Moody's maintains stable outlook on Sri Lankan banking sector amid stable operating environment

Moody's Investors Service has maintained its stable outlook on Sri Lanka's banking system, as moderate economic growth and reduced external volatility should keep operating conditions for the country's banks stable.

"Continued strong loan growth may put downward pressure on asset quality and liquidity conditions, but nonperforming loan (NPL) ratios will remain at low levels," says Srikanth Vadlamani, a Vice President - Senior Credit Officer at Moody's.

"We therefore expect a degree of asset quality deterioration consistent with the current credit profiles of Sri Lankan banks," adds Vadlamani.

Moody's conclusions are contained in its just-released report "Banking System Outlook -- Sri Lanka: Stable Operating Environment Drives Stable Outlook." The outlook expresses Moody's expectation of how bank creditworthiness will evolve in Sri Lanka over the next 12-18 months.

Despite external funding challenges, the rating agency expects economic growth to remain stable at about 5.0% in 2017, a marginal improvement over the 4.7% expected in 2016.

The stable outlook on the banking system differs from the negative outlook on the B1 long-term foreign currency issuer rating assigned to the Government of Sri Lanka. Sri Lanka's B1 sovereign credit rating outlook was changed to negative from stable on June 20, 2016, driven primarily by the sovereign's high level of government debt and implementation risks surrounding planned fiscal reforms.

Moody's expects asset quality will deteriorate as a result of the relatively rapid 16% loan growth year-on-year at end-September 2016, a key driver of which has been growth of construction loans. The weakening in asset quality will come from a generally low 2.9% nonperforming loan ratio for the system at end-September 2016, which are close to the lowest level for the last decade.

Capital levels are also likely to remain largely stable as pressure on liquidity and funding cause loan growth to moderate. Loan-to-deposit ratios have increased to about 91%, close to the peak reached in 2012, driven by the strong loan growth over the last 18 months.

Positively, though, the banks' profitability will remain stable, with the firm interest rate environment supporting net interest margins. Cost-to-income ratios may also continue to improve, although only marginally, driven by positive operating leverage.

Finally, government support to banks should remain stable, with the rating agency expecting government support for individual banks to be forthcoming if needed.