Solid performance of Sri Lankan banks maintained by regulatory reform and consolidation

Sri Lanka’s banks are currently experiencing considerable change. Regulatory matters are a prominent concern, alongside the ups and downs of loan growth and economic policy. A careful balancing act is being performed as a result, with those able to tread the narrow path recording healthy bottom lines and continued service expansion in 2018. The year ahead will likely see this trend continue. There is an expectation that an election year may see some fiscal loosening overall to the benefit of credit growth – particularly in the consumer segment. Meanwhile, meeting the new regulatory standards accompanying the rollout of Basel III and International Financial Reporting Standard 9 (IFRS 9) requires some significant changes in the way lenders do business (see analysis). Non-bank financial institutions (NBFIs) also face regulatory shake-ups, with those finding the new standards challenging likely to seek mergers. At the same time, the impact of currency depreciation and economic and political turbulence on business customers is a concern, along with a corresponding hike in non-performing loans (NPLs). Following a global trend, digitalisation and financial technology (fintech) are changing the industry, and the next few years look set to be transformative.

Sector Oversight

The sector’s main oversight body is the Central Bank of Sri Lanka (CBSL), which is headquartered in Colombo and headed by its current governor, Indrajit Coomaraswamy. The CBSL is semi-autonomous and has a five-member monetary board, which includes the governor, the secretary to the minister of finance and three members appointed by the president. The monetary board has the power to issue directives to the whole sector.

The CBSL consists of 30 different departments, including the Bank Supervision Department and the Supervision of NBFI. Each of the central bank’s departments play a significant role in monitoring and regulating the banking sector, as does the Centre for Banking Studies, the CBSL body responsible for training, education and awareness programmes across the industry. The Bank Supervision Department has a range of duties, from promoting the market-driven consolidation of financial institutions to crisis preparedness.

The CBSL divides the sector into licensed commercial banks (LCBs) and licensed specialised banks (LSBs), with the former the larger of the two in terms of assets. The two categories, together with the CBSL itself, made up 69.8% of the country’s combined financial sector assets in 2017, with LCBs accounting for 