Fitch Ratings has raised concerns about the increasing reliance on gold-backed lending within Sri Lanka’s finance and leasing companies (FLCs) sector, pointing to heightened exposure to collateral price risks and vulnerability to adverse movements in gold prices.
Over the past few years, Sri Lankan FLCs have experienced rapid growth in gold-backed loans, driven by a decline in demand for their core vehicle-financing business. Gold-backed loan balances have surged, more than quadrupling between the financial years ending March 2019 (FYE19) and FYE23, elevating its share in the sector’s gross loans to 18%, up from 4% at the end of FY19.
Several factors, including increased demand for shorter-term financing, attractive product yields, and the liquidity of gold collateral allowing lenders to recover defaulted facilities through regular auctions, have fueled this trend. While FLCs reduced their exposure to gold-backed lending in 1QFY24, the decline was viewed as temporary, linked partly to a drop in local gold prices during that period following a global price decrease and exacerbated by Sri Lankan rupee appreciation.
Fitch warns that an excessive concentration in gold-backed loans could expose some FLCs to significant tail risks, especially if collateral haircuts prove insufficient to protect them from sudden and substantial price falls. Lessons from 2012 and 2013 highlight the potential increase in non-performing loans (NPLs) and credit costs during sharp declines in gold prices.
As competition rises among FLCs, average loan-to-value (LTV) ratios have increased, ranging between 70% and 80%. However, these ratios could deteriorate rapidly in the event of falling gold prices or borrower defaults, potentially adding to accrued interest. Unlike in markets such as India, gold-backed lending in Sri Lanka is not subject to any regulatory LTV cap.
The current regulatory capital framework in Sri Lanka incentivizes FLCs to build larger gold loan portfolios quickly, potentially causing them to underestimate risk levels and reserve insufficient capital for potential shocks. The valuation of gold collaterals in Sri Lanka is at the lenders’ discretion and subject to their calculation methodologies, unlike in India where regulators stipulate collateral valuation methods.
Fitch notes that Sri Lankan FLCs do not consider borrowers’ repayment capacity when underwriting a gold-backed loan, focusing solely on collateral value. While the non-performing loan (NPL) ratio from gold-backed lending remains lower than conventional lending products, it has come under pressure due to the challenging operating environment and weakened repayment capacities. Among FLCs rated by Fitch based on standalone strength, the 90+ day past-due ratio on gold loans increased to 5.3% at end-1QFY24, from 1.9% at end-FY22, indicating growing defaults in this segment. Source – Fitch
