Trust underlies any financial system. Banks and other deposit-taking institutions, like finance companies, depend on deposits and to a lesser extent debt to fund their business. Only around 10% of their business is funded by shareholder money. Depositors, and lenders, must have the confidence their savings and loans are safe and will be paid back with interest at the agreed time. If anything undermines confidence in a financial institution, it will soon find itself in a liquidity crunch as lenders and depositors try to get their money out. If a large bank, a finance company, or several financial firms at once, find themselves in such a crisis the regulator and the government may have to step in to prevent contagion. If a crisis were allowed to snowball the financial system may convulse depositors and lenders demand their money back at the same time.
Because of scale advantages and the high level of capital they are required to have, banks and large finance companies have so far weathered the Coronavirus related shocks, where customers were granted moratoriums on loan repayments. However the crippling economic conditions, falling demand for credit and a looming deadline for finance companies to boost their minimum capital in combination pose an unprecedented challenge for mid-sized and small finance companies that analysts say have few solutions. For most small and medium sized finance companies, navigating out of this crisis will leave their shareholders impacted in two ways. First, many finance companies are forecast to lose money in 2020 and 2021 which erodes their capital. Second those that raise new capital will have to do so at much lower valuations than were possible a few years ago, diluting their current shareholders by a greater percentage. Many will be impacted by both these factors. Currently Sri Lanka has 44 Non bank financial institutions (NBFI’s). Of these 41 are Licensed finance companies (LFCs). NBFIs also include three specialised leasing companies (SLCs), which do not raise public deposits. For the purposes of this story Echelon is discussing the impact on LFCs which we refer to as ‘finance companies’.
Sri Lanka has a history of finance company failures. During 1988 to 1990, 13 registered finance companies failed. In 2002 a savings bank called Pramuka Bank went bust. In 2009 eight Ceylinco group related companies had liquidity problems when Golden Key, an illegal Ceylinco owned deposit taking firm collapsed. In May 2020, the regulator cancelled the license of The Finance Company, one of the firms previously controlled by Ceylinco. In 2013 CIFL, another finance company, collapsed. In July 2020 the finance company regulator, the Central Bank, suspended operations of ETI Finance and Swarnamahal Financial Services, because the two firms were insolvent due to ‘various irregularities,’ the central bank said.
None of these finance company failures were exclusively due to difficult economic conditions. They were due to a combination of bad governance, weak internal controls, fraud, poor management and weak regulatory oversight. Over the last decade however, the regulator has taken several steps including improving oversight, requiring companies to have more capital commensurate with their risks, and encouraging consolidation within the sector. However, the recession in 2020, forecast by the central bank, casts an ominous shadow over the future of the weakest finance companies and is threatening to set back the rest of the sector’s financial health significantly. Finance companies exist because commercial banks, which provide over 85% of the loans in Sri Lanka, don’t service a segment they estimate are too risky, costly and beyond their ability to evaluate and risk manage. The future of any business is tied to the prosperity of the customers it serves.
Low economic growth since 2012 has disproportionately impacted Sri Lanka’s small and medium sized enterprises (SMEs). In 2019 SMEs’ contribution to the economy shrank after a seven year run of poor growth. The lockdown due to the coronavirus pandemic is forecast to impact SMEs the hardest, shrinking the sector’s GDP contribution further in 2020. (See chart 1)
Finance companies are not all the same. Ten finance companies, LOLC Finance, People’s Leasing and Finance, Central Finance, L B Finance, Citizens Development Business Finance (CDB), Commercial Credit and Finance, Commercial Leasing and Finance, Vallibel Finance, Mercantile Investment and Finance and Siyapatha Finance, are all listed companies controlling Rs1 trillion, or 70% of the Rs1.4 trillion total assets in the sector. The largest finance companies are bigger than some commercial banks.
The other 31 finance companies control just 30% of the assets and many of them will be short of resources to weather the recession, its impact on small businesses and the fallout. Because they are in the fringes of the economy SMEs are considered subprime borrowers – defined as persons or organisations with a low credit score. Sometimes SMEs get a bad rap as greedy and irresponsible but that’s often not the case. Even prime borrowers go to the subprime sector when they are unwilling to share detailed financial information, seek a larger facility than a bank would grant or are offering a low down-payment. A borrower can be a prime and subprime borrower at the same time or at various times in an economic cycle. A mortgage borrower from a bank might obtain a car lease from a finance company because the bank wouldn’t lend any more money. Finance companies mostly lend to SMEs, or the subprime sector. And the shrinking of the sector had an impact on finance companies in 2019, when their outstanding loans shrunk by 3%. Overall credit grew by 4% in 2019, far lower than than the growth in nominal GDP. (See chart 2) Finance and leasing company bad loans are now rising. By the second quarter of 2020 they had reached 14% of total lending, but in many small firms dud loans are much higher. In five companies, dud loans range from 15.5% to 41.8% and these exclude finance companies where the regulator has withdrawn the license or suspended operations. (See chart 3) Non-performing loans are often rescheduled after a new agreement with a borrower having trouble keeping up with payments. Commercial banks apply international accounting rules to classify non-performing loans which are far more robust than the 50% loan loss provision applied when a loan is six months overdue and 100% provision for a year without payments, applied in finance companies. In addition to impacting profit, large non-performing loan provisions erode capital, increase the cost of new capital and leads to credit downgrades. Shareholders irked at a stock price decline may demand directors and management be replaced. The turn in fortunes for finance companies were dramatic. Finance companies were growing credit at almost double the rate at which bank credit was growing. In 2013 finance company loans grew 17.3% compared to 8.8% growth at banks and in 2014 loan growth topped 16% compared to 13% at banks.
