Sri Lanka's banking sector expected to see continued growth and profitability

With strong asset growth, reliable profitability and solid capital adequacy, the Sri Lankan banking sector stands in sound health these days as it looks forward to a period of continued economic stability. Like other sectors, the industry is moving in the direction of greater capital and technological requirements, and continues to undergo a period of consolidation – particularly among its smaller players. In addition, new legislation on microfinance holds promise in seeing banking services spread further beyond the Western Province, with major benefits for companies and individuals outside of the country’s metropolitan centre.

At the same time, however, the sector does face challenges as economic growth slows down and the government attempts to take some of the heat out of recent credit growth. Capitalisation may increasingly be a challenge as loan books expand and while new requirements are being introduced with the sector moving towards Basel III. All elements are occurring in a context where country risk may be creeping upwards. Nonetheless, 2017 appears likely to see continued profit growth, with many banks and finance companies adjusting to accommodate new technological advances and rising expectations from the country’s younger and increasingly sophisticated consumers.

Sector Overview

As of early 2017 the sector included 13 local and 12 international licensed commercial banks (LCBs) and seven licensed specialised banks (LSBs). The main difference between these two classifications is that only LCBs may issue current accounts or engage in trade financing and offshore banking businesses. In addition, there are 46 licensed finance companies (LFCs) and five specialised leasing companies (SLCs). These – along with pension and providential funds, primary dealers, rural banks, credit cooperatives, stock market outfits and other small intermediaries – make up Sri Lanka’s financial services sector, which in 2015 accounted for 5.7% of GDP. In the first half of 2016 the sector’s growth rate was 15.1%.

The regulator for the industry is the Central Bank of Sri Lanka (CBSL), overseeing all institutions not covered by the Securities and Exchange Commission of Sri Lanka – which manages the activities of the stock market and its associated institutions – and the Insurance Board of Sri Lanka, which looks after life, non-life and reinsurance activities. The Monetary Law Act of 1949, Banking Act of 1988 and Exchange Control Act of 1953 provide the legal basis for the CBSL’s supervision of the sector, with LFCs coming under the Finance Business Act of 2011 and SLCs under the Finance Leasing Act of 2000.

The sector further includes the Sri Lanka Banks’ Association (SLBA), which all the country’s banks are members of, and the Association of Professional Bankers, which brings together industry players and experts to promote the development of the sector. Other professional bodies include the Leasing Association of Sri Lanka and the Lanka Microfinance Practitioners’ Association. Since 2003 there has also been a financial ombudsman, through which complaints and disputes involving customers and banks, as well as non-banking financial institutions (NBFIs), can be resolved independently.

Facts & Figures

According to data from the CBSL, the banking sector – including LCBs and LSBs – had combined assets of LKR8.45trn ($57.6bn) in the second quarter of 2016, while other entities – including NBFIs, LFCs and SLCs – had combined assets of LKR1.11trn ($7.6bn). Both figures represent considerable growth over the same period in 2015, when the respective totals were LKR7.35trn ($50.1bn) and LKR891.3bn ($6.1bn).

Indeed, net loans and advances for banks rose from LKR4.12trn ($28.1bn) to LKR4.95trn ($33.8bn) over the same period, while for NBFIs they grew from LKR681.95bn ($4.6bn) to LKR868bn ($5.9bn) in that time. This expansion has largely been funded by growing deposits, with CBSL figures also showing total liabilities, including equity, for banks rising from LKR7.35trn ($50.1bn) to LKR8.45trn ($57.6bn) between the second quarter of 2015 and the same period in 2016, while for NBFIs the figure increased from LKR891.29bn ($6.1bn) to LKR1.11trn ($7.6bn). Within these figures, total deposits in the banks rose from LKR4.95trn ($33.8bn) to LKR5.7trn ($38.9bn), while NBFIs saw their total deposits increase from LKR436bn ($3bn) to LKR500bn ($3.4bn).

