RAY OF HOPE: PERSPECTIVE ON THE INTERNATIONAL
SOVEREIGN BOND RESTRUCTURE

Q: What are your views on the recent agreements reached with major bondholders in terms of the sovereign bond restructure?

A: There is certainly light at the end of the tunnel with this agreement, as the unique restructure proposal with macro-linked bonds provides the flexibility to link the returns of the bonds to the underlying performance of the economy, based on the twin criteria proposed in terms of the average nominal GDP during 2024-27 and the cumulative real GDP growth assumption of 11.1 percent. It is now a matter of time before we see whether the IMF agrees that the overall restructure proposal (inclusive of domestic debt and other creditors) meets debt sustainability targets established for the country, which includes the debt to GDP ratio, debt servicing to GDP and gross financing needs.

Q: From a financial reporting perspective, what challenges will financial institutions face?

A: The restructure presents several challenges for financial institutions. Among these, the first of the two most critical challenges will include the fair value of the restructured instrument because at the date of restructure, it will see a substantial day one loss – since the exit yield of the original instrument will be much higher compared to the yield to maturity of the restructured instrument.

The second challenge is the requirement to provide for expected credit losses of the restructured instrument in line with SLFRS 9 (Financial Instruments) by incorporating counterparty credit risk characteristics.

Based on calculations performed by the Financial Services Risk Management team of EY, restructured bonds demonstrate a recovery rate of 58 percent at an exit yield of 11 percent.

However, financial institutions have preempted these circumstances and in consultation with the Institute of Chartered Accountants of Sri Lanka (CA Sri Lanka), have maintained adequate provision cover to supplement these identified losses. All the banks in the country have maintained a cumulative provision (minimum) cover between 52 and 55 percent.

Based on the real GDP growth rates we see for 2024, there is a high probability of exceeding the IMF cumulative growth target of 11.1 percent

Q: Why is there a chance of a higher recovery rate with a probabilistic approach?

A: The recovery rates of these bonds are linked to macroeconomic behaviour. The US Dollar to Sri Lankan Rupee exchange rate will remain a key input to the estimated nominal GDP in dollar terms.

When simulating the Sri Lankan Rupee to US Dollar depreciation leading up to 2027 in multiple scenarios, the forecasted depreciation rate is likely to range between 350 and 370, based on the best information available as of now. This is likely to result in an average GDP within upside scenario 3 or for that matter, even border on 2.

Furthermore, based on the real GDP growth rates we see for 2024, there is a high probability of exceeding the IMF cumulative growth target of 11.1 percent, which could potentially contribute to a recovery rate that’s higher than the baseline scenario.

Q: What role does risk management play in the current financial services climate?

A: Notable initiatives have been seen especially when it comes to mitigating financial risks, particularly relating to credit risk, market risk, operational risk and liquidity risk.

Ensuring regulatory compliance too is a key aspect especially with the recent trends of higher legal and financial penalties. Banks have already started validating their transaction monitoring systems relating to anti-money laundering and combatting financing of terrorism.

Q: And what are the key trends in credit risk management in the financial services industry?

A: Post-implementation of SLFRS 9, there has been a significant shift in credit risk management. We see that most financial institutions are aligning their credit underwriting and pricing to internal ratings-based approaches.

Furthermore, institutions are more focussed on customer-centric profitability that is derived based on risk adjusted returns on capital. There is a growing trend of banks taking initiatives to actively strengthen their loan monitoring processes by deploying early warning signals and behavioural scorecards.

Q: Could you outline the important changes in capital assessment for financial institutions?

A: Efficient capital management has been critical over the past few years. The internal capital adequacy assessment process and integrated stress testing framework have been crucial for financial institutions to maintain sound capital.

We have worked with multiple banks in the country as well as the region to strengthen the stress testing framework by deploying macro-linked stress testing mechanisms. This leads to the deployment of multiple stress levels based on the behaviour of key macroeconomic variables, which allow for a plausible stress testing process.

Q: How can EY assist in these areas?

A: EY offers capabilities in comprehensive financial accounting advisory and risk management services.

Our expertise includes advising on complex accounting issues, valuing intricate financial instruments, structuring optimal financial products, quantifying regulatory risks (Pillar 1 and Pillar 2), assessing capital adequacy, conducting stress tests, validating quantitative models, establishing robust governance frameworks across accounting and risk management functions, and offering capacity building programmes.

These services enable financial institutions to navigate regulatory requirements effectively, manage risks prudently, optimise financial strategies, and enhance overall operational resilience and governance.

– Compiled by Yamini Sequeira

Telephone: 2463500 | Email: rajith.perera@lk.ey.com | Website: www.ey.com/en_gl/locations/sri-lanka