SRI LANKA FINANCE SURVELLANCE: RFC Ratings


Given the recent dismal record of a number of unregistered finance companies in Sri Lanka, public confidence in the industry as a whole has been undermined. Prakash Jerome, Head of Rating, RAM Ratings Sri Lanka proves some valuable insights into the sector.

Against the backdrop of the global financial turmoil, the fall of some unregulated finance companies in Sri Lanka has affected their registered counterparts. Moreover, the spate of negative publicity amid a challenging economic environment has fuelled panic, and 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 Ceylinco-related RFCs to Lankaputhra Development Bank Ltd and Merchant Bank of Sri Lanka PLC whose AA-/P1 rating has been put on Rating Watch, with a developing outlook by RAM Ratings Lanka. The move is expected to quell depositors’ concerns to some extent.

In view of these developments, RAM Ratings Lanka has put seven entities within our portfolio on Rating Watch, highlighting a possible change in their ratings. A Rating Watch focuses on identifiable events that cause a rated entity to be placed under special surveillance.

In 2004, the Central Bank mandated that all RFCs should obtain credit ratings - so that the depositing public can gauge the risks of a particular financial institution (”FI”). Since commencing operations in 2005, RAM Ratings Lanka has rated 19 RFCs. Our financial institution ratings represent independent opinions on these institutions’ ability to pay their interest and deposit obligations in a timely manner.

In the past two years, RAM has either had to downgrade some RFCs’ ratings or signal that their long-term ratings could be lowered in future (via a negative rating outlook) if adverse credit trends persist. However, it is neither the intent nor purpose of ratings to rise and fall in tandem with economic cycles. That said, financial institutions with strong fundamentals and robust risk-management systems are expected to retain their ratings.

RAM’s credit ratings take into account the role of an FI within the overall financial system. In this regard, the RFC sector as a whole only makes up a small portion of the entire domestic financial system’s assets (end-December 2008: 3.6 percent). Even so, this sector assists in the development of the economy as they finance small and medium-scale businesses and entrepreneurs (typically shunned by banks). Even though this business model entails higher risks, strategies can be adopted to minimize these risks. It is for this reason that RAM Ratings Lanka carries out an exhaustive evaluation of such companies’ underwriting track records and processes.

While financing vehicles are the industry’s main revenue spinners, some RFCs have delved into real-estate trading. It has been found that RFC’s that deal extensively in real estate are prone to additional credit, market and liquidity risks, especially under the current gloomy economic climate. In addition, our analytical experience suggests that these companies have weaker cash flow profiles due to their revenue-recognition policies. In the past three years, RAM has revised downwards the ratings and/or rating outlook of three RFCs that had ventured into real estate.

The domestic RFC industry is composed of a few large companies and many smaller ones. The two big RFC’s accounted for some 42 percent of the Rs.175.6 billion industry as at end-December 2008. There has also been an influx of new players over the past four years, hence increasing their number from 28 to 34. Moreover, commercial banks have also made inroads into the leasing arena. These two factors have combined to render the RFC industry more fluid. Nonetheless, players with extensive branch networks, strong franchises and niche focuses have successfully countered these competitive threats.

In terms of financial performance, the RFC industry reached its zenith in FYE 31 March 2006 (“FY Mar 2006”); returns on assets (“ROA”) and returns on equity (“ROE”) came up to 4.02 percent and 26.91 percent, respectively, as at the end of that fiscal period. Even though the industry’s gross income posted robust growth the following year, overheads and provisions had risen even faster. Consequently, the industry’s ROA and ROE declined to 3.79 percent and 24.56 percent, respectively. In the last two years (i.e. FY Mar 2007 and FY Mar 2008), interest expenses and overheads have affected the RFC industry’s performance. As at end-December 2008, the industry’s annualized ROA and ROE stood at a respective 1.95 percent and 12.73 percent.

Over the short to medium term, the sector is expected to concentrate more on restoring or maintaining, through tighter monitoring and recovery efforts, the quality of its assets. Therefore, its financial showing is expected to moderate. This is in fact a more prudent strategy, as the Sri Lankan economy increasingly feels the ripple effects of the global recession.

Similarly, the RFC sector’s credit portfolio had become healthier - as indicated by its net non-performing-loan (“NPL”) ratio (on a six-month classification basis) of 1.76 percent as at end-March 2006. Although the industry’s gross NPL ratio came up to 5.66 percent, more robust earnings had helped towards making adequate provisions. Nevertheless, its net NPL ratio had deteriorated again in the following years, driven by macroeconomic factors. That said, RAM Ratings Lanka notes that astute business strategies and sound risk-management systems can cushion FIs against these threats to some extent. In fact, the lending portfolios of several RFCs have been strengthened by beefing up monitoring and recovery activities. As mentioned earlier, monitoring and collections are expected to assume centre stage within the overall industry.

On a more positive note, the RFC sector has been able to maintain its liquidity level at about 15 percent which is above the minimum stipulated by the regulator. RFCs are expected to keep 15 percent of their time-deposit liabilities in the form of liquid assets, with 20 percent in the case of demand deposits (savings). In March 2009, the Central Bank relaxed the liquidity requirements for the industry. RFCs are now obliged to hold only ten percent of their time-deposit liabilities in the form of liquid assets, with a 15 percent requirement for demand deposits. In addition, the sector’s loan-to-deposit ratio has also improved in the last two years.

At the same time, it is observed that depositors seem to have adopted a more short-term view against the environment of rising interest rates. As these deposits are in turn loaned out as advances in the form of leases or hire-purchase facilities - which typically have maturities of two to five years - a mismatch then arises between deposit liabilities and loan tenures. This disparity is inherent in any bank or finance company. As such, any FI will face a liquidity crisis in the event of a mass withdrawal of deposits. 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.

The importance of confidence in FIs therefore cannot be over-emphasized. Such confidence can only be engendered by integrity. Good corporate governance, together with a strong regulatory regime, becomes essential towards sustaining public confidence. In this regard, the Central Bank has issued a direction on corporate governance to RFCs, in a bid to improve their governance practices. While this is a positive move, true corporate governance is more likely to emerge only if all stakeholders demand it. In other words, corporate governance should be driven by the market. In this regard, Sri Lanka, as a developing nation, has many challenges. Foremost among them is the country’s limited investor base.


In the interim, however, the regulator has been encouraging RFCs to be more transparent. A case in point is the requirement to conspicuously display their financial statements and to disclose their credit ratings when advertising to attract depositors.

Capital is perhaps the most crucial factor vis-à-vis instilling public confidence in an FI. In 2005, the Central Bank increased RFCs’ minimum capital requirement to LKR 200 million each. To date, 16 companies within RAM Ratings Lanka’s portfolio have met 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 stated, finance companies are expected to maintain a minimum proportion of their assets in the form of capital. In the past three years, the industry has kept its overall capital adequacy above the minimum requirement of ten percent.

By contrast, unregulated finance companies do not have to observe prudential norms. Recent developments have brought to light that placing deposits in FIs based solely on the presence of prominent personalities can be dangerous. RAM Ratings Lanka encourages investors to place their funds with regulated finance companies. It would also be prudent to check the credit ratings of FIs and read reports on their creditworthiness, available through rating agencies’ websites. In aid of investor education and market awareness, such reports and rationales can be accessed via RAM Ratings Lanka’s website at www.ram.com.lk.