Recent Policies

Much of this expansion is connected to overall economic growth. The country was largely shielded from the global financial crisis of 2008, with Sri Lankan financial institutions generally lacking any significant international exposure. This kept the sector in good stead as the civil conflict came to an end in 2009, after which the economy expanded rapidly, with real GDP rising 8% in 2010, 8.4% in 2011 and 9.1% in 2012.

A slowdown did follow, however, as the external environment weakened and domestic macroeconomic imbalances had an effect. Nonetheless, GDP growth for 2015 stood at around 4.8%, while GNI per capita at current US dollar rates grew from $2020 in 2009 to a welcomed $3800 in 2015.

Still, what is surprising to some observers is that this growth has continued in spite of recent government moves to tighten monetary expansion. The authorities have taken such steps since 2015, when a low interest rate environment, combined with increasing consumption, drove accelerating private sector credit demand.

By the end of 2015 this demand for financing had expanded by 25.1%. The CBSL responded by raising interest rates in February and July 2016, while in January 2017 the CBSL also increased banks’ statutory reserve ratios by 150 basis points. “Continued commitment to fiscal consolidation will contribute towards strengthening the real GDP growth, provided that the implementation of reforms are sustained amidst challenges in the long-term,” Indrajit Wickramasinghe, CEO of Union Bank, told OBG.

Economic Trends

These measures did eventually have an effect, with the CBSL reporting in October 2016 that growth in credit granted to the private sector by LCBs had decelerated in August from 28.5% in the previous month to 27.3%. These numbers were still some way above the CBSL’s stated target of around 20% annual credit growth, raising the prospect of further interest rate rises and more efforts to tighten the money supply. The general expectation in Colombo was that the 2017 budget would see some fiscal tightening, in line with Sri Lanka’s agreement with the IMF, further dampening credit growth for the year.

However, while the 2017 budget aimed for a deficit of 4.6% – compared to 5.4% in 2016 – capital expenditure increased from LKR500bn ($3.4bn) in 2016 to LKR798bn ($5.4bn) in 2017. A further concern is that lending in the real estate sector has accounted for much of banks’ asset growth over the last few years. With the end of civil conflict in 2009 there was a rush – by expatriate Sri Lankans in particular – to invest in new middle- and high-end apartments in Colombo; yet there are concerns as to whether there might not be an oversupply of such real estate in 2017. Private banks and the CBSL will likely be more closely examining the levels of risk exposure in this sector in 2017.

In any case, the 2015 credit boom was, naturally enough, a great boon for banks’ profits, with these reaching record levels. That year, some LKR97bn ($661.4m) in profits was registered by LCBs and LSBs, up 10% from LKR88bn ($600m) in 2014. This was despite thin net interest margins of around 3.5%, a result of the environment of low interest rates. Profitability remained strong into 2016. For banks as a whole, CBSL figures show net profit equalling LKR52.12bn ($355.4m) for the second quarter of 2016, up from LKR45.7bn ($311.6m) in the second quarter of 2015. For NBFIs, CBSL figures showed net profit for the three months to the end of June 2016 at LKR5.4bn ($36.8m), up from LKR4.7bn ($32bn) for the same period in the year before.

Yet, in an economy where per capita income still averages $3800 – despite healthy increases in recent years – loan and asset quality may be a concern at a time of rapid credit expansion, particularly in a market with so many lenders competing to boost their loan sheets. The overall trend in non-performing advances, however, has been downwards. In the second quarter of 2016, the net non-performing loan (NPL) ratio stood at 1.6% for the banking sector overall, down from 1.7% at the end of 2015 and 2.6% at the end of 2014. The NPL ratio for NBFIs also fell from 1.83% to 1.26% in the same period. Financial institutions have thus shown a determination to ensure loan quality, tightening controls over their credit procedures, while a culture of steady repayment remains widespread.

