Wednesday, June 27, 2012

Why does S&P classify the Sri Lankan banking sector as 'high risk'

The ratings agency Standard & Poor's has issued a report that says the Sri Lankan banking sector faces high economic, credit and regulatory risks. The Central Bank was quick to issue a rebuttal but what is the report all about and should it concern the public?

The report details the risks the SL banking industry faces in comparison with that of the banking sector in other countries. It is important to note that the major  issues stem from the institutional framework and regulatory conflicts. It does not look at individual institutions but looks at risks the sector as whole faces.

The problems identified have to do with bank regulators (Central Bank) , the system of justice and broad macro economic policy. These will impact on the sector as a whole, although some banks will be more affected than others, depending on specific circumstances, such as the quality of their loans and internal control systems.

The issues highlighted will have long term detrimental impact, my guess is probably over a 2-5 year horizon. This gives time for corrective action, if regulators are interested. There has been no sudden deterioration in the banking system, the issues highlighted have been building up over the past 5 years.  

The report, is in my opinion,  of relevance for long term investors, particularly foreign investors. For local investors/companies, in my opinion,  there is not much that can be done except that investment horizons should be shortened (look for 2-3 year paybacks) and minimise dealings with more vulnerable entities. 

Pertinent comments in the report are:

"Nevertheless, in our view, Sri Lanka's economic imbalances could increase if credit growth continues at the current pace."

Banking sector credit is still growing quite fast, the main drivers being construction projects by the Government as well as private sector projects. This will keep the rupee under pressure and may push inflation and the budget deficit.

"relaxed lending practices and underwriting standards, as well as a weak payment culture and rule of law."

The relaxed lending practices is a relative term, it is not clear if this relates more to state banks or private sector banks. Credit evaluation is not standardised and the level of credit information is low, so evaluation, especially of personal loans cannot be as sophisticated as that in developed markets. 

The rule of law is a concern due to the inefficiency of the court system and the increased susceptibility to corruption and influence which means enforcing contracts, mortgages etc is difficult, time consuming and expensive. The GoSL repudiation on the oil hedging contract is an example of an issue that has raised this red flag amongst rating firms, banks and investors.

"We view the banking regulations in Sri Lanka as somewhat weaker than international standards. Governance and transparency of banks are weak by global standards."

"The key regulations for banks seem sufficient. However, finance companies are less regulated, in our view. This is despite the December 2008 collapse of a finance company triggering a run on a bank in that group."

"Moreover, we see a potential conflict of interest in the central bank's role. In addition to policy formulation and supervision of banks, the monetary board of the central bank also oversees Employees' Provident Fund investments. The fund is a large investor in Sri Lankan banking stocks."

Largely self explanatory, comments refer mostly to certain state banks and the recent interference in private banks, eg through the removal and appointment of directors, the EPF/ETF/SLIC using their shareholdings to remove experienced bankers and nominate unqualified state nominees. 

Finance companies are vulnerable due to high concentration of loans to certain asset classes (eg pawning, land and vehicles) and rapid growth in credit  in an environment of rising interest rates. Exposure to share market is also problematic since share prices have been falling.

How is this relevant to the public?

It is a broad macro level report. For the public in general the main issue is where they should invest their money. Remember Ceylinco? Could it happen again?

In my opinion there are several finance companies that look distinctly shaky, so be careful where you invest your money. Only invest in the ones that are listed by the Central Bank. Even amongst the regulated ones, some are better than others, so read the rating report (all are supposed to be rated) and go for the ones that have higher (A or BB) ratings. There is no point trying to get higher interest rates if one risks losing the capital invested.

For investors and businessmen it is a message that governance matters. Many have been pooh poohing the impact of corruption and have not noticed a deterioration in the rule of law. If the systems don't work, one cannot rely on the law to protect ones investment.  If you get into difficulties there is little hope unless one has influential friends. Some have discovered this the hard way.

Liberal economics and governance tend to go hand in hand with liberal politics. When one is lacking, it tends to show up in one of the others.

For those interested, the methodology behind the S&P assessment is detailed here.

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