CB must balance financial stability and credit growth: ICRA Lanka

• Warns reducing policy rates beyond certain point will not expand credit growth as banks have limited risk appetite
• Points out banks were under pressure well before COVID-19
• Calls for fiscal support in COVID-19 recovery process
• Outcomes of multiple CB rate cuts could lead to currency pressure, money printing to pay SDF interest to banks 
• Says credit guarantee scheme good but success depends on banks recovering loans in timely manner 
• Cautions of depositors moving away from banks increasing funding costs in the long term 
• Projects 2Q recession of 4.5% 

Ratings agency ICRA Lanka yesterday called on the Central Bank (CBSL) to strike a balance between financial system stability and credit growth warning that reduction of policy rates beyond a certain point may not expand credit growth as targeted by the Government because banks have limited risk appetite. 

Releasing a new report on the CBSL’s COVID-19 crisis response titled ‘Finding balance between financial sector stability and credit growth’, ICRA Lanka, which is part of Moody’s Investor Services, acknowledged steady credit flow to the real economy is imperative for the post-COVID19 recovery. But it noted that in order to facilitate this, the CBSL needs to ensure financial institutes have both the capacity and the willingness to lend. 

The report points out that financial institutions were on a weaker footing even before the COVID-19 crisis due to the Basel III capitalisation requirements, the deterioration in asset quality, and dwindling profitability due to macro factors. Therefore, the risk appetite of financial institutes was at the moment is low, it warned.

“The reduction in policy interest rates beyond a certain point may not generate appreciable expansion in credit in the economy as the financial institutes’ risk appetite would not improve in a state of crisis. The credit guarantee scheme is a step in the right direction to improve the risk appetite but its success depends on whether the banks can recover the value of the guarantee in a timely manner in case of defaults,” the report said. 

The rating agency also pointed out the net outcome of the CBSL’s actions have far more intricate dynamics and risk implications for the system therefore, looking forward, it is important to strike a balance between financial stability and credit growth. 

“In the current context, non-monetary measures should also play a pivotal role in spurring economic growth which will in return lead to a healthier credit expansion.” 

The financial sector in Sri Lanka is under heavy pressure as the country was brought to a standstill due to the COVID-19 pandemic. As the country limps back, the economy is expected to contract with ICRA Lanka forecasts Q2 growth to record a 4.5% recession.

With a view of facilitating speedier economic recovery, the CBSL has taken a number of steps to increase credit flow to the economy by enhancing the liquidity in the banking and the financial sector. While noting the timely actions and the need to act swiftly given the severity of the challenges faced by the economy, ICRA Lanka believed maintaining the soundness of the financial system is of paramount importance to long-term economic stability. 

Broadly speaking, the key objectives behind the CBSL’s COVID-19 response so far are; to provide relief to the affected individuals and businesses, to ensure the Financial Institutions (FIs) have adequate liquidity to stay afloat through the crisis, and to encourage FIs to extend credit to the real economy during the crisis. To achieve the aforementioned objectives, the CBSL has implemented several initiatives; reduced its policy rates historical lows, released part of capital and liquidity buffers built up overtime as a result of the adoption of Basel III, relaxed administrative and supervisory compliance requirements for FIs, and implemented a debt moratorium and credit schemes to support COVID-affected businesses and individuals.

As a result of the rate cuts and release of buffers, the money market liquidity shot up driving the short-term interest rates down. The idea behind this is to make cheaper wholesale funding available for FIs, so that the interest margins are enticing enough to cover the risk. However, as the crisis deepens, the risk premium will overshadow the interest rate cuts and ultimately, it would come to a stage where the rate cuts would not have any effect on the lending as FIs’ implicit risk premium is far greater than what the borrowers are willing to pay for. As pointed out earlier, Sri Lankan financial sector was already on a weaker footing before the crisis, hence FIs, especially the banks would be cautious when lending. Therefore, the reduction in interest rates beyond this point may not generate appreciable expansion in credit in the economy, as the FIs’ risk appetite would not improve in a state of crisis. 

“The reduction in interest rates has several implications on the balance sheets of the FIs. With the real interest on savings eroding, we expect the deposit base of the banks and LFCs to shrink in the medium to long term resulting in an increase in funding cost.” 

Heavy-handed credit expansion inevitably leads to build-up of excessive credit risks and inefficient allocation of funds. It could help ‘bad borrowers’ (i.e. individuals or companies which have had poor financial standing even before the crisis) to prolong their survival. Low interest rates may also attract individuals who do not have a genuine requirement (reckless investors/speculators) to borrow. Given the recent relaxation of macro-prudential requirements, these trends could increase the credit risk for the system.

Risk-based capital adequacy frameworks and higher minimum capital levels were introduced recently to ensure proper risk priced lending by banks and leasing/finance companies to ensure systemic stability. With the CBSL lowering the capital requirement these efforts are now being nullified. With relatively smaller capital base, now the FIs can operate with higher leverage. This could increase the vulnerability of the financial system if the credit expands rapidly. 

With real interest rates falling to lower single digit levels, the quest for yield will be on. This could drive individuals and companies to take riskier investment positions. The repercussions of such an event can be devastating on the faltering economy as seen from the past events.

In addition, the CBSL has relaxed various supervisory requirements, collateral eligibility, and asset eligibility to provide banks with greater flexibility in supporting lending. However, these steps increase the vulnerability of the system and delay recognition of issues.

“Currently, the excess liquidity level is significantly greater than the pre-crisis levels. If high surplus liquidity level persists for a long time, it would end up permanently in the Special Deposit Facility (SDF), and the CBSL would have to print money to pay interest on the SDF deposits in the process fuelling more liquidity. Build-up of excess liquidity puts pressure on the rupee to depreciate as well. This will be a major obstacle to attract foreign investment to debt and equity markets to build much needed forex reserves for the country,” ICRA Lanka warned.