Branding Sri Lanka’s banking as high risk: Hurling charges not the best cure for healing

Differences of opinion are normal

It is not unusual for one to find instances where there is a difference of opinion as to how one sees oneself and how others see him. Such differences invariably lead to hurling charges at each other and even making counter-charges to prove that the original opinions expressed had all been wrong. Such angry reactions, though not uncommon, prevent one from finding cures to heal one’s ailments if they had been working stealthily within one’s system without showing any symptom.

The recent episode of Sri Lanka’s banking industry being branded as ‘high risk’ by the global rating agency, Standard and Poor’s, and the angry reaction of the authorities to that branding is a classic example of the existence of and reaction to such differences of opinion.

The Central Bank: “Sri Lanka’s financial system is stable and sound”

The Central Bank’s Financial System Stability Review, also known as FSSR, for 2011, released a few months ago, has categorically assured its readers, based on the information available to the Bank as at the time of writing, that the country’s financial system continued to remain “stable and resilient” in 2011 “sustained by strong domestic economic growth despite the increasingly turbulent global economic and financial environment.”

In a message to the FSSR, the Governor of the Bank has attributed several reasons for the strengthening of the overall soundness of the country’s financial system: “Growth in assets, higher capitalisation, adequate liquidity buffers, low risk levels and healthy earnings.”

In six chapters and seven box articles in FSSR, the Central Bank has argued cogently and assuredly that the country’s financial system is sound, without threats or risks and free from worries. The FSSR has used historical data to prove its point and even conducted some stress testing, a way to look at the system’s ability to withstand extremely hazardous events that might hit it unexpectedly.

The Central Bank: “The financial system is not overly stressed”

The methodology used and the results of stress testing for Sri Lanka have been reported by the Bank in Box Article 1 in FSSR. Accordingly, by using ten partial indicators covering such areas as money and bond market, foreign exchange market, stock market and the banking sector, the Bank has concluded that the stress levels which the system has faced in 2011 are not overly high and there is no need for worry.

The monthly movement of stress levels indicated, according to the Central Bank, negative stresses until October when they reversed to positive levels in the last two months, mainly due to the high volatility in the exchange rate in those two months.

Even then, the positive stress levels have been less than 1mark, meaning that they are insignificant and therefore manageable. For the first three months of 2012, the Bank has projected positive stress levels which are nearly zero and on the decline. Hence, as far as the Central Bank is concerned, there is nothing to worry since the financial system can take even most unexpected beats from the market and still come out of them unhurt.   

This is how Sri Lanka has seen itself: sound, resilient, low risk and growing.

Standard and Poor’s: Both the economy and the banking industry are at high risks

Within two months of the release of the assuring FSSR, Standard and Poor’s, by adopting a completely a different methodology, has come out with opposite conclusions. In its Banking Industry Country Risk Assessment or BICRA series which it does for individual countries, the rating agency has sounded the world community that Sri Lanka is high risk with respect to its economy as well as to its banking industry.

BICRA classifies a country to one of the ten groups from 1 to 10, one indicating the lowest risk and 10 the highest risk. Risks are assessed with respect to a country’s economic risks and banking industry risks. As it happens, both the economic risks and banking industry risks are positively correlated and therefore if a country is with low economic risks, its banking industry too has low industry risks.

Similarly, if its economic risks are high, so are its banking industry risks. Accordingly, if a country’s sovereign ratings are low exhibiting high economic risks as in the case of Sri Lanka, that country cannot expect to have a low risk banking industry, however well the domestic banking industry is being managed by its authorities.

Hence, according to BICRA methodology, for Sri Lanka to show a low risk banking industry, it should first upgrade its sovereign rating and show a low risk economy.

Ingredients of the Standard and Poor’s analysis

To assess a country’s economic risks, BICRA takes into account four basic factors relating to its economy.

1.The structure and the stability of the country’s economy

2.The flexibility of the macroeconomic policy pursued by the country’s central government

3.The actual or potential economic imbalances in the country

4.The credit risks of economic participants, namely, households and enterprises

For a country to show good marks with respect to its economy, it should pass all these tests.

With respect to the risks associated with a country’s banking industry, BICRA measures six basic factors relating to its banking industry.

1.The quality and effectiveness of banking regulations conducted by the country’s central bank

2.The track record of the country’s government and the central bank in reducing the vulnerability to financial crises

3.The competitive environment of the country’s banking industry

4.The banking industry’s risk appetite, structure and performance

5.The existence of possible distortions in the financial markets

6.The range and the stability of the funding options available to banks, including the role of the central bank and the government in providing such funding.

Though these criteria appear to be independent of the criteria in the country economic risk category, all of them have relevance to that category because if a country scores low marks relating to its banking industry, it should necessarily score low marks in the economic risk category as well.

Outsiders see Sri Lanka differently

The Standard and Poor’s has given very low marks to Sri Lanka on a majority of above criteria and as a result, Sri Lanka has been ranked very close to the highest risk category of the BICRA scale. Accordingly, Sri Lanka has been ranked at Category 8 in both the economic risk category and the banking system category though it has been ranked just one notch above at 7 with respect to banking industry category.

This is how outsiders have seen Sri Lanka: High risk in both the economy and the banking industry.

The official reaction to the high risk story    

Immediately after the press announcement relating to these rankings was made by the Standard and Poor’s, Sri Lanka’s Central Bank countered it by issuing two press releases, one on the general status of the banking system in the country and the other on the desirability of the investments made by the Employees Provident Fund, a fund managed by the Monetary Board of the Central Bank, in the banking and financial institutions supervised by the same Monetary Board.

