An Echelon Media Company
Saturday May 15th, 2021
Banking

Sri Lanka’s DFCC Bank downgraded to CCC+ after sovereign rating cut

ECONOMYNEXT – Sri Lanka’s DFCC Bank has been downgraded to ‘CCC+’ from ‘B-‘ by Standard and Poor’s after an earlier cut in the sovereign rating with stable outlook.

The short term ratings was C.

“DFCC–like other banks in Sri Lanka–is highly exposed to the country’s economic conditions and
sovereign creditworthiness,” the rating agency said.

About 95 percent of DFCC’s loans are in Sri Lanka, with the central government accounting for 20 to 25 percent of the bank’s total credit risk exposures.

“We expect operating conditions for Sri Lankan financial institutions to remain tough amid subdued
economic activity globally post the COVID-19 pandemic,” S&P said.

“The sovereign’s weakening external and fiscal performance is adding to the challenge.”

Sri Lanka has already imposed import controls.

“Our ‘CCC+’ transfer and convertibility (T&C) assessment on Sri Lanka is a key factor in our analysis
of the country’s banking industry,” the rating agency said.

“The T&C assessment reflects our view of the likelihood of the sovereign restricting domestic entities’ access to foreign exchange needed to meet debt service obligations, including capital controls.

“So far, the government has restricted imports to reduce foreign currency outflows and used interest rate incentives for deposits to support foreign currency inflows. We believe any government actions to restrict foreign currency outflows could hurt banks’ ability to meet their obligations.

“For example, in a severe stress scenario, the government could implement deposit withdrawal limits and other capital controls if market sentiment turned more cautious.”

Though the cost of external funding is rising for Sri Lanka banks, domestic deposit growth was strong

“In our base case, we expect domestic deposit holders’ trust and confidence in the banking system to remain intact,” the rating agency sad.

“Deposit growth remained strong in the first nine months of 2020 at an annualized rate of 20 percent.

“With the sovereign’s deteriorating external financing conditions, investor confidence may weaken and the risk of funding or liquidity stress for banks may increase.

“Currently, we expect banks, especially the large ones, to continue to benefit from flight to quality.
Similar to other banks in the country, DFCC has grown its loan book, maintained regulatory
capitalization, and increased liquidity as a result of stimulus measures. ”

The full rating rational is reproduced below.

Rationale

We downgraded DFCC to reflect the bank’s high exposure to Sri Lanka’s deteriorating economic
and fiscal conditions. Our actions follow the lowering of our sovereign rating on Sri Lanka because
of the rising fiscal and external imbalances in the country. (See “Sri Lanka Downgraded To
‘CCC+/C’ On Increasing External Financing Risks And Fiscal Deterioration; Outlook Stable,”
published today on RatingsDirect).

DFCC–like other banks in Sri Lanka–is highly exposed to the country’s economic conditions and
sovereign creditworthiness. About 95% of DFCC’s loans are in Sri Lanka, with the central
government accounting for 20%-25% of the bank’s total credit risk exposures.

We expect operating conditions for Sri Lankan financial institutions to remain tough amid subdued
economic activity globally post the COVID-19 pandemic. The sovereign’s weakening external and
fiscal performance is adding to the challenge.

Sri Lankan financial institutions are unlikely to be immune to increasing credit pressures on the sovereign. This could hit the banking sector. We expect the sector’s nonperforming loans to rise to about 8.5% of total loans in 2021, from 5.3% as on Sept. 30, 2020, and 4.7% at end-2019.

The cost of external funding is rising for Sri Lankan banks. That said, they have limited reliance on
external funding compared to the sovereign.

Customer deposits remain the main source of funding for banks. In our base case, we expect domestic deposit holders’ trust and confidence in the banking system to remain intact. Deposit growth remained strong in the first nine months of 2020 at an annualized rate of 20%.

With the sovereign’s deteriorating external financing conditions, investor confidence may weaken and the risk of funding or liquidity stress for banks may increase.

Currently, we expect banks, especially the large ones, to continue to benefit from flight to quality.
Similar to other banks in the country, DFCC has grown its loan book, maintained regulatory
capitalization, and increased liquidity as a result of stimulus measures.

But earnings and asset quality remain under pressure. While COVID-related moratorium on loans and other regulatory policies have supported borrowers, we believe underlying economic conditions remain weak.

We lowered our risk-adjusted capital ratio forecast for DFCC to around 2.5% by Dec. 31, 2021,
from 3.0% previously, to reflect the heightened risks from the bank’s exposure to the sovereign.

The bank is vulnerable to and reliant on favorable operating conditions. Economic conditions and the sovereign’s ability to continue to service its debts are vital for DFCC’s creditworthiness. We revised the bank’s stand-alone credit profile (SACP) to ‘ccc+’ from ‘b-‘.

Our ‘CCC+’ transfer and convertibility (T&C) assessment on Sri Lanka is a key factor in our analysis
of the country’s banking industry. The T&C assessment reflects our view of the likelihood of the
sovereign restricting domestic entities’ access to foreign exchange needed to meet debt service
obligations, including capital controls.

So far, the government has restricted imports to reduce foreign currency outflows and used interest rate incentives for deposits to support foreign currency inflows. We believe any government actions to restrict foreign currency outflows could hurt banks’ ability to meet their obligations.

For example, in a severe stress scenario, the government could implement deposit withdrawal limits and other capital controls if market sentiment turned more cautious.

Outlook

Our stable outlook on DFCC mirrors that on Sri Lanka and reflects our view that the bank will
remain vulnerable and dependent upon favorable business, financial, and economic conditions to
meet its financial commitments.

In our view, COVID-19 has heightened key vulnerabilities at the sovereign level and across the banking system. We believe these systemic pressures will continue to undermine the bank’s creditworthiness, but don’t expect an immediate credit or payment crisis over the next 12 months.

Downside scenario

We could lower our ratings on DFCC if we take a similar action on Sri Lanka. The sovereign rating
could be lowered if external buffers decline substantially more than we currently forecast, or
access to external financing proves extremely difficult. (Colombo/Jan03/2021)

Leave a Comment

Your email address will not be published. Required fields are marked *

Your email address will not be published. Required fields are marked *

Comments

Leave a Comment

Your email address will not be published. Required fields are marked *

Your email address will not be published. Required fields are marked *