Increased liquidity pressure on Lankan finance companies

If weak macro conditions persist

Fitch Ratings has today commented that challenges to liquidity in the Sri Lankan Registered Finance Company (RFC) sector could arise if the weak macroeconomic environment continues.

The sector Outlook is Stable to Negative, reflecting the agency’s view that the ratings of well capitalised RFCs with an established franchise should remain unchanged in the short to medium term - i.e. they should be better able to weather the current weak macroeconomic conditions.

However, some negative rating actions could be expected on the smaller RFCs with weak deposit franchises and low support elements if the high inflationary, high interest rate environment were to persist, with liquidity increasingly becoming a challenge.

Fitch notes that whilst RFCs are currently meeting the statutory minimum liquid ratio of 15% as imposed by the Central Bank of Sri Lanka (CBSL), maintaining liquidity could become a challenge in a scenario where deposit growth slows or contracts, and asset quality weakens substantially over a short time horizon. Rising interest rates since the latter part of 2006 coupled with inflationary pressures has impacted credit quality in the sector, with its client base coming mostly from the relatively riskier market segment lying beyond the risk appetite of commercial banks.

This is depicted by rising delinquencies over the period with the gross NPL ratio rising to 13.8% at end-June 2008 (Q109) from 11.5% at end-March 2007 (FYE07). The RFCs’ loan book primarily consists of leases and hire purchase for the financing of relatively lower-value commercial vehicles.

Fitch observes that deteriorating asset quality is exacerbated by the challenge of fully recovering dues on the sale of foreclosed assets, owing to a declining demand for vehicles in tandem with falling profitability throughout the economy.

In addition to credit risk, RFCs are subject to significant market risk, as fixed rate vehicle leases and hire purchase agreements with average tenures of five-years are primarily funded by customer deposits which mature in one-year or less.

Deposits, which accounted for 63% of the RFC funding base at Q109, are benchmarked against deposit rates of private licensed commercial banks (LCBs). RFC rates on one-year fixed deposits are restricted to the CBSL cap which was imposed in 2005 at 3% above the preceding quarter’s weighted average 364 day Treasury Bill (T-Bill) rate.

Fitch observes that the gap between the CBSL cap, the average RFC one-year fixed deposit rate and the average private LCB one-year fixed deposit rate has progressively narrowed during the latter part of 2006 and early part of 2007 as commercial banks scrambled for growth and liquidity.

However, since then the gap between RFC rates and private LCB rates has significantly widened, and RFC rates have moved close to the CBSL cap as they continued to grow in a period of high inflation and high interest rates, while LCBs have correspondingly eased off on growth.

The increasing premium on RFC rates over commercial bank rates is indicative of increased liquidity requirements within the sector as a result of their continuing growth and rising credit costs.

Effective from 1 April 2008, the CBSL reduced the ceiling on a one-year fixed deposit to 2% above the 364 day T-Bill rate. Fitch observes that the probable intention of the reduction was to mitigate aggressive growth in the current environment, and thereby minimise rising systemic risk in the RFC sector.

However, whilst some RFCs are recognising this and are curtailing growth, Fitch observes significant growth in a number of RFCs.

This could be detrimental as the credit profile of these companies could deteriorate if the current economic climate were to persist. In such a scenario, improving liquidity by way of deposit mobilisation could become a challenge.

Furthermore, Fitch notes that whilst the larger established RFCs are able to minimise re-financing risk as they continue to have access to institutional funding, most commercial banks have made policy decisions to curtail growth to the large majority of this sector; therefore short-term liquidity relief and refinancing of borrowings would be an increasing challenge to a number of the smaller companies.