Sri Lanka's banking sector moves to comply with global regulations

Sri Lanka’s banking sector is currently implementing major changes in the way business is done, due mainly to the rollout of Basel III and International Financial Reporting Standard 9 (IFRS 9) regulations. Stricter capital requirements are pushing non-bank financial institutions (NBFIs) to consolidate, while a host of new rules are being collated for the country’s emerging financial technology (fintech) industry. These new frameworks and procedures should leave lenders in a stronger position going forward, in terms of both their capacity to meet and deal with new shocks, and their ability to expand business and functionality across the island.

Basel III

Issued in the aftermath of the 2007-08 global financial crisis, the Basel Committee on Banking Supervision’s third accord, Basel III, aims to strengthen regulations and requirements for banks regarding capital adequacy, leverage, liquidity and funding. In 2013 the Central Bank of Sri Lanka (CBSL) established the first local foundations of this new accord, which began to take effect from June 2017. The process of incremental adoption by financial institutions has been ongoing since then.

The first foundation involves meeting a minimum Tier-1 capital adequacy ratio (CAR). Under the previous Basel II arrangement, this was a minimum of 5% of risk-weighted assets (RWAs) for all banks. Under the move to Basel III, however, banks are first divided into those having assets below LKR500bn ($3.2bn) and those with assets exceeding this value. Those in the first group saw their Tier-1 CAR lifted to 7.5% before rising to 8.5% by the start of 2019. Those surpassing the asset threshold were designated as domestic systemically important banks (DSIBs) and required an additional buffer of 1.5% of RWAs.

The ratios for NBFIs were set differently, with specialised leasing companies (SLCs) with less than LKR100bn ($629.8m) in assets seeing their Tier-1 CAR requirement rise from 6% in July 2017 to 8.5% by July 2021, while those with assets above the threshold are required to increase their Tier-1 CAR from 6% to 10% over the same period.

Licensed finance companies (LFCs) with less than LKR100bn ($629.8m) in assets are required to raise Tier-1 CARs from 6% in July 2018 to 8.5% by July 2021, while those surpassing the limit have to increase their ratio from 6% to 10% over the same period.

In terms of leverage ratios – which compare a bank’s capital base with its assets – since January 2018 these have been required to be above 3% for the smaller banks and 4% for DSIBs. Meanwhile the liquidity coverage ratio – the amount banks must maintain to cover immediate obligations – was set at 100% in January 2019.

Finding the Capital

Many Sri Lankan banks already possessed CARs above the required levels, although some have found meeting the new obligations challenging, particularly those who had expansionist strategies and pushed ahead with rapid loan growth. Raising additional capital has also been hampered recently by a lack of buoyancy in the country’s capital markets (see Capital Markets chapter). In addition, in the past, some banks – particularly state-owned banks – made high dividend payouts leading to a thin initial capitalisation from which they could accrue the new requirements.

Nonetheless, by January 2019 all DSIBs were able to report Tier-1 CARs that were higher than those required by Basel III, with the three largest DSIBs – Bank of Ceylon, People’s Bank and Commercial Bank of Ceylon – boasting Tier-1 CARs of 10.77%, 10.8% and 12.11%, respectively, at year-end 2018. Indeed, local banks largely demonstrated that they were ahead of the global curve regarding regulation and their ability to absorb shocks.

Meanwhile, however, some smaller banks and NBFIs have been facing more challenges in meeting the escalating requirements. The CBSL has urged LFCs and SLCs that find the new ratios difficult to consolidate with other institutions – while also warning that there will be little regulatory forbearance for those who do not meet their obligations. Consolidation is part of the central bank’s overall strategy for the NBFI segment, with the Basel III requirements seen as an opportunity to facilitate mergers and strengthen the financial sector overall.

IFRS 9

The shift to IFRS 9 should also help strengthen the financial sector. This, too, traces its history back to the global financial crisis of 2007-08, after which the international accountancy rules of the time, known as the International Accounting Standard 39, were widely thought to have been inadequate in preventing recession.

Previous regulations employed a system of fair value, which led to delays in the recognition of financial losses. IFRS 9 involves a shift from incurred loss accountancy to expected credit loss – a more forward-looking approach that requires financial institutions to identify current business drivers and model the impact of possible future scenarios on their company. Banks and NBFIs have to calculate their expected credit losses for the next 12 months and for the entire life cycle of all their performing and non-performing assets.

At the same time, IFRS 9 introduces a more stringent basis for asset classification and hedge accountancy that brings actuarial techniques into line with risk management activity. The previous system identified four major categories of assets, which have been reduced to two under IFRS 9. The latest rules also measure banks’ equity investments at fair value – a measurement that was not required under previous regulations.

Transitioning

Sri Lanka’s banks are now engaged in the transition to this new model, which is being rolled out under directives from the CBSL and in consultation with the Institute of Chartered Accountants of Sri Lanka. While the new standards came into effect on January 1, 2018, financial institutions were allowed to continue posting quarterly results under the old system for the first nine months of the year, after which IFRS 9 became obligatory for quarterly and annual returns. The year ahead will thus likely see results become clearer, with many sector professionals and investors watching to see how banks and NBFIs cope with the changes.

Overall, IFRS 9 requirements involve an increase in loan loss provisions – which, while making banks more stable and better able to respond to external and internal shocks, also increase impairments and complicate the ability of banks to grow their loan books. The new system also requires a shift from traditional, retrospective accountancy techniques, where the results of past actions were evaluated, to prospective techniques, where the modelling of future risks and real-time assessments are prioritised. To handle the processing load, manual systems will have to be replaced by new technologies, and automation is therefore a prerequisite for IFRS 9.

Enter Fintech

This creates further opportunity for the growing fintech field in Sri Lanka, the development of which is a key plank of the CBSL’s Roadmap 2019. Determining the nature and scope of a safe space for fintech product development is thus a current priority, and the central bank appealed to fintech professionals for ideas in May 2018.

Development of virtual banking is the immediate goal, and the central bank is also working to establish some of the necessary fundamentals, such as LANKAQR, a national QR code for local currency payments introduced in 2018. Other moves have included the establishment of an inter-industry working committee to explore blockchain. The CBSL has also appointed a task force to identify which regulatory steps will be necessary to enable virtual currency schemes in the country, in order to ensure system stability and security.

Cashless payment systems based on smartphone technology are also beginning to increase in popularity. Services such as JustPay, which allows realtime transactions between customers and retailers of up to LKR10,000 ($62.98) by mobile phone, have received backing and licensing from the CBSL’s LankaClear – the former national cheque-clearing house – and can now take advantage of the national QR code system. JustPay proposes a procedure using point-of-sale terminals that will be cheaper than debit or credit card systems for both retailers and consumers. The hope is that these mobile payment systems may also synergise with e-commerce developments, and enable apps to link retailers with delivery companies and customers in the future.

The new regulatory landscape should see Sri Lanka’s financial institutions become more secure and better able to take advantage of new trends in technology. Such changes are not without their challenges, however, and those firms able to adapt the quickest will likely herald the biggest gains.