Basel Iii

Perhaps more of a risk in this environment is capitalisation, particularly for small and medium-sized enterprises (SMEs), as they extend their loan books in response to competition. Capital adequacy ratios (CARs) have been in decline, and for banks the average CAR stood at 14.7% in the second quarter of 2016, down from 16% in the same period in 2015. For NBFIs, the core capital-to-risk weighted assets ratio fell from 14.47% to 12.59% over the same period. Yet these are clearly still well above the CBSL’s regulatory requirements for CARs on Tier-I and Tier-II capital of 5% and 10%, respectively. Indeed, by and large Sri Lankan banks and NBFIs remain well capitalised. This should stand them in a good position as the country moves towards the implementation of Basel III – a process that commenced in January 2017. The CBSL expects the switch-over will take two to three years.

Currently, the minimum core capital requirement for LCBs is LKR10bn ($68.2m) and LKR5bn ($34.1m) for LSBs and licensed branches of foreign banks. Under Basel III, a core capital requirement of LKR20bn ($136.4m) has to be met in 2017, with this amount shifting upwards in stages in the periods to follow until full implementation. At the same time, the CBSL has also been raising the liquidity coverage ratio, and in January 2017 it rose to 80%, with further increases of 10 percentage points each January thereafter until full coverage is reached. The CBSL has also been raising the requirements for NBFIs. The minimum capital requirement for a finance company was set at LKR400m ($2.7m) in 2008, while for a leasing company the figure has been LKR300m ($2m) since January 2015. Both are due to increase substantially in 2017.

For the majority of banks and NBFIs, these requirements are unlikely to be difficult to meet. However, banks that do not possess the necessary levels of capital may find raising these funds expensive going forward, as the Sri Lankan economy slows and risk premiums rise. This force will be an additional incentive for the sector to consolidate – a long-standing goal of the country’s financial sector regulators.

Indeed, the previous government had prepared legislation to enforce this very type of consolidation for both banks and NBFIs. The new government has taken a more market-driven approach, believing that the gradual raising of standards and competitive forces is a way to drive out the less robust players and therefore streamline the sector.

Concentration

Nevertheless, while the total number of banks and NBFIs indicate that such a consolidation is perhaps overdue, in some respects Sri Lanka remains under-banked. Among the 25 LCBs, two are state-owned, 11 are domestic private banks and the rest are foreign. In regard to LSBs, six are state-owned and two are private.

For LCBs, the distribution of assets is around 42% for state banks, 46% for domestic private banks and 10% for foreign banks. Two state entities, the People’s Bank and Bank of Ceylon, dominate the LCB sector, along with the four largest privately owned banks in the country: Commercial Bank of Ceylon, with some 13% of assets; Hatton National Bank, with 10%; Sampath Bank, with 8%; and National Development Bank with some 4%. Seylan Bank also has around 4% of assets and Nations Trust Bank holds 3%. The two state-owned LCBs and top four private LCBs account for some 77% of total LCB assets.

This concentration among the six or seven systemically important banks means that the remaining players have very little market share between them. Many choose to specialise, with foreign banks in particular tending to leverage their overseas connections to work in areas such as project finance and high-net-worth individual retail banking. These firms are also highly unlikely to have a presence on the ground outside of a very limited geographical area, usually within the Western Province.

According to CBSL data, Sri Lanka had a banking density of 17 branches per 100,000 people in 2014 – about half that of the US, but more than India’s 13 per 100,000. In 2014 Sri Lanka also had 6554 bank branches and 2635 ATMs. Filling the financial services gap beyond the more densely populated Western Province has traditionally been the job of NBFIs, and there is an increasing recognition of the vital role they play in providing financial services. The importance of encouraging a well-regulated and well-balanced deposits and loans system for rural areas is also recognised under the Microfinance Act, which went into force in mid-2016.

Calling Home

Meanwhile, one of the most important areas for the financial sector remains processing the large amount of overseas remittances that flow into the economy from Sri Lankan workers living abroad. In July 2016 remittances covered some 40% of the country’s overall import bill and reached $618.3m. For the period from January to July 2016, remittances totalled $4.8bn, up 4.5% on the same period in 2015. The earnings of Sri Lankans working abroad were approximately twice the value of tourism sector revenues, which is the country’s other primary source of foreign exchange.

