Gold's Losing Luster Reveals The Cracks In Sri Lanka's Pawning Segment

Primary Credit Analysts: Geeta Chugh, Mumbai (91) 22-3342-1910; geeta.chugh@standardandpoors.com Deepali V Seth, Mumbai (91) 22-3342-4186; deepali.seth@standardandpoors.com Secondary Contact: Amit Pandey, Singapore (65) 6239 6344; amit.pandey@standardandpoors.com

Table Of Contents
Regulations Contributed To Runaway Growth How Sri Lankan Banks Compare With Regional Peers The Ride On The Bull Run Could End In A Tumble But The Fall Is Unlikely To Hurt Too Much Related Criteria & Research

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Gold's Losing Luster Reveals The Cracks In Sri Lanka's Pawning Segment
The recent reversal in gold's fortunes could prove painful for Sri Lankan banks. As gold prices soared over the past few years, Sri Lanka's banks substantially expanded their pawning loans (gold-backed loans). Standard & Poor's Ratings Services believes that this has exposed Sri Lanka's banking industry to the risk of high credit costs (provisioning expenses related to nonperforming loans [NPLs]) because of the recent about-face in gold prices. We expect defaults in pawning loans to increase over the next 12 months unless clear signs of gold prices stabilizing emerge. Nevertheless, banks' overall earnings will likely offer sufficient cushion against higher credit costs in the pawning segment. Overview Pawning loans account for the largest share of the loan portfolio of Sri Lankan banks. Therefore, falling gold prices pose risks of high credit costs to the country's banking sector. However, we expect banks to be able to absorb the downside in the pawning segment.

Pawning loans in Sri Lanka are typically 12 month loans given to borrowers against a pledge of personal articles made of gold. These loans are entirely backed by such collateral and have virtually no restrictions on their end use. We believe the competitive nature and need for a rapid turnaround in the pawning business could compromise the ability of banks to perform thorough credit assessment of borrowers, including checking their credit histories recorded with the Credit Information Bureau of Sri Lanka. Banks' pawning loans grew at a steep average annual rate of about 50% over the past three years, compared with average annual loan growth of 25% for the banking industry. Pawning loans constitute 14.4% of the total loan book of Sri Lanka's banks as of March 31, 2013. This is the largest sectoral exposure for Sri Lankan banks. The banks with the most pawning loans outstanding are also the biggest in the country. Moreover, the share of pawning loans to total loans of many large banks, especially those that the government owns, is higher than the industry average in Sri Lanka (see charts 1 and 2).

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Gold's Losing Luster Reveals The Cracks In Sri Lanka's Pawning Segment

Chart 1

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Gold's Losing Luster Reveals The Cracks In Sri Lanka's Pawning Segment

Chart 2

Regulations Contributed To Runaway Growth

In our view, the steady rise in gold prices in recent years, the zero risk weight on pawning loans in the calculation of regulatory capital ratios, and the absence of restrictions on loan-to-value (LTV) ratios have contributed to rapid growth in pawning loans. The risk weight on pawning loans is as high as 125% on gold loans (after deducting collateral value adjusted for potential volatility in the gold prices) in neighboring India. The zero risk weight in Sri Lanka, in our view, underestimates the risk of price volatility in a commodity such as gold. In addition, it provides an incentive for the banks to rapidly grow their pawning portfolio without the need to hold any regulatory capital for this business. While the secured nature of these loans is a positive, local regulations for pawning restrict forced selling of pledged gold for 12 months from the date of the pledgethe typical duration for such loans. Such regulations make banks vulnerable to volatility in gold prices during the restricted period. There are no limitations on the maximum permissible LTV on pawning loans in Sri Lanka, although banks seem to be lowering their LTVs this year under some informal guidance from the Central Bank of Sri Lanka (CBSL). Based on

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Gold's Losing Luster Reveals The Cracks In Sri Lanka's Pawning Segment

anecdotal information, the average LTVs at origin for banks declined to 60%-70% in 2013 compared with 80%-90% last year. However, most banks' LTVs on outstanding loans will likely have spiked, given that global gold prices have already fallen about 27% in the first half of 2013. Loans with higher than average LTVs are more affected. We believe that for such loans the collateral value would already be lower than the loan amount. Regulation does not require banks to submit the credit history of pawning borrowers to the Credit Information Bureau of Sri Lanka. This increases moral hazard and could adversely affect the credit culture, given that default does no harm to an individual's credit history.

