SL banking outlook remains negative - Moody’s

The outlook for the Sri Lankan banking system for the next 12-18 months remains negative, according to Moody’s Investor Service. 
“Disruptions caused by the coronavirus outbreak will exacerbate economic challenges for Sri Lanka, which in turn will pressure banks’ asset quality. Yet strong capitalization and liquidity, as a result of stringent regulatory requirements, will provide buffers against stress,” the rating agency said this week.
In the event that the coronavirus outbreak in Sri Lanka worsens and leads to a deeper, more prolonged economic slowdown, the credit-negative impact for banks will amplify.
Disruptions from the coronavirus outbreak will worsen Sri Lanka’s economic challenges. Tourism-dependent Sri Lanka is taking a hit from the coronavirus outbreak as it still reels from the 2019 Easter Sunday terrorist attack. The country’s export-oriented ready-made garment industry is suffering from order cancellations and deferments due to lockdowns in key export markets, including the US and Europe. At the same time, Sri Lanka's own lockdown is reducing domestic economic activity. Further, domestic dollar liquidity remains vulnerable to tightening external financing conditions.
Asset quality will deteriorate further, but loan restructuring and moratoriums will cushion near-term impact. The financial health of borrowers across a wide range of segments will deteriorate, with small and medium enterprises (SMEs) being particularly vulnerable because they tend to have weak liquidity. Banks are also facing increasing asset risks from their concentrated exposures to domestic conglomerates. While loan moratoriums and restructuring will provide temporary relief, they could raise risks for banks in the longer term, especially in the event of a prolonged outbreak.
Capitalization will be stable despite an easing of regulatory capital requirements. In March, regulators reduced the capital conservation buffer by 100 basis points for domestic systemically important banks and by 50 basis points for the others from 2.5 per cent.
The move was to encourage banks to boost lending but we do not expect capital ratios to decline much because credit demand will remain weak, offsetting a deterioration of internal capital generation. This means banks' regulatory capital ratios will stay well above minimum requirements, providing buffers against unexpected losses.
Profitability will weaken further: Net interest margins will decline as a result of regulatory reductions in lending rates, slower loan growth and increases in loans that are restructured or under moratoriums. A deterioration of asset quality will also lead to increases in credit costs, although regulatory forbearance will mitigate the impact. A reduction in the corporate income tax and the removal of some other taxes, including a debt repayment levy, will ease some pressure on profitability.
Funding and liquidity will be stable: Deposit growth will keep pace with loan growth as credit demand weakens. Furthermore, banks hold large amounts of liquid assets due to stringent liquidity requirements. At the same time, domestic dollar liquidity could tighten due to capital outflows.
Government’s capacity to support the banks will weaken: The government’s debt burden will increase amid tightening financial conditions and weak economic growth, while unprofitable state-owned enterprises will continue to pose large contingent liabilities to the sovereign (country).