By: Staff Writer Colombo (LNW): Fitch Ratings has warned of risks in Sri Lanka’s domestic debt restructuring plan but noted that it resolves uncertainties around its impact on the local banking sector. The Sri Lankan Government’s proposal for treatment of domestic debt marks a significant step towards resolving uncertainties around the impact of the sovereign’s debt restructuring on the local banking sector, but complications may arise from a number of factors, Fitch Ratings said. The proposal excludes banks’ holdings of Sri Lankan rupee-denominated treasury securities, which will alleviate some of the pressure on their already stressed capital positions from weakening loan quality and the rupee’s depreciation. Fitch’s base case did not expect treasury bills held by banks to be subject to restructuring, but assumed banks’ treasury-bond holdings would be. Bank holdings of Sri Lanka Development Bonds (SLDBs), which are foreign-currency denominated but governed by local law, will be affected, as anticipated, and an impact on international sovereign bonds (ISBs) as well is still expected. However, these together account for only about 5.5% of banks’ combined assets, a much smaller share than treasury securities (26.4% for Fitch-rated domestic banks). The proposal also includes a restructuring of foreign-currency bank loans to the government (less than 1% of combined assets for Fitch-rated banks), though without detailed plans. “The Government has outlined three treatment options for SLDBs. We expect banks will generally opt for the choice involving conversion of such debt into local currency-denominated instruments; banks have so far opted to convert maturing SLDBs to rupee-denominated treasury bonds since the announcement of suspension of foreign debt servicing in April 2022,” Fitch Ratings said. Fitch said that provisioning should help to moderate the hit to bank capital from the debt treatment. Fitch-rated Sri Lankan banks have already made provisions of 35% or higher for ISBs, with SLDBs being subject to lower provisioning due to the possibility of obtaining rupee-denominated treasuries. Nonetheless, worsening impaired loans (end-May 2023: 13.3% of system loans, from 1Q22: 8.4%) in line with the economic stress associated with the sovereign default and the unwinding of forbearance provided during the Covid-19 pandemic are already exerting pressure on banks’ thin capital buffers. “We do not believe a restructuring of the sovereign’s local-currency obligations is likely to trigger a loss of depositor confidence in the banking system, based on the proposed plans. However, funding stress remains a negative sensitivity for bank ratings. Fitch-rated Sri Lankan banks’ national ratings remain on Rating Watch Negative (RWN) to reflect the potential for the banks’ creditworthiness relative to other entities on the Sri Lankan national ratings scale to deteriorate. This reflects heightened near-term downside risks to credit profiles from capital and funding stress,” Fitch Ratings said. Fitch Ratings said that a downgrade of the sovereign’s ‘CC’ Long-Term Local-Currency Issuer Default Rating would not automatically drive a downgrade in Sri Lankan bank ratings.