How Sri Lankan Banks Compare With Regional Peers

Sri Lankan banks have among the highest exposure to pawning loans. Globally, pawn shops (which pawn not just gold or jewelry, but also other valuable items) predominantly undertake the pawning business, and banks are seldom involved. According to the World Gold Council, China accounted for 33% and India 28% of the total physical gold demand in the first quarter of 2013. We do note some pawning loans in these two markets, although they are more in the informal sector. In China, pawning loans account for a very small proportion of total loans and such loans are provided by pawn shops. Pawning here encompasses not only gold but also cars and properties. We consider such loans as part of shadow financing and estimate that these loans are about 0.4% of total bank loans. LTV ratios are typically very low and the interest rate is very high (4%-5% a month). In India, banks, finance companies, and local money lenders are active in pawning. Banks and finance companies have grown this business rapidly in the last few years. They have been gaining market share from the informal sector where the interest rates are much higher. Nevertheless, pawning loans still forms a relatively small part of banks' portfolio. As of March 2012, gold loans formed 2.5% of Indian banks' overall loans. On an average, the major portion of gold loans in India are for agriculture. There are no restrictions on LTV ratios for the banks although finance companies' LTV ratio is capped at 60%. The rapid gold loan growth is a concern in India too, but the quantum is lower than in Sri Lanka; regulations in India are also somewhat more stringent.

The Ride On The Bull Run Could End In A Tumble

Sri Lankan banks' ride on galloping gold prices could end poorly. This is because borrowers may choose to default and not redeem pledged gold, the value of which could be lower than the outstanding loan amount. We understand that most banks do not hedge the gold-price risk. This is unlike a few large pawning companies in emerging markets, such as Mexico, that use derivatives to manage gold-price risk. NPLs in the pawning segment have already started to rise in Sri Lanka. According to the CBSL's Financial Stability Report, NPLs increased 38% for consumption-related pawning advances in the 12 months to September 2012. NPLs in this segment for the Sri Lankan banks that we analyzed increased to 1%-5% of total loans as of April 30, 2013, from

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Gold's Losing Luster Reveals The Cracks In Sri Lanka's Pawning Segment

less than 1% as of Dec. 31, 2011. We expect NPLs in other segments to also rise as operating conditions remain challenging and the loan book seasons. Gold prices have dipped sharply from their peak in the third quarter of 2012. Therefore, we expect NPLs to further increase in the coming months as the loans that originated when gold prices were high come due for repayment. However, the government recently imposed a 10% tax on gold imports, and this could offer some support to domestic gold prices. This could enable banks to realize relatively more money when auctioning off the pledged gold, thus limiting their ultimate loss. Credit losses in this business in the past few years have been very low. But that could certainly change if the gold prices stay depressed for a sustained period. We expect growth in pawning to be sluggish in 2013 because we understand that the CBSL has advised banks to be cautious while expanding in this segment. Accordingly, banks have reduced promotions for pawning loans and lowered LTVs to make such loans less attractive for borrowers. We expect overall credit growth in Sri Lanka to remain slow in 2013.

But The Fall Is Unlikely To Hurt Too Much

We expect the performance of the pawning loans segment to be highly correlated to gold prices. But the significant volatility makes it hard to predict whether prices will go up or down. The lack of a gold-price hedge for many banks leaves the sector vulnerable to rising credit costs if gold prices fall. In our base-case scenario, we expect the earnings of Sri Lankan banks to absorb the higher credit costs associated with pawning loans. We do not expect these factors to significantly affect banks' overall capital position. Bank's overall pre-tax return on assets was 2.4% as on Dec. 31, 2012. Returns in the pawning business were likely to have been higher because of lower credit costs in that segment until 2012. A steep rise in the credit costs, beyond the pawning segment returns, will start hurting bank's capital levels. Moreover, a sustained weakness in the gold prices could lead to unexpected losses. This could hurt banks' capitalization because they haven't allocated any capital buffer for risk in the pawning business.

Related Criteria & Research

Banking Industry Country Risk Assessment: Sri Lanka, Nov. 19, 2012 Understanding Standard & Poor's BICRA Assessment Of Sri Lanka, June 22, 2012

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