The Central Bank last week said that the overall outlook for financial system stability remains favourable, although external and domestic risks have increased.

This assessment is contained in the Bank’s Financial System Stability Review 2007, excerpts of which were released to the media last week.
Following is the full text of the Bank’s statement.

The Central Bank of Sri Lanka has released its Financial System Stability Review (FSSR) 2007. As part of its mandate of maintaining financial system stability, the Central Bank conducts surveillance of the financial system to identify potential risks and vulnerabilities and to assess its capacity to cope with disturbances and shocks. The results are presented in the FSSR, which is published annually.

The purpose of the FSSR is to provide information to financial institutions and market participants to prepare for and to manage these risks and to encourage awareness and debate among the wider public on issues affecting financial system stability.

The FSSR 2007 is based on the performance of the financial sector in the first half of 2007 and any subsequent information that is available for the third quarter of the year. The report contains six chapters. The report starts with an overall assessment of financial system stability and the potential risks and vulnerabilities that may arise in the future.

Chapter 2 discusses the global and domestic macroeconomic developments and risks. Chapter 3 deals with the recent developments in domestic financial markets. Chapter 4 covers the performance of the banking sector, while Chapter 5 deals with the performance of other key financial institutions. Chapter 6 provides an assessment of the financial infrastructure, particularly the main (systemically important) payment and settlement systems and changes in the legal framework relating to the financial sector.

The report notes that the financial system, supported by sustained economic growth, has been resilient and is expected to remain stable amidst challenging domestic and international macroeconomic and financial market developments. The major (systemically important) financial institutions remain sound as a result of improved financial positions and risk management systems within an enhanced regulatory and supervisory framework which has strengthened their resilience and enabled them to withstand shocks. However, there are downside risks which require continued vigilance and risk mitigation measures.

Internationally, there has been a deterioration in global financial market conditions. Sri Lankan financial institutions were not directly affected by the recent episodes of volatility in international markets, but there could be indirect consequences, such as higher credit risk premiums for emerging economies and the likely moderation in global economic growth and world trade in 2008.

On the domestic front, the robust economic growth continues to underpin financial system stability. However, inflationary pressures mainly stemming from higher energy and imported food prices and large fiscal deficits and the consequential rising interest rates, present macroeconomic challenges to financial stability. Appropriate monetary and fiscal policies are being pursued to contain this risk.

The rising public debt service obligations could exert an upward pressure on interest rates in the future. However, the debt management strategy being implemented to extend the maturity profile of public debt should help to contain the problem.

Credit growth has been decelerating, although it is still high, in response to policy measures. This is beneficial for maintaining financial stability, as it will dampen inflationary pressures and reduce the likelihood of an increase in credit risk in banks. In addition to tightening monetary policy, the Central Bank introduced several prudential requirements to curtail bank lending for consumption purposes and to mitigate the risks associated with this type of lending (specially through credit cards). These measures include the imposition of general provisioning and the increase in risk weights on consumption lending.

The banking sector continued to be profitable and sound. Banks were able to cope in the rising interest rate environment by re-pricing deposit and loan rates, thereby maintaining their profitability.

The capital funds of banks have increased and the capital adequacy ratios of the banking system are well above the minimum regulatory requirements, demonstrating higher risk absorptive capacity. The asset quality of banks, which has improved significantly in the past few years due to better risk management techniques and loan recovery procedures, enhanced prudential requirements and risk-focused supervision, is being maintained. The provisioning levels have also increased, indicating greater resilience. Credit, market and liquidity risk are at manageable levels. However, there are some areas where risks could build-up.

The high growth in bank lending could bring about a rise in credit risk and non-performing loans and banks are advised to maintain high credit standards to avoid adverse developments in this area. Banks should also improve their asset-liability management to mitigate liquidity and market risks arising from asset-liability mismatches. The overall resilience of the banking system is expected to improve with the implementation of the Basel II Capital Adequacy Framework and integrated risk management systems in 2008. The profitability of finance and leasing companies could become constrained in the higher interest rate environment, as funding becomes more expensive and these companies have less flexibility to adjust their rates. However, the industry is expected to weather these conditions due to its strengthened capital base and provisioning policies. Nevertheless, careful monitoring of developments in this sector is warranted.

The overall outlook for financial system stability remains favourable, although external and domestic risks have increased. The growth prospects of the Sri Lankan economy are expected to strengthen the performance of the business sector and improve the profitability of financial institutions. The continuation of policies to address the domestic macroeconomic imbalances is imperative to stabilize domestic financial markets. Financial regulators and institutions will need to continue their vigilance and take proactive measures to promote the development, efficiency, soundness and stability of the financial system.

The FSSR 2007 is now available for sale to the public at the Central Bank Sales Counter, Centre for Banking Studies, No. 58, Sri Jayawardenapura Mawatha, Rajagiriya, at the Rs.250/= and is also available on the Central Bank website – www.cbsl.gov.lk The Sinhala and Tamil versions of the report will be available shortly.