In the first statement, while denying the claim that Sri Lanka’s banking industry is of high risk, the Central Bank has counter-charged that it has noted “with grave concern, a statement by Standard and Poor’s, issued yesterday, on the Sri Lankan Banking System and wishes to state that the statement is factually incorrect, illogically analysed, and is highly contradictory.” To prove its point, the Central Bank has quoted the historical data which it had also presented in FSSR for 2011.

The same numbers can be interpreted differently

The evidence for the soundness of Sri Lanka’s banking system comes, according to the Central Bank, from the growth in assets, deposits and loans and advances and the improvement of many financial ratios like capital adequacy, profitability, provisions for bad loans and non-performing loan ratios.

These historical numbers are good enough to show that there had not been a high risk in the country’s banking industry in the past. But, when looked at prospectively, the very same excessive growth in asset, deposit and credit bases of banks present room for potential instability and therefore, they carry high risks.

In fact, in the generic presentation of the partial stress indicators in Box Article 1 of FSSR for 2011, the Central Bank itself has admitted that a high growth in credit and high volatility in interest rates, exchange rate and maturity profile of investments favouring short maturity investments would increase stress levels of banks.

Hence, when looked at from a historical sense, the country’s banking system is sound and low risk. But when looked at from a futuristic sense, the very same indicators would point to the opposite. In my view, this is the cause for the dispute between the Central Bank and the Standard and Poor’s.

The Standard and Poor’s has adduced three reasons for categorising Sri Lanka’s economy as high risk: Poor economic resilience, high credit risks and growing economic imbalances. These three criteria, it appears, have been read by the rating agency from a point totally opposite to how they have been read by the Central Bank.

In the annual report as well as FSSR for 2011, the Central Bank had repeatedly maintained that Sri Lanka’s economy was both stable and resilient. It had an improved macroeconomic environment with single digit inflation, a properly managed external sector and an improving government budgetary position. Hence, even the economic imbalances that had tried to show themselves up due to an adverse external situation had been subdued by proper management of the economy.

Though private sector credit had increased, there were no signs of credit risks rising in the system as had been shown by the low non-performing loan ratios maintained by banks. Thus, according to the Central Bank, the economy was stable and so was the country’s banking industry.

Standard and Poor’s: Sri Lanka has poor resilience

But the rating agency’s assessment of economic resilience had come from a different source. It has used the per capita income that has marked Sri Lanka as a low income country, quite opposite to the Central Bank’s claim that it was a middle income country, and wide – spread inefficiencies throughout the economy, a factor which the Central Bank had not reckoned or accepted as prevalent.

Sri Lanka’s per capita income converted to US dollars by using an overvalued exchange rate had put the country at the lower middle income country category. However, when the per capita income is recalculated by using a corrected exchange rate, there is no appreciable growth in the per capita income from 2006 onwards. So, to the Standard and Poor’s, Sri Lanka is still a low income economy; but to the Central Bank, it is a middle income economy.

Economic resilience is not a historical fact but how a country would rise back after it would be hit by an unexpected disaster. Inefficiencies in an economy marked by wastage, corruption, policy inconsistencies, prohibitive rules and regulations, an unproductive public sector and continuously loss making public enterprises are crucial factors that determine the level of resilience of an economy.

While the Central Bank in its reports has not touched upon these issues, the rating agency, as it has admitted in its statement, has given a high weight to them. Thus, the two institutions have come up with two different readings.

Standard and Poor’s: Growing imbalances are potential threats    

As for the economic imbalances, the rating agency has once again read the numbers from a point opposite to the Central Bank. While the Central Bank has shown complacence about the growing external debt of the country and the rising borrowings of both the government and the private sectors, the rating agency has seen them as potential destabilising factors.

Hence, its assessment has been that Sri Lanka’s external position has reflected a “weak external liquidity and moderately high and increasing external debt.” The weak external liquidity has not been commented upon by the Central Bank in any of its reports.

The need for the government to borrow again and again to repay previous external debt, for the Central Bank to provide foreign exchange in increasing volumes to meet day to day foreign exchange requirements in the foreign exchange markets and low external inflows are not by any standard an improved external sector position. They therefore exhibit future external vulnerabilities.

A holistic assessment of credit risks

The assessment of the credit risks by the Standard and Poor’s has gone far beyond the type of analyses which one can expect from any official source in any part of the world. The official sources, including those of Sri Lanka, normally look at only narrow economic criteria when they make such analyses. However, for the rating agency, it is a composite of several factors that contribute to a high credit risk in Sri Lanka. These factors have included “moderate private sector debt in the context of low income levels, relaxed lending practices and underwriting standards, as well as a weak payment culture and rule of law.”

The rating agency further elaborates it as follows: “The use of cash flow analysis for underwriting is limited in Sri Lanka, and some exposures are concentrated. Moreover, risk management practices are evolving, in our view.”

Weak rule of law distorts credit culture        

The weak rule of law is not something which an official agency would like to point out in its analysis of credit risks in a country. What it means is that since laws are not applied equally to all the people, some creditors and debtors get favourable treatment from law enforcement agencies thereby weakening the credit culture of a country.

The rating agency has given credit to the Sri Lankan authorities for efficiently and effectively resolving the crisis that arose in the Ceylinco Group of financial institutions in mid to late 2009. Hence, it cannot be blamed for being blind to all the good factors that have contributed to the efficiency of the banking industry in the country.

However, this single contribution could not raise the country’s overall score and therefore Sri Lanka has been ranked at Group 8 of the BICRA Scale denoting high risk in both the economy and the banking industry.

Hence, hurling charges will not help Sri Lanka to heal its ailments. Instead, it should patiently revisit its status, as the Buddha had preached in the Brahmajaala Sutra in the Deegha Nikaya to monks who had got angry at others talking ills of the Buddha, and see whether there is scope for the country to improve itself.

(W.A. Wijewardena can be reached at [email protected] )