Fitch issues fresh warning on Lankan banks

• Says risks may rise with lifting of restriction on ISB investments
• Foreign currency borrowings declined to Rs. 881 b by end-1Q21, from Rs. 984 b at end-2019, accounting for 5.8% of sector assets
• Banks main investors in SLDBs but their holdings of these securities declined 15% in 2020 to Rs. 448 b
• Take-up in SLDBs by banks has been less than higher-yielding ISBs
• CBSL requires banks to adopt risk mitigation measures to bridge possible maturity mismatches
• Fitch expects Lankan banks to continue to face difficulties in accessing FX funding due to sovereign's low credit rating

Fitch Ratings yesterday warned that the end of the suspension on Sri Lankan banks' investments in International Sovereign Bonds (ISBs) had the potential to increase banks' exposure to sovereign and foreign-currency funding and liquidity risks.

Banks' credit profiles are already significantly exposed to the sovereign, with Fitch-rated Sri Lankan banks having about a third of their combined assets exposed to the Central Government at end-2020. In addition, they face foreign-currency risks, including through their US Dollar-denominated ISB investments.

The Central Bank on 16 June revoked the previous indefinite suspension on investments in ISBs by banks. Sri Lankan banks had invested heavily in ISBs, which prompted the CBSL to halt investments in ISBs by banks from December 2020, due to concerns about the pressure on the domestic foreign-exchange market through dollar outflows. 

CBSL now permits banks to purchase ISBs in the secondary market, provided this investment is funded by fresh overseas borrowings.

The directive requires banks to adopt risk mitigation measures to bridge maturity mismatches that could arise. Fitch expects Sri Lankan banks to continue to face difficulties in accessing foreign currency funding due to the sovereign's low credit rating. 

Foreign currency borrowings declined to Rs. 881 billion by end-1Q21, from Rs. 984 billion at end-2019, accounting for 5.8% of sector assets. Fitch also said refinancing needs remained high as short-term loans made up around 63% of the banking system's external debt at end-2020.

Fitch opined the latest directive stipulated that fresh offshore borrowings sourced to buy foreign currency government securities have to be invested in both ISBs and Sri Lanka Development Bonds (SLDBs) in equal proportion, and as such would also contribute to increased investments in SLDBs by banks. 

Banks are the main investors in SLDBs, but their holdings of these securities declined 15% in 2020 to Rs. 448 billion. Take-up in SLDBs by banks has been less than the higher-yielding ISBs, which are listed and more widely held. There are no limits on banks' subscription to SLDB issuances.

Fitch-rated Sri Lankan banks' investments in ISBs and SLDBs accounted for 6.4% of their assets at end-2020. The extent of incremental investments in ISBs and SLDBs by banks remains to be seen, but Fitch expects the banks to add only a limited amount of ISBs and SLDBs. This is due to the lower appetite of some banks to add to their exposure to foreign currency government securities and potential funding access challenges.

Fitch said the risks to banks from their holdings of foreign currency government securities were exacerbated by recent measures that had reduced minimum buffers, such as a reduction in the risk weights on foreign-currency claims on the Government held by banks to 10% in 2021 from 20%, and cut in the loss-given-default rates to 10% from 20% when computing expected losses in 2021.

Fitch said the 'CCC' rating on Sri Lanka reflected the sovereign's challenging foreign-currency external debt repayment burden over the medium term, low foreign-exchange reserves, and high and rising government debt that gives rise to sustainability risks. 

Sri Lankan banks’ ratings continued to remain constrained by the sovereign credit profile, it added.