SME DEBT MORATORIUM: WHAT’S IN IT FOR THE BANKS?

ASSESSING THE IMPACT OF THE ONE-YEAR DEBT MORATORIUM FOR SMALL BUSINESSES IS DIFFICULT. IT’S NOT AS BAD AS INITIALLY BELIEVED. ONE THING IS CLEAR, IT IS LIKELY TO BENEFIT THE BANKS THE MOST

It was the last week of November. Sri Lanka’s top bankers assembled at Temple Trees, the Prime Minister’s office. The euphoria was still fresh after President Gotabaya Rajapaksa assumed office a little over a month ago. The caretaker government had announced sweeping tax cuts to boost economic activity. Banks are easy prey to cash-strapped governments. Most lenders’ effective tax rate had been above 55% and the newly announced tax cuts brought that down to about 45%. However, the seasoned bankers were under no illusion the summons was for more good news. They sat expectantly around rows of long tables in the officious meeting room along with key ministers of the caretaker government and top officials from the Treasury Department and Central Bank. Everyone stood up when Prime Minister Mahinda Rajapaksa, the president’s elder sibling walked in; after all, he was president for two terms and nearly had a third, and won the war.

In his affable self, Rajapaksa waxed eloquently about the government’s plans to revive the struggling economy and asked the bankers for suggestions to uplift small and medium businesses. Now that banks got the tax concessions, Rajapaksa insisted banks should pass down the benefit. He suggested a debt moratorium and gave the bankers a week to draw up a plan. “This was not a request. It was an order,” one banker who attended the meeting said. In December, the Finance Ministry issued a press release in which it said that the President and Prime Minister directed banks to suspend recoveries of outstanding SME loans up to Rs300 million to the confusion and surprise of banks, and everyone else.

The bankers had not worked out the details yet. “That news went viral on social media. Small business clients flooded us with calls,” a banker who spoke to Echelon on condition of anonymity said. Banks worried with many borrowers refusing outright to service their loans. SME loans make up a significant share of bank lending books: some smaller banks have exposure over 45% to small businesses. Market analysts worried a liquidity crunch could hit banks as these businesses stopped repaying loans and non-performing loans increased.

Bad loans rose to 4.9% of total banking industry loans in the third quarter of 2019, up from 3% in the first quarter of 2018 It was only in January 2020 that the Central Bank issued guidelines to banks on the SME debt moratorium, ignoring the proposals submitted by the banks. Moody’s, a rating agency, sounded a warning.

“The debt moratorium is credit negative for Sri Lankan banks and the sovereign because it risks increasing SMEs’ risk appetite and relaxing their attitude toward debt repayments, ” the rating agency said in a research note. At the time of going into press, there was still some confusion everywhere: borrowers, bankers, auditors and market analysts were still uncertain about how the scheme worked and the impact it would have. Moody’s also gave voice to concerns harboured by most market analysts. “The debt moratorium will help slow the banks’ nonperforming loan formation this year, but we anticipate an increase in bad debts when the grace period ends, especially if the domestic economic conditions remain weak,” it said.

In Moody’s view, the debt moratorium was not going to work. “Similar to our expectation on any macroeconomic benefits from the tax cuts announced for businesses and households, the (SME debt moratorium) is similarly unlikely to lead to a significant and sustained acceleration in economic activity.”

THE DIRECTIVE INSTRUCTS BANKS NOT TO BASE LENDING DECISIONS SOLELY ON CREDIT REPORTS FROM CRIB

Despite the initial shock and complexities of the scheme, it didn’t take long for market analysts to realise that the debt moratorium scheme was unlikely to dent banks’ prospects. It turns out banks would benefit the most from the scheme. There are still several grey areas: for instance, how are banks supposed to treat non-performing loans under a new accounting standard IFRS-9 introduced only a year before? It’s now apparent the government’s laudable debt moratorium scheme is mostly vote-baiting ahead of April’s general elections.

The Central Bank too, despite toeing the government line—it cut policy rates in January by 50 basis points to boost credit growth—appears astute enough in formulating its guidelines not to cause systemic risks to the financial system. Small businesses were elated over the news of the moratorium. Of course, they would be. Cash is the lifeblood of business and SMEs needed plenty of oxygen for a revival after a period of stagnant economic growth compounded by the terrorist bombings in Easter 2019. Credit growth had contracted in 2019 and banks were certainly in no mood to lend to SMEs.

“Willingness to lend continued to contract in the third quarter, while the contraction was notable towards retail and SME categories,” the Central Bank said in its credit survey for the period. “Banks tightened their willingness to lend by reducing the size of credit lines, increasing collateral requirements and increasing loan covenants,” it said.

At first glance, the President and Prime Minister’s scheme promises to provide much-needed relief to SMEs. Through the Central Bank’s directives, the brothers in power wanted banks to extend a one-year moratorium on capital repayments for performing and non-performing SME borrowers. Performing borrowers could also get a fresh loan up to Rs300 million at the average weighted prime lending rate.

This is a lower rate of interest banks charge their low-risk borrowers. During the moratorium period, borrowers will have to pay the monthly interest component. SMEs qualifying for the scheme must report an annual turnover of Rs16-750 million and be in manufacturing, services, agriculture and construction. There’s heavy lobbying by trading businesses to get included.

The directive instructs banks not to base lending decisions solely on credit reports from CRIB. However, businesses need to submit credible business plans. They must also provide sufficient collateral. Banks must defer all legal action to recover unpaid debts or seize assets pledged as collateral. Non-performing borrowers can qualify if half the initial capital has been paid.