The banking and NBFI sectors have been some of the key beneficiaries of this income stream, with a number of innovative approaches employed to access this lucrative market. Commercial Bank, for example, has introduced an online remittance system in cooperation with a number of banks in the Gulf, as the Middle East accounts for 62-65% of all Sri Lanka’s remittances. The system enables real time money transfers, with expatriates able to deposit money in the country in which they work while their relatives at home can then immediately withdraw the money from a local ATM. With some 1.2m Sri Lankans working abroad, this is a major source of business with long-term benefits, as expatriates often retain their account with the bank they work with upon their return to Sri Lanka, and their families are also brought into the banking system.

Further expanding in this segment, Commercial Bank also recently introduced a remittance card that offers emergency loans and discounts to expatriates and their families back home. This effectively opens up a credit facility for many who were previously outside of the formal banking system.

Cutting Edge

These advances in e-banking are not restricted to remittances, however. In recent times, the sector has increased the standards of electronic services, as well as the overall quality of the banking experience. Internet and phone banking are receiving major investments across the industry. This should help address the issue of over-concentration in the economically vibrant Western Province, as e-services are earmarked for roll out across the country, leap-frogging the need for an abundance of physical branches.

The IT sector will play a large role in this shift, as companies must have secure connections for both consumer transactions and their own back-office purposes. “The IT sector needs to work more to ensure consumer trust – only then will we see more non-cash transactions,” Santosh Kumar, country manager for Mastercard, told OBG. Investments in new IT is also a priority when it comes to meeting international banking standards, particularly as the sector moves to adopt Basel III requirements. Shifting away from paper trails to electronic systems helps with screening and anti-money laundering procedures, with the banking and NBFI sectors taking this very seriously in their plans for IT development.

Supporting Investment

In the past, much of the growth in Sri Lankan banking and finance has been consumer driven, particularly for the domestic banking and NBFI sector. Car loans, for example, provided both segments with considerable profitability in the past, as the economy boomed and citizens, emerging from the uncertainties of 30 years of conflict, looked to finance their improving standard of living and make larger purchases.

Now, as the economy slows down and major infrastructure projects – such as Colombo Port City, Megapolis, Hambantota Port and others – are being implemented, the larger banks are looking to boost their investment banking portfolios, as well as their interests in retail. This dovetails with moves to consolidate the sector into larger entities, capable of financing large projects. “There is plenty of economic activity going on,” Mangala Gamage, head of finance at People’s Bank, told OBG, “And with this, we are moving more into investment banking, where we need bigger banks to undertake project financing.”

Indeed, scalability is something the market currently lacks, with large projects usually financed offshore, as the local market lacks the depth of resources necessary to take on significant amounts of risk. As a result, project financing currently remains a small, niche area for the sector.

Meanwhile, lending continues to be a particular concern for SMEs, with People’s Bank being one of the major sources for this type of funding. The government has also recently announced a LKR5bn ($34.1bn) allocation for a SME-specific financing scheme, with the CBSL now working on a financial inclusion policy framework that will set quantitative targets for the disbursement of SME loans and the opening of SME bank accounts. Rural development banks are also to be consolidated, overseen by the CBSL’s regional departments, with the role of such institutions in making concessional loans to SMEs likely to expand in the future.

Outlook

With the economy’s growth slowing down and regulatory requirements increasing, the period ahead looks to be a tough one for smaller banks and NBFIs. Some consolidation is expected and generally welcomed, as it will strengthen the sector and enable it to offer a wider range of services, both in retail and investment. Risk from the exit of smaller entities is of no great concern, given that the majority of the sector’s assets remain highly concentrated in a handful of major banks and NBFIs.

Thus, 2017 is expected to see continued growth and profitability, although much will depend on the government’s handling of wider political and economic pressures. In the longer term, continued investment in IT and opening up to other regional markets could see Sri Lanka’s banks make an increasingly positive impression beyond the country’s own borders. Meanwhile, a challenge exists in funding the growth of the domestic economy – a vital step for sustainable economic development, especially as the government seeks to boost exports while also addressing the spread of domestic industries beyond the Western Province. As ever, such challenges are also providing new and significant opportunities.