Central Bank responds to S&P’s assessment of Lankan banking system

The Central Bank of Sri Lanka notes with grave concern, a statement by Standard and Poor’s, issued yesterday, on the Sri Lankan Banking System and wishes to state that the statement is factually incorrect, illogically analysed, and is highly contradictory.

1. Soundness of the Banking System

Quite contrary to the rationale for the statement, Sri Lankan banking system is sound and resilient with the performance of the banking industry improving over past few years. As indicated in the Table below, key financial soundness indicators of the banking sector which accounts for 55% of financial system assets, were maintained at healthy levels.



The Key Financial Indicators display a conspicuous improvement in the gross non performing advances ratio (NPA) from 5.2% in 2007 to 3.8% in 2011 with absolute volumes of NPA indicating only a relatively lower growth of 25% in comparison to the overall credit growth of 69%, during this period. This evidence is contrary to the comment on the existence of a ‘weak payment culture’.

The capital base of the banking sector has increased nearly two fold since 2007 with the introduction of the Basel capital standards and enhanced minimum capital requirement for banks. Profitability of the banking sector, which has continuously increased, has further reinforced the level of capital. These factors have contributed to the improvement in capital adequacy ratios despite the significant growth in assets. It is pertinent to note that the core capital ratio and total capital ratio of 5% and 10%, respectively, imposed by the Central Bank are more stringent than the international standards.

Liquidity of the banking system has been well managed with the statutory liquid assets ratio being maintained well above the limit of 20%. The growth in deposits and significant representation of retail deposits, further support liquidity risk mitigation.

Concentration of credit exposure is regulated by the Central Bank with Directions on maximum amount of accommodation, lending to related parties and banks being advised to impose sector wise exposure limits. Any concentrations to certain entities have been permitted by the Monetary Board in consideration of national priorities and/or national interest and the ability of the banks to

withstand any potential risk arising from such exposure. Mandatory lending of at least 10% of the advances portfolio to the agriculture sector was introduced with the intention of enhancing the food sustainability of the country.

2. Regulatory framework governing licensed banks

Despite the global financial distresses, the Sri Lankan banking industry stands resilient and the regulations in force are of international standards. Licensed banks are required to comply with the requirements of the Banking Act and Directions issued on fundamentals such as capital adequacy, liquidity, related party exposure, ownership of share capital, classification of loans and advances, income recognition and provisioning, risk management in foreign exchange business, integrated risk management, off-shore banking transactions and assessment of suitability of bank directors and the key management. The compliance of banks with these regulations is monitored strictly on an on-going basis and corrective action initiated.

A mandatory Direction on corporate governance encompassing all aspects of good governance and transparency is already in place. All these prudential regulations are given effect in line with the Basel Core Principles of effective bank supervision issued by the Bank for International Settlement, Basel and in text and action they are more stringent than those in many countries in the region as well as globally. Additionally, the mandatory requirement for banks to obtain certifications from external auditors on their compliance with corporate governance directions and internal controls on financial reporting, which are required to be published along with the audited financial statements provides an independent assessment for the general public on each bank’s level of internal controls, transparency and governance.

Further, Anti Money Laundering procedures and Know Your Customer requirements are also in place with respect to all banking transactions. Sri Lanka

possesses a well-developed payments and settlement system to facilitate banking transactions, which is subject to the provisions of the Payments and Settlements Act.

Thus, the views of Standard and Poor’s that ‘the risk management practices are evolving’ and that ‘the banking regulations in Sri Lanka are somewhat weaker than international standards’ and specifically ‘governance and transparency are weak by global standards’ are baseless. Importantly, this statement of Standard and Poor’s is self-contradictory with their contentment on key regulations for Sri Lankan banks.

3. Supervision of banks

The Central Bank has a continuous supervision process which is an uninterrupted monitoring of banks to assess the trends of banks on an individual and a system-wide basis. This process facilitates early identification of any potential risks. Spot examinations of banks are carried out on specific issues as and when required based on triggers identified through the continuous supervision process. Thus, the supervisory process is well equipped to proactively detect any build up in risks.

Further, the affairs of banks are assessed through on-site examinations which are conducted at least once in two years. However, the Central Bank conducts follow up examinations on a more frequent basis based on the risks and significance of the examination findings. Measures have already been initiated to increase the frequency of conducting on-site examinations in the future.

Hence, Standard and Poor’s statement that the frequency of on-site supervision may not be sufficient to detect risk build ups in banks is not justifiable.

4. Mandatory deposit insurance

With a view to further strengthening financial stability in the country, the mandatory deposit insurance scheme was introduced in 2010. This has helped to ensure continued depositor and investor confidence in the financial system. The deposit insurance fund amounted to Rs. 4.7bn by end 2011. The financial safety net mechanism afforded by the above is further strengthened and supplemented by access to the lender-of-last-resort facility available through the Central Bank.

There have been no banking failures in Sri Lanka despite the global financial crisis. In December 2008, a licensed bank faced a distress situation due to a crisis in a credit card company within the Group and not due to a failure of a finance company. The resolution framework put in place by the Central Bank in late 2007, well before the global financial crisis emanated, proved to be an anchor to the overall financial system stability especially when other countries, including ones with advanced financial systems, were struggling to protect the financial system stability at the cost of public funds.

5. Regulation and supervision of licensed finance companies and specialized leasing companies

In addition to banks, all licensed finance companies (LFCs) and specialized leasing companies (SLCs) are also closely monitored and regulated by the Central Bank. LFCs and SLCs are subject to on-site examinations at least once in every 2 years and weekly, monthly and quarterly reports are obtained through a web based data reporting system. Apart from the regular supervisory procedures, spot examinations are conducted when the Central Bank identifies an issue.

Both LFCs and SLCs are also subject to appropriate prudential regulations which include Directions on capital adequacy, liquidity, business transactions with related parties, classification of loans and advances, income recognition and

provisioning, assessment of suitability of directors and key management personnel and corporate governance. Further, the Finance Business Act, No. 42 of 2011 was enacted recently, which provides for enhanced supervisory and regulatory powers on LFCs and powers to curb unauthorized finance business. All LFCs are required to list with the Colombo Stock Exchange in order to increase transparency of financials and corporate governance.

In conclusion, Central Bank of Sri Lanka wishes to assure the public that the Sri Lankan banking system is sound and resilient and is not prone to high risk as indicated in the statement of Standard and Poor’s.