ECONOMYNEXT – A proposal in Sri Lanka’s budget for 2021 to merger finance and leasing companies with their parents will result in customers with a higher risk profile being denied credit, Fitch Ratings said.

“FLCs typically cater to sub-prime customers, which banks have very little appetite for,” the rating agency said.

“However, if the proposed mergers are enforced, we expect the risk appetite of the amalgamated bank to be lower than the simple aggregated risk appetite of the parent and the FLC subsidiary, as the FLC business is unlikely to be a core business line for the parent.”

In a re-organization of finance companies, banks bought some of the best capitalized finance companies.

As a separate entity, finance company subsidiaries could also pay slightly higher rate of interest.

Fitch said ratings of banks which merge with their subsidiaries are unlikely to be affected in the short term as the risks of the subsidiary were already factored in.

“However, the extent of the impact of absorbed FLCs on banks’ business models and their consolidated risk and financial metrics, particularly asset quality and profitability, will be important for the banks’ ratings in the medium term,” Fitch said.

“We believe banks will be reluctant to absorb their FLCs due to the significant difference between their risk profiles and underwriting practices, leading to elevated challenges in achieving effective management.”

Sri Lanka however has a large number of deposit taking finance companies, which are small and are less able to absorb shocks, though two of the biggest in the sector have also failed, partly due to regulatory forbearance and the lack of a mandatory resolution framework based on capital thresholds, analysts say.

Sri Lanka has seen higher levels of monetary instability and output shocks under a so-called ‘flexible inflation targeting’ regime, where consumption falls after each currency collapse, led to spikes in bad loans.

Two currency crises came quickly on top of each other (2015 and 2018) after Sri Lanka’s soft-pegged central bank dropped its policy rate band in favour of targeting a call money rate, as it also targeted a perceived output gap, critics have said.

“The sector continues to struggle with lack of access to capital, muted income generation and very weak asset quality despite the regulatory moratoriums for stressed loans,” Fitch said.

Fitch said the fragmentation at the lower end – where 33 FLCs, out of the total 44, accounted for only around 31 pecnt of sector assets – have posed challenges to Sri Lankan financial-sector stability, despite the sector’s moderate 8 percent share of financial-sector assets at end-2019.

The full statement is reproduced below

Sri Lankan Banks’ Ratings Unaffected by Proposed FLC Mergers

Mon 23 Nov, 2020 – 3:09 AM ET

Fitch Ratings-Colombo-23 November 2020: The mergers of Sri Lankan finance and leasing company (FLC) subsidiaries with their parent banks will not have an immediate impact on the banks’ ratings, says Fitch Ratings.

The agency’s assessment of our rated banks is based on their consolidated credit profiles and already factors in the risks of having subsidiary FLCs.

However, the extent of the impact of absorbed FLCs on banks’ business models and their consolidated risk and financial metrics, particularly asset quality and profitability, will be important for the banks’ ratings in the medium term. The proposal was announced in the government’s budget speech for 2021.

We believe banks will be reluctant to absorb their FLCs due to the significant difference between their risk profiles and underwriting practices, leading to elevated challenges in achieving effective management.

FLCs typically cater to sub-prime customers, which banks have very little appetite for. However, if the proposed mergers are enforced, we expect the risk appetite of the amalgamated bank to be lower than the simple aggregated risk appetite of the parent and the FLC subsidiary, as the FLC business is unlikely to be a core business line for the parent.

The proposal affects five Fitch-rated banks with FLC subsidiaries – Hatton National Bank PLC (AA+(lka)/Negative), which owns HNB Finance Limited (AA-(lka)/Negative), Commercial Bank of Ceylon PLC (AA+(lka)/Negative), which owns Serendib Finance Limited (AA-(lka)/Negative), Sampath Bank PLC (AA-(lka)/Stable), which owns Siyapatha Finance PLC (A(lka)/Stable), Bank of Ceylon (AA+(lka)/Negative), which owns Merchant Bank of Sri Lanka & Finance PLC, and People’s Bank (Sri Lanka) (AA+(lka)/Negative), which owns People’s Leasing & Finance PLC (A+(lka)/Stable).

These subsidiaries’ assets account for 0.5%-7.7% of their group assets (median: 3%) and 0.5%-26% of profit before tax (median: 5%).

The government’s budget speech, presented on 17 November 2020, reiterated the importance of consolidation in the FLC sector, which has been on the cards since 2014 when the Central Bank of Sri Lanka (CBSL) announced its ‘Master Plan for the Consolidation of the Financial Sector’.

It led to several banks acquiring FLC subsidiaries in 2014 and 2015, including the acquisition of HNB Finance (then Prime Grameen Micro Finance Limited) by Hatton National Bank and Serendib Finance (then Indra Finance Limited) by Commercial Bank of Ceylon.

Fitch thinks consolidation in the Sri Lankan FLC sector is positive for its long-term stability, but will not necessarily ease its near-term challenges.

The sector continues to struggle with lack of access to capital, muted income generation and very weak asset quality despite the regulatory moratoriums for stressed loans. For details, see Sri Lanka Finance and Leasing Dashboard: FY20, published 19 October 2020.

These headwinds and the fragmentation within the FLC sector at the lower end – where 33 FLCs, out of the total 44, accounted for only around 31% of sector assets – have posed challenges to Sri Lankan financial-sector stability, despite the sector’s moderate 8% share of financial-sector assets at end-2019.

The CBSL has taken regulatory action against several FLCs that failed to meet capital requirements, including cancellation of licences held by The Finance Company PLC and suspension of the business activities of ETI Finance Limited and Swarnamahal Financial Services PLC.

We expect significant increase in M&A activity within the FLC sector in next 12-24 months, even among standalone small FLCs, as there are at least 20 that are currently facing capital challenges, either on an absolute basis or to meet the regulatory capital ratios.

Several FLCs have already announced potential mergers, including Abans Finance PLC (BB+(lka)), which is on Rating Watch Evolving to reflect its potential amalgamation with Softlogic Finance PLC.