HSBC Global Research views on financial system stability in Sri Lanka

Following are excerpts from the chapter on financial stability in HSBC Global Research report’s on Sri Lanka released last week.

The Central Bank also has the objective of maintaining financial system stability. According to the Bank, financial system stability means a safe and secure financial system which is able to withstand external and internal shocks. Such a system creates a favourable environment for depositors and investors alike, facilitates effective and efficient functioning of financial institutions and markets and hence promotes investment and economic growth.

The Central Bank discharges this role by establishing the required legal framework, regulating and supervising key categories of financial institutions, maintaining stability in key financial markets, overseeing the payments and settlements system, acting as lender of last resort and by regular surveillance of the entire financial system, including insurance and stock market activities.

Increased resilience
According to the International Monetary Fund’s (IMF) Article IV consultation concluded in 2007, financial sector stability has improved in Sri Lanka and progress has been made in strengthening the supervisory framework.

However, the financial situation of the banking sector still depends crucially on the performance of the state owned banks. In this regard Bank of Ceylon and People’s Bank are key, as they together account for nearly a third of the banking system’s assets.

Both these banks were recapitalised in the 1990s though this was not combined with effective restructuring, resulting in significant underperformance. However, more recently, progress has been made in restructuring these banks. The restructuring programme for Bank of Ceylon was initiated in 2004 and that for People’s Bank at the end of 2005.

The overall performance of the banking sector has been improving over the last few years, with gross non-performing loan ratios having fallen sharply to below 6% in 2006 compared with 12.3% in 2003. NPL ratios for state owned banks have also improved from nearly 18% in 2003 to around 8% in 2006 – reaching levels similar to private domestic banks though high compared to the 1% NPL ratio for foreign banks.
Capital adequacy ratios have also improved across the banking industry – both total capital and Tier 1 capital. Within the state banks, capital adequacy for Bank of Ceylon is above the regulatory minimum of 10% and that of People’s Bank has reached 2% following the recapitalization programme of the Asian Development Bank (ADB). Capital adequacy ratio for licensed specialised banks was 20.3% and that for finance companies 15.0% as at the end of 2006. However, a number of risks still remain. The state banks remain structurally weak and face a number of operating challenges. Poor risk management practices, large stock of bad debt, inadequate use of information technology and a large labour force are obstacles to modernisation and restructuring.

Further, the lending by state owned banks to state owned enterprises increases the risk to the banking system.

While credit growth is a sign of financial deepening, loan growth to the housing sector is running at a historical high of around 45% y-o-y and that for consumption purposes is also at a record high of 59% y-o-y, as at the end of March 2007.

This is clearly an area of concern and supervision will need to be strengthened to mitigate the risks of a potential rise in NPLs. Moreover, the Sri Lankan banking system continues to be characterised by high spreads – almost double those of other economies in the region. The key point here being that the threshold for the interest rate spread is set by the state owned banks which have higher operating costs on account of a large labour force and an inadequate use of information technology, for example. Private domestic banks and foreign banks, which are typically more efficient, are therefore effectively benefiting from the “inefficiencies” of the state owned banks.

Economising on operational costs and improving overall risk management, especially for the state owned banks, is vital. Furthermore, consolidation in the banking industry will also help in reducing cost of intermediation by improving returns to scale and also prepare banks for regional competition. Regulatory and supervisory framework
The Central Bank, which is responsible for regulating and supervising all major financial institutions and overseeing the payment and settlement system, has implemented a number of initiatives in the recent past to enhance the existing regulatory and supervisory framework, including plans to adopt the Basel II capital accord by January 2008.

We have listed below some of the developments:

• A capital charge for market risk was introduced in 2006 in line with the Basle Capital Accord which requires a minimum capital adequacy ratio of 10% of risk weighted assets for all banks.
• The Central Bank issued guidelines to banks for the parallel computation of the capital charge, in preparation for Basle II.
• Minimum entry capital requirement of banks was enhanced so as to facilitate consolidation in the banking sector.
• A general provision for loans was introduced at the end of 2006. All banks are required to maintain 1% of total performing loans and advances and non-performing loans in the overdue category (loans and advances in arrears for 3-6 months).
• Prudential norms relating to registered finance companies were further strengthened by the imposition of a new minimum core capital requirement and 10% capital adequacy ratio.
• For primary dealers, minimum capital required was increased and capital adequacy was raised to 8% from 5%. The Bank has also continued to review and initiate reforms to strengthen the existing legal framework and introduce new legislation to smooth the functioning of the financial system.
• The Banking Act was amended in 2006 to widen its scope and also address ambiguities in the existing law.
• The National Payments Council was set up in2006, comprising representatives from all major stakeholders to facilitate formulation of a modern national payment and settlement policy.
• The Monetary Law Act was amended to fix the minimum percentage of loans to be extended to any specified sectors of the economy by licensed banks.
• Comprehensive anti money laundering legislation was enacted in March 2006, building on the Suppression of Financing of Terrorism Act of 2005.