LFC credit growth slows in 9M FY March 2013

The Licensed Finance Company (LFC) sector remained a small segment of Sri Lanka's financial institutions industry accounting for 5.90% of its assets as at end December 2012 (end December 2011: 4.60%).

The increase in its share of the industry was largely due to the issuance of an LFC licence to the largest Specialised Leasing Company (SLC) in the country, a report by Ram Ratings stated.

Three other SLCs had also obtained the LFC licence during the year. This has been the general trend of late given the funding constraints and higher costs of operating as an SLC.

The LFC sector assets excluding these SLCs accounted for only 4.92% of the financial institution industry's assets as at end December 2012. Following a 44.31% year-on-year (yo-y) increase in assets in FYE March 31, 2012 (FY Mar 2012), the industry's growth slowed to an annualised 32.75% in 9M FY Mar 2013 amid a slowdown in credit growth.

As at end December 2012 the sector comprised 47 players operating with 844 branches across the island (end December 2011: 40 players with 532 branches). Credit growth slowed in 9M FY Mar 2013 due to a drop in demand for vehicle financing loans as import duties spiked during the period while lending rates and inflation remained high thereby eroding disposable income levels.

As such, many players sought to diversify their lending portfolios, thus channelling funds to micro-credit loans and pawn brokering. Going forward, the easing of interest rates and inflationary pressures are expected to result in a gradual increase in demand for credit. While vehicle financing is expected to remain the main growth driver, other credit assets such as pawning and microfinance are expected to gain in prominence within the loan mix. The LFC sector's asset quality had weakened in the 9M ended FY Mar 2013 as envisaged.

Unfavourable macroeconomic conditions and the seasoning of loans subsequent to the aggressive loan growth witnessed the previous year had resulted in a deterioration of credit quality. As LFCs cater to a social stratum whose risk profile is higher than that of a bank's clientele, the impact of the unfavourable macroeconomic environment had been magnified in the sector. In the short term, delinquencies are expected to increase as loans have yet to season and the sector continues to be challenged to maintain credit quality overall asset quality, therefore, is expected to remain at current levels. In the longer term however we expect asset quality to be supported by better macroeconomic conditions, resulting in reduced incidence of non performing loans (NPLs) and improved recoveries.

The sector demonstrated only a modest improvement in performance due to slower credit growth in 9M FY Mar 2013. Overall margins had narrowed as funding costs increased amid a faster repricing of shorter-tenure deposits in a high interest rate scenario. However, the sector's yields stood higher than that of banks, thereby resulting in wider margins. Increased lending to lower income earners in the form of micro finance loans had also given rise to lucrative margins. Notably, a strengthening of core income was witnessed as the bulk of funding was channelled to interest earning credit assets. This is viewed positively in light of the volatility of returns from non-core assets such as real estate and equity investments. Going forward, while easing interest rates are expected to result in broader margins, the benefits are expected to be offset to some extent by a probable increase in credit costs as new NPLs trickle in with the seasoning of loans.

While customer deposits continued to be the sector's chief funding source, the funding mix increasingly tilted towards borrowings. Given the removal of withholding tax (WHT) on listed debentures and the benefits associated with funding through long term debt such as the easing of inherent maturity mismatches, a further tilt towards corporate debt is expected.

Moreover, the interest rate caps on medium term deposits ranging from 2-3 years - effective January 2013 - may result in LFCs increasingly relying on longer-term borrowings.

However, the funding mix is expected to remain dominated by deposits. Meanwhile, liquidity levels are expected to remain stable amid the gradual rise in credit demand.