Sri Lankan Registered Finance Companies: Past, Present and Future

Against the backdrop of the global financial turmoil, the fall of unregulated finance
companies in Sri Lanka has affected their registered counterparts. Furthermore, the spate of
negative publicity amid the challenging economic environment has fuelled panic; public
confidence in registered finance companies (“RFCs”) has taken a beating. Nonetheless, the
Central Bank of Sri Lanka has taken steps to infuse market confidence by vesting the
management control of troubled Ceylinco-related RFCs to Lankaputhra Development Bank
Ltd and Merchant Bank of Sri Lanka PLC (whose AA-/P1 ratings have been put on Rating
Watch, with a developing outlook, by RAM Ratings). This move is expected to quell
depositors’ concerns to some extent.

The RFC industry’s financial performance had reached its zenith in FYE 31 March 2006 (“FY
Mar 2006”). Returns on assets (“ROA”) and returns on equity (“ROE”) stood at 4.02% and
26.91%, respectively, as at end-March 2006. The following year, however, the industry’s
overheads and provisions increased faster than its robust gross-income growth. As a result,
its ROA and ROE declined to a respective 3.79% and 24.56% as at end-March 2007. In
fiscal 2007 and 2008, interest expenses and overheads had affected the RFC industry’s
performance. As at end-Dec 2008, the industry’s annualized ROA and ROE were 1.95% and
12.73%, respectively.

In the short to medium term, RAM Ratings Lanka expects the RFC sector to concentrate
more on restoring or maintaining (through tighter monitoring and recovery efforts) asset
quality. Therefore, the sector’s financial performance is expected to moderate. We also
envisage industry players to redouble their efforts in pruning overheads to fortify
themselves against weathering the impending storm, as the Sri Lankan economy
increasingly feels the pinch from the global recession.

The health of the sector’s credit portfolio is reflected in its net non-performing-loan (“NPL”)
ratio (on a 6-month classification basis), which had improved from 6.51% to 1.76%
between FY Mar 2002 and FY Mar 2006. Although the industry’s gross NPL ratio came up to
5.66% as at end-March 2006, more robust earnings had helped the industry to make
adequate provisions. In subsequent years, however, the RFC industry’s net NPL ratio started
rising again due to macroeconomic factors, reaching 5.21% by end-December 2008. That
said, RAM Ratings Lanka notes that RFCs’ business strategies and risk-management
systems may provide some buffer against these threats. In fact, several RFCs have been
able to nurse their lending portfolios back to healthy by beefing up monitoring and recovery
efforts. As mentioned earlier, monitoring and collections are expected to take centre-stage
for the industry. As a consequence, we anticipate loan expansion to moderate.

On a more positive note, the industry has preserved its liquidity level at 15% above the
regulatory minimum in the last 3 years. RFCs are expected to maintain 15% of their time-
deposit liabilities in the form of liquid assets, with 20% in the case of demand deposits
(savings). In March 2009, the Central Bank relaxed liquidity requirements for the industry.
RFCs are now obliged to hold only 10% of their time-deposit liabilities in the form of liquid
assets, with a 15% requirement for demand deposits. In addition, the sector’s loan-to-
deposit ratio has also improved over the past 2 years.
RAM Ratings Lanka notes that depositors have adopted a more short-term view due to the
environment of rising interest rates. As these deposits are in turn lent to borrowers in the
form of leases or hire-purchase financing, which typically have tenures of 2 to 5 years, a
mismatch arises between deposit liabilities and loan maturities. This mismatch is inherent in
all banks and finance companies. Hence should there be a mass withdrawal of deposits, any
financial institution would face a liquidity crunch. It is because of this that public confidence
is so crucial, as eloquently quoted by Walter Bagehot (famed British journalist): A bank
lives on credit. Till it is trusted, it is nothing; and when it ceases to be trusted, it returns to
nothing. Going forward, we expect liquidity levels to remain above the statutory minimum.

Capital is perhaps the most crucial factor vis-à-vis instilling public confidence in a financial
institution. In 2005, the Central Bank increased the minimum required core capital for RFCs
to LKR 200 million. In this regard, 16 companies within RAM Ratings Lanka’s portfolio
currently comply with, or are expected to meet, this requirement before end-2009. Another
regulation that RFCs are expected to adhere to is the capital-adequacy requirement. Broadly
speaking, finance companies are expected to maintain a minimum proportion of their assets
in the form of capital. In the past 3 years, the industry has kept its overall capital adequacy
above the minimum requirement of 10%. Looking ahead, RAM Rating Lanka expects most
RFCs to be able to preserve their capital adequacy above the minimum threshold in the
short to medium term.

Taking into account the abovementioned industry statistics, we believe that the current
situation faced by the RFC industry is more of a crisis of confidence, rather than a significant
deterioration in business fundamentals. Apart from this, the global recession is likely to
further dampen the export sector which will have ripple effects in the economy. In this
backdrop, the whole financial sector’s asset quality will be tested and within the RFC sector
some form of consolidation may well become inevitable.