Sluggish economic activity, external and domestic vulnerabilities, muted private credit growth and the sovereign's weakened credit profile are significant downside risks to the operating environment for Sri Lankan banks, Fitch Ratings says.

"We lowered our assessment of the operating environment score for Sri Lankan banks to 'ccc' with negative outlook from 'b-' with negative outlook, after the Sri Lanka sovereign rating was downgraded to 'CCC' from 'B-' in November 2020. The weaker sovereign credit profile could affect the banks' operating environment, which is already weak due to the coronavirus pandemic," it said.

Fitch expects Sri Lanka's real GDP to expand in 2021 by 4.9% in 2021, albeit off a lower base, following a contraction of 6.7% in 2020. However, our forecasts are subject to a high degree of uncertainty regarding the evolution of the pandemic globally and in Sri Lanka.

"In our view, the operating environment continues to have a high influence on bank ratings in Sri Lanka, as it affects the level of risk of doing business and banks' financial and non-financials rating factors," it said.

Fitch expects heightened operating environment risks to manifest primarily in the banks' financial profiles, with asset quality and profitability likely to be the most impacted.

Fitch-rated banks' impaired (stage 3) loan ratios have been rising (9M20: 10%, 2019: 9.4%) despite the spate of relief measures announced by the Central Bank of Sri Lanka for borrowers as well as banks in terms of bad loan recognition.

"We expect this trend to continue in to 2021, albeit at a slower pace. Deteriorating asset quality and the associated higher credit costs are expected to keep banks' profitability lower in 2021 than pre-2019 levels, despite improvement from 2020 profitability," it said.