support the capital if there is a need, working with parties such as the ADB or other multilateral agencies.

Kodituwakku: The regulatory forbearance has been provided on the capital conservation buffer, whereas I was referring to the stresses stemming from the market and how we might then build our capital. For that we need more time, due to the current market conditions.

Manatunge: Although regulators have been proactive in providing forbearance, banks haven’t used them yet. If a bank were to make use of the forbearance, then it would immediately place that bank on the backfoot with degrowth in the balance sheet. Shrinking bank balance sheets will also hurt economic recovery.

My opinion is that in the move to restructuring, we should consider some consolidation supported by a recapitalization. We have nearly 26 banks in this country, which is perhaps a bit too much for an economy like this.

By consolidation, you mean merging between banks. How can the regulator play a part in this?

Manatunge: This has also been implemented in countries such as Korea and the Philippines following the Asian financial crisis. Regulators can initiate this along with the sovereign debt restructuring. Reducing the number of financial institutions to about three or four creates resilience by reducing overall cost in the industry. Resilience is important given how fragile some parts of the financial sector, including the finance companies, are. Even a large bank will feel the impact of even one bank failing as customers lose confidence.

Regulators can play a part by reducing the mass of red tape around consolidation. Providing additional incentives should also be considered.

What are your thoughts on creating a bad bank to take on the stressed assets of the entire sector?

Seneviratne: Many countries have adopted this arrangement, but there are many aspects we need to consider beforehand. Do we have the legal structure to support such a system? Where does the capital for this bank come from? The idea has been mooted, but there is nothing substantive. We don’t know how this will work.

Commenting on consolidation. That should be the way forward and the regulator should also support that process. There will be branch closures after a consolidation, no point having several branches in one town. Cost efficiency is a key outcome and the positive impact of that will benefit customers and the economy at large. The regulator can drive a consolidation policy with tax incentives and other policies.

Is consolidation too much for the sector to be dealing with during a particularly challenging time such as this? 

Seneviratne: We need to work on that parallelly. There is nothing to gain from duplicating things, whereas efficiency is one important way for the sector to preserve capital.

Manatunge: Any locality will have 8 to 10 banks and possibly even more ATMs. We are duplicating infrastructure to cater to the same clientele. Take Singapore for example, they only have three local banks, for such a huge economy. Our ability to invest in technology is enhanced if the banks were stronger, larger and had a lower cost base.

On the proposal to establish a ‘bad bank’ to pool all the stressed assets in the sector. We don’t have the legal framework for this and Sri Lanka lacks effective bankruptcy laws similar to the Chapter 11 you find in the U.S. On the other hand, it should not be the aim of ‘bad banks’ to sell assets and kill the business in the process. If at all a ‘bad bank’ should be funded by the banks themselves with additional funding from the World Bank or ADB. That bank should have a rehabilitation mindset rather than liquidation as a solution to a stressed asset.

Besides, many of the bad banks established in the world have failed due to poor governance sometimes through political influence. We have to be careful when creating a bad bank. It can’t operate as a commercial bank because its scope should be to rehabilitate and support the industries beyond what the commercial banks can immediately do. The ‘bad bank’ should not be run as a commercial bank, it should instead rehabilitate and transfer the customers and assets back to the banking system. As was said, we haven’t even done one percent of the work needed to take policy in this direction.

Any thoughts you’d like to share in closing?

Kodituwakku: A ‘bad bank’ has been mooted in the past as well. It should aim to revive industries and not to liquidate companies. Due to this crisis, most banks have started rehabilitation units within the bank itself. The ‘bad bank’ idea could be a move forward to take charge of those stressed assets for some time. It’s a good idea, we should not rule it out. But the objective of the ‘bad bank’ should be for the benefit and progress of the country.

Seneviratne: Banking is a key industry for the revival of the country’s economy. The past few years have been challenging for the system. Sector wide in the quarter to September 2022 there was a 40% profit decline in the industry year-on-year, mainly due to higher loan impairments. We need to take care of our customer base, who are in this challenging situation not due to their own fault, to survive. The stability of the system is important for the country’s survival.

Manatunge: I’m optimistic about the revival of Sri Lanka’s economy. We are a small economy and with proper management, we can develop industries and bring life back to the economy. This crisis is a case study, the learnings from which we should use to build a long term economic view, political stability, accountability, governance and policy consistency.

I believe this is a man-made disaster. We have all the resources we need, and people who love their country. Although we will have to experience some difficulty and pain now, we can recover. But we need the vision and commitment to make it a reality. We have to be accountable and consistent in our policies to attract investments. If we do it right, recovery can be achieved very quickly