Global credit rating agency Fitch Ratings has assigned a negative banking-sector outlook for Sri Lanka in 2018 saying that operating conditions will remain challenging, putting mild pressure on performance for the rest of the year and possibly 2019. However, as the performance of Sri Lankan banks remained fairly stable through 2017 and 1^st quarter 2018 (1Q18), Fitch expects their credit profiles to remain broadly intact. In its 1Q18 report card on Sri Lankan banks, Fitch notes that the implementation of Basel III in 2017 has prompted Sri Lankan banks to raise capital, leading to generally better capital ratios. The banks have raised Tier 1 capital of Rs 66 billion and Tier 2 capital of Rs 45 billion since 2017 ahead of the full implementation of Basel III in 2019, which includes Rs 10 billion of equity by the large state-licensed commercial banks. Further capital-raising is likely in 2018, although much of the shortfall was bridged in 2017. Fitch believes that large state commercial banks are the most likely to need further capital, as they are vulnerable to dividend demands from the state and their ability to raise capital may be constrained. Fitch does not expect a significant increase in NPL ratios despite risks to asset quality. It notes that the gross NPL ratio for the sector rose to 3.0% by 1Q18 from 2.5% at end-2017 due to a 25% increase in absolute NPLs on the back of difficult operating conditions, with relatively slow economic growth and pressure on disposable income. There has also been an increase in rescheduled loans in 2017 and in 1Q18 across Fitch-rated banks, indicating ongoing pressure on asset quality. The net profit growth for Fitch-rated banks in 2017 dropped to 10% from 25% in 2016 amid higher credit costs and taxes, although there was considerable improvement at the pre-impairment level. Credit costs have continued to rise in 1Q18, and while pre-provision operating profitability buffers could still absorb the higher credit costs, they could weigh on sector ROA in 2018. The report said deposits will remain the main source of funding for Sri Lankan banks, as it was in 1Q18 with 83% of total funding. The share of current and savings accounts (CASA) for the sector had decreased to 34% of total deposits from 37% at end-2016 due to the shift to term deposits on account of higher interest rates. The loans/deposit ratio for the sector had eased slightly to 87% by 1Q18. It notes that the implementation of SLFRS 9 in 2018 presents an additional challenge for Sri Lankan banks, as it could add more pressure on capitalisation through a possible significant one-off adjustment, and drive a structural increase in normalised credit costs. The Basel III capital shortfall could widen through the impact of SLFRS 9, although the impact on regulatory capital ratios is likely to be spread out across several periods.