Rising risk of Sri Lankan banks defaulting on their obligations: S&P

This trend is expected to persist until the Sri Lanka's external situation stabilises, which may take time, S&P said in a statement

There is a rising risk of Sri Lankan banks defaulting on their obligations, especially those in foreign currency, including deposits and trade finance products, rating agency Standard & Poor's said on Friday.

This trend is expected to persist until the sovereign's external situation stabilises, which may take time, S&P said in a statement.

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The rating agency considers an entity to have defaulted if it doesn't make payments on its obligations within five business days of the due date, in the absence of a stated grace period.

Forex liquidity risk remains high

The operating conditions for Sri Lankan financial institutions will likely remain weak over the next 12 months. After the sovereign default, banks are facing extremely high liquidity risk. There is a loss of appetite in international markets for Sri Lankan debt, leading to lower rollovers.

The rating agency said that despite a decline in the proportion of foreign currency liabilities, the banking system's forex liabilities are material at about 20 per cent of total liabilities. Sri Lankan banks have limited access to cross-border funding.

The interbank market seems to have completely dried up. Few banks are understood to have delayed payment on their forex obligations due to foreign currency shortage. External funding for the Sri Lankan banking system will likely continue to shrink for the next few months.

Domestic depositors' confidence could be tested

Core customer in local currency deposits, the main source of funding for Sri Lankan banks, have so far been stable, reflecting depositors' confidence.

Growth in domestic deposits has remained positive, despite the rate slowing in the fourth quarter of 2021 to an annualized growth of 10 per cent. The rate has further reduced this year.

"We expect domestic deposits to continue to inch-up, in part due to a lack of alternative investment options and the absence of capital account convertibility in Sri Lanka", rating agency said.

Credit risk remains high for banks

Subdued economic activity in Sri Lanka, political uncertainty, and weak external and fiscal performance could hurt banks.

Weak operating conditions are already increasing credit risks for Sri Lanka's banks. The banking system's stage-3 loans were high at 7.6 per cent as of December 31, 2021. Additionally, about 6 per cent of the loans were under moratorium. The reported non-performing loans (NPLs) at 4.5 per cent of total loans were low relative to the stage 3 loans.

"We believe the NPL ratio figure understates the true asset quality of the banking system. The lower ratio is mainly due to the moratorium and other concessions granted on repayment of loans due to the Covid-19 pandemic", S&P added.