SME-Debt_chart-set-1

They will get their accrued penal interest rates waived, and the remaining loan balance rescheduled with interest repaid over twice the number of outstanding instalments, following a one-year grace period. They may also apply for working capital loans which the government will guarantee up to 75%. However, even small businesses harbour reservations.

Most don’t know how the scheme would work and what comes next after the moratorium ends in December 2020. The Central Bank had set a deadline of January 31st for SMEs to submit applications to their banks for the moratorium. This was extended to February 10th because many SMEs were not aware of the scheme. Small business associations appealed for more time. They asked the government to launch ad campaigns targeting small businesses and also set up a help desk and hotline. Day’s before the initial Jan 31st deadline, only a few SMEs had applied for the moratorium, bankers said. For one bank with a high SME exposure, less than half a per cent of its performing SME clients had applied; and as did only 1% of its non-performing SME clients.

A debt relief package announced after the devastating Easter attacks in 2019 also saw only half of eligible SMEs apply. “The poor uptake is due to two reasons. One is limited awareness. The second reason is the fact that we’ve already rescheduled most of these loans,” a banker said not wanting to be named. With credit growth falling in 2019, most banks had rescheduled existing loans more than they gave out new ones. “We had rescheduled close to 35% of our lending portfolio”. The scheme may not achieve too much, it is apparent.

FITCH SAID SME BORROWERS WILL FACE DIFFICULTIES REPAYING THEIR OBLIGATIONS TO BANKS ONCE THE MORATORIUM ENDS UNLESS THE ECONOMY RECOVERED.

The intention is clear: SMEs make up over 70% of Sri Lanka’s businesses, contributes 52% to gross domestic product and provides 45% of all employment. A stimulus to this segment could potentially uplift the economy, and win votes.

However, the moratorium will not be the primary driver of the revival. Accessing the moratorium could be hard. It is unclear if banks will disregard CRIB reports entirely, but businesses still need to submit credible business plans and provide collateral which the banks can refuse. There are also concerns about the medium-term impact on SMEs.

Issuing a rating outlook on January 29th, credit rating agency Fitch said SME borrowers will face difficulties repaying their obligations to banks once the moratorium ends unless the economy recovered.

“(We) expect GDP growth to pick up to 3.5% in 2020 from 2.8% in 2019, which should ease pressure on borrowers,” it said. Market analysts expect interest rates to rise from end-2020 which could compound repayment difficulties further; it is also unlikely banks will sustain the proposed concessionary rates reserved for their prime customers. The bankers, auditors and market analysts interviewed for this story had one thing in common: they all wore a wry smile on their faces when they discussed the moratorium’s likely impact on banks. Banks will benefit from the SME moratorium in several ways. For instance, a bank will earn an additional year of interest income from each SME borrower under the moratorium.

This is because while capital repayments get deferred for a year, SMEs will still have to pay interest monthly: miss one payment then they get knocked out of the scheme. Also, while banks will absorb the accrued penal interest on the bad debt, borrowers must pay interest for a period twice as long as the balance period on the loan.

SME-Debt_chart-set-2

With interest income intact, banks’ bottomlines will unlikely get hit.
Because the new scheme will disallow banks to pass resolutions to recover assets from non-performing SME borrowers, they can save up some expensive legal fees. Importantly, customers now disputing a bank’s possession of their assets may find it difficult to argue their case if they again find themselves in courts. Some business owners claim at court that they never signed the loan documents. They’d be walking into a trap by now applying for a moratorium. Banks remain the darling of Sri Lanka equity investors despite prohibitive taxes in the past, and now the SME debt moratorium. The removal of a 7% debt repayment levy and 2% Nations Building Tax will favourably impact profitability.

The benefit from these two tax cuts will be higher than any negative impact from the moratorium, market analysts said. Banks are also unlikely to experience a serious liquidity crunch. SME loans account for about 12% of total banking industry loans, according to the Central Bank. Banks will also benefit from economic growth, consumption and private sector credit picking up; as will the SMEs. There will be no liquidity crunch because of weak lending growth in 2019 and most banks having also piled up cash reserves from rights issues over the last year.

Liquidity to assets ratios, a measure of liquidity for banks, had increased from 20% to about 30% in the period as well. Trading at multiples of 0.6 times book value, the record low valuations are compelling reasons to invest in banking stocks. There’s still no clarity on how banks will provide for bad debts under the IFRS-9 accounting standard introduced in 2018. Then, banks’ profits took a hit due to higher provisioning but the oneoff adjustments were intended to make the banks more insulated from risk.

Now, however, while some bankers argue that the SME debt moratorium would reduce non-performing loans, others argue the classification would remain: a directive from the Central Bank is awaited. Banks will have a tough time managing loan books. Their core banking systems cannot be tweaked quickly enough to accurately reflect a loan scheme under the moratorium conditions. General ledgers have to be manually tracked.

“Monitoring these loans is going to be an operational nightmare,” one banker said.

An auditor shared another concern: banks have been known to reschedule loans just to understate non-performing loans, it was not easy for auditors to track these to ensure risk profiles were not compromised. We don’t know if the scheme will be a success. Assessing the impact now is futile with many variables to consider from economic growth, interest rates, to how many SME’s will apply for the moratorium and go on to realise new business opportunities and grow. The government is intent on its purpose. “This scheme was pushed on us,” a banker said.

“So we will have to report how well it’s doing. This means we may have to go before our SME customers and ask them to apply for the moratorium,” he said.

However, most others are confident the exercise is merely an elections ploy.