Proposal to raise capital floor to benefit banking sector: Fitch

A proposal to increase the minimum capital requirements for banks in Sri Lanka should help to strengthen the capitalisation of some banks and appears aimed at bringing about consolidation in the banking sector, which should raise systemic stability of the sector in the long term, Fitch Ratings says.

The Sri Lanka government in its 2017 draft budget proposed to increase the minimum capital of licensed commercial banks to LKR20bn from LKR10bn and licensed specialised banks to LKR7.5bn from

LKR5bn. Of the 15 domestic banks rated by Fitch, six did not meet this requirement based on reported core capital as at 1H16. Of these six, three do not even meet the existing, lower capital requirements.

This underscores Fitch’s view that capitalisation in the sector needs to be shored up.

Banks were initially expected to adhere to the current lower minimum capital requirement from 1 January

2016. However, the Central Bank of Sri Lanka granted extensions to some banks to meet this

requirement by 1 January 2018 with specified interim targets. Fitch believes that such regulatory

forbearance has contributed to bank undercapitalisation and could undermine the authorities’ objective

of consolidation.

Fitch is of the view that the reported capital adequacy ratios of banks in Sri Lanka continue to benefit

from certain exposures that do not attract a capital allocation under local regulations. Fitch has long

highlighted that capitalisation of major state banks is thin on an adjusted basis. Internal capital

generation at these banks is constrained by dividends to the government and they are likely to continue

to be dependent on the state for core capital infusions. Capitalisation of most nonstate

banks has also

been decreasing amid rapid credit expansion. The sector has not also raised much core capital through

capital infusions from shareholders. Fitch believes banks could face challenges in raising capital,

particularly as the operating conditions in Sri Lanka remain difficult , as signalled by Negative Outlook on

the sovereign rating, which was downgraded to ‘B+’ from ‘BB’

in February 2016.

There could be greater urgency for banks to build their capital buffers if the Central Bank of Sri Lanka

implements Basel III capital standards in the near future as expected. Fitch believes that this could pose

a challenge to some of the banks that do meet the enhanced minimum capital requirements because

they would need to have sufficient capital to fulfil additional requirements.

A previous plan to bring about financial sector consolidation under the “Master Plan for the Consolidation

of the Financial Sector” did not significantly reduce the number of banks. There are 25 licensed

commercial banks and seven licensed specialised banks in Sri Lanka.