CB unveils Banking Soundness Index

The Central Bank of Sri Lanka has constructed a simple aggregate banking soundness index (BSI) on an experimental basis, using an approach similar to that taken by the central banks of the Czech Republic, Turkey and Pakistan.
The Bank said however financial market indicators were not included, due to the limited number of listed banks, minimal number of listed bank bonds and the relatively shallow and undeveloped capital market in Sri Lanka.

The BSI indicates that the financial soundness of the banking sector has strengthened since 2000. The BSI declined marginally in 2008 from 2007 due to a slight decline in capital ratios, increases in non-performing loan ratios and a decline in the liquid assets to total assets ratio. However, the banking sector remains profitable, sound and resilient with adequate capital, liquidity and provisioning buffers, thereby preserving its stability

The partial individual indicators selected for the BSI are similar to the IMF’s core set of banking sector indicators, with some minor differences. Capital adequacy and profitability indicate the cushion a bank has at its disposal against potential risks and is a measure of its ability to absorb a reasonable level of losses.
The asset quality indicators reveal the credit risk associated with the bank loan portfolio. The liquidity indicators measure the bank’s reserve against potential liquidity problems, such as loss of access to market sources of funding or large scale deposit withdrawals by the public.
The interest rate risk measures the maturity mismatch between assets and liabilities and indirectly measures the potential losses caused by a rise in interest rates.
The foreign exchange risk covers banks’ exposure to exchange rate movements in either direction.
Table shows the partial indicators that were selected and the weights assigned. The interest rate risk was excluded for the time being, due to the non-availability of data for an adequately long period in an easily accessible form on the net balance sheet position of assets and liabilities.
A partial indicator of interest rate risk will be included in the BSI in the near future, the Central Bank said.
It said an important factor in compiling the BSI is the allocation of weights, as it is difficult to judge the relative importance of each partial indicator to the index.
This could be done by using statistical methods or using expert judgment. In this computation, the latter method has been used. The methodology does not take into account the potential correlation between individual partial indicators. The partial indicators and their weights may be revised from time to time, depending on their importance.
The aggregate BSI has been compiled using quarterly data from Licensed Commercial Banks and Licensed Specialised Banks, for the period 1998 (which is the base year) to 2008.
The BSI indicates that the financial soundness of the banking sector has strengthened since 2000. The BSI declined marginally in 2008 from 2007 due to a slight decline in capital ratios, increases in non-performing loan ratios and a decline in the liquid assets to total assets ratio. However, the banking sector remains profitable, sound and resilient with adequate capital, liquidity and provisioning buffers, thereby preserving its stability.
a) Capital Adequacy: The capital adequacy partial indicator improved since 2000, but has declined slightly in 2008, as risk weighted assets have increased at a higher rate than capital funds. Banks migrated to the Basle II Capital Adequacy Framework which covers for operational risk, in addition to credit and market risk. The total capital adequacy ratio (CAR) at 13.5 per cent and the Tier 1 CAR at 11.5 per cent are well above the regulatory requirements, and thereby sustained the resilience of the banking sector.
b) Asset Quality: The asset quality partial indicator has been on a declining trend since 2001,which is a positive development for banking stability, because this partial indicator has a negative impact on the BSI, but has risen in 2008 due to an increase in the non-performing loan ratios. The asset quality of the banking sector deteriorated slightly due to the slow-down in the economy. Banks would have to focus more on credit risk management to reduce non-performing loan ratios.