Foreign banks earn high risk-return reward

The foreign banks in Sri Lanka have consistently achieved higher returns, both in terms of total assets and risk-weighted assets, indicating that they are also able to earn a higher risk-return reward compared with the domestic banks.

This was revealed in a special report on foreign banks of Sri Lanka released by the Fitch Ratings.

The foreign banks have earned higher returns by generating larger net interest margins (NIMs) and earning higher levels of fee and commission income through their off-balance-sheet transactions. From a shareholder perspective, however, they have under-performed the sector.

Returns on equity fell below the sector average after 2005 due to the larger foreign banks padding up their capital bases in view of increased regulatory capital requirements and single and aggregate borrower limits.

On account of their better asset quality and higher levels of fee income, the foreign banks have continuously outperformed the sector and they registered an improvement in profitability in FY08.

The report also said the foreign banks carry a larger component of risk-weighted assets compared with their domestic counterparts. Risk-weighted assets to total assets were 88 percent at FYE08 for the foreign bank sector compared with 72 percent for the domestic private banks and 41 percent for the state banks.

This should not necessarily be viewed as an indication of riskier lending but rather an indication of the higher volumes of business generated through off-balance-sheet transactions, especially given the fact that the overall creditworthiness of obligors is relatively better in these banks.

Over 20 percent of assets used for credit risk weight computation for these banks (after credit conversion but before risk-weighting) are off-balance-sheet items compared with less than 10 percent for the domestic banks.

Credit growth trends among the observed sample of foreign banks have broadly been in line with the sector until FY07 (although growth rates appear more pronounced due to the smaller base). In 2007, the CBSL requested the banking sector to curb loan growth in order to reduce inflationary pressures; this together with banks’ concerns about credit quality resulted in a system wide slowdown in loan growth.

System loan growth continued to be flat in FY08, particularly in the final quarter, due to the secondary effects of the global financial crisis in the local market, followed by liquidity stresses in the domestic non-bank financial sector.

However, given that the larger foreign banks cater to a premium (less risky) client base, they have been less affected by the prevailing environment, and registered an increase in loan growth to 18 percent at FYE08 (FYE07: 10 percent).

Non-interest income has continued to be an important contributor to the total income of foreign banks, accounting for approximately a third of total income since 2006. However, this is somewhat lower than in previous years (35 percent in FY08 compared with 56 percent in FY03), when non-interest income was equally or more important than interest income.

This reflects the recent increases in the lending business of these banks, rather than a decrease in non-interest business. The split between interest and non-interest income is now more in line with the domestic bank sector.

The composition of non-interest income has changed in recent years, with the share of fees and commissions increasing to 62 percent of non-interest income in FY08 (FY03: 40 percent).