OREANDA-NEWS. The operating environment for Sri Lankan banks is likely to improve in 2015 and 2016 with pressures on asset quality and the loans/deposits ratio diminishing and the potential for loan growth to pick up, says Fitch Ratings. However, longer-term challenges for the banking sector remain. Foreign-currency borrowing has been rising, and capital levels are low relative to many other banking systems in other peer emerging markets.

The reported capital adequacy ratios (CAR) for Sri Lankan banks exceed the regulatory minimums of 5% and 10% set by the Central Bank of Sri Lanka (CBSL) for core CAR and total capital, respectively. Furthermore, the capital quality of Sri Lankan banks is generally high, consisting mostly of core capital.

Fitch highlights, though, that Sri Lankan bank CARs are boosted by the absence of a capital charge on certain key asset exposures. The zero risk-weight attached to gold-backed loans and foreign currency-denominated exposures to the sovereign, in particular, mischaracterises the risks associated with such exposures. This was evident in the spike in NPLs from gold-backed advances in recent years due to declining gold prices.

By applying higher risk weights to these exposures, the banking sector's core CAR would be reduced by about 300bp according to Fitch estimates. The reduction would be particularly significant in the case of the large state banks.

Residual provisioning risks, credit concentrations and a volatile operating environment remain as significant challenges for Sri Lankan banks over the medium term, and highlight the risks associated with relatively low capital buffers. These risks are reflected in the intrinsic financial profile or Viability Ratings of the major Sri Lankan banks which are mostly in the single 'B' range.

Sri Lanka has not yet moved toward the implementation of Basel III-recommended reforms, which would act to improve capital ratios over the medium and long term. Under Basel III, the CBSL would be likely to introduce additional capital requirements for banks deemed to be systemically important (D-SIBs), in line with global trends.