Sri Lanka’s banking system is now flush with cash after the pandemic stuck as companies are deleveraging and the central bank has pumped liquidity into the system. Good lending opportunities have become dearer for banks too. The stagnation of opportunities due to the crippled economy is the first of three challenges facing finance companies.
subprime borrowers are the most likely to default on loans during downturns because they tend to have much less equity invested. When asset prices fall borrowers walk away from loans with an outstanding greater than underlying assets’ worth. This was demonstrated when led by the global gold price decline finance company dud loans increased by 20% in 2014 when borrowers abandoned gold backed loans. ‘High lending rates and the gold price fluctuation affected pawning (gold backed loans)’, the Central Bank’s 2014 annual report revealed. The fact that finance company loans are mostly asset backed can also lead to a false sense of security. Liquidity is fickle and the excessive confidence can blindside a firm to their excesses. The sector’s regulator has warned in the past that firms are operating with very high short-term assets and liability mismatches. The assets are leases and loans. (See chart 4)
The share of loans and leases in the finance company portfolio now account for 94% of lending. Unlike banks, finance companies cannot seize defaulters’ securities pledged to obtain a loan without court sanction (unless it’s a lease or higher purchase lending). Obtaining a legal order is a lengthy, costly and onerous process. Banks have access to Parate rights which allows them to seize and auction defaulters’ securities. That’s a challenge for the loans portfolio. For leases the challenge is different. Resulting from the pandemic, the suspension of vehicle imports is expected to halve the number of vehicle registrations in 2020 to a 17-year low. At a time when banks are also flush with cash, finance companies will struggle to lend for vehicles which now account for 53% of loans. Politicians and bureaucrats have suggested that the suspension of vehicle imports will last for one year, or two. The struggle for credit growth in a contract market or one where the few opportunities are grabbed by the banks, or large finance companies, is the second challenge. In the financial year ending 2020 finance companies posted their third straight year of falling profits. (See chart 5)
The challenges will have an impact on the smaller finance companies. Currently nine percent of deposit taking institutions’ assets in Sri Lanka are held by finance companies. First Capital, an investment bank, recently published an analysis of the sector where they forecast market share to shrink to 6%. First Capital only covers 31 listed finance companies. Nine finance companies are not listed at the stock exchange. It also forecasts that in the financial year 2021, finance companies will make total losses of Rs29 billion. In 2019 they made a profit of Rs21 billion and in 2020 a profit of Rs13 billion. The scale of the loss forecast by First Capital in 2021, if realised, will wipe out 85% of the profits made in the two years prior.
The third challenge for the sector is the looming deadline from the regulator to increase their minimum capital in compliance with a new capital adequacy framework introduced in 2018. Effected from July 2018, the capital framework requires finance companies to have a minimum Rs2.5 billion tier one capital (comprising share capital, share premium and retained earnings). The large finance companies are unaffected by the new capital rules as they already meet the requirements. First Capital’s research team estimates that 12 of the largest listed finance companies of the 31 listed won’t be affected. Due to impacts of the pandemic, the regulator has granted a year more than earlier planned for the industry. Deadlines have been extended until July 2021. The capital rules are similar but the required amounts of capital differ depending if a finance company with assets more than Rs100 billion or not. First Capital estimates that finance companies must raise Rs11 billion in additional capital by end 2020 and a total Rs20 billion by 2021 (incling the amounts raised in 2020) to comply with the capital adequacy requirements.
The murkiness and the risks seem to have alarmed the regulator. Since 2014 it has been proposing consolidation in the finance company sector to reduce the number of firms and create larger and better capitalized ones. Already Abans Finance has announced a merger with Softlogic Finance, Associated Motor Finance has announced a merger with Arpico Finance and Commercial Credit and Finance will merge with Trade Finance and Investments. In the past, faced with rising dud loans and tightening margins, owners and managers will gamble for salvation, taking even greater risks and speculative bets. They will conceal non-performing loans in the expectation that the prices of assets backing them will somehow recover, that these loans can somehow be packaged as a security and sold or in the expectation the financial firm itself can be sold while the muck remains hidden. No longer are finance companies this delusional. The scale of the challenge can pose a significant systemic risk for the financial sector.
The crippling economic conditions, contracting credit and a looming deadline to increase core capital suggested those old ways would not suffice. Nevertheless the scale of the challenge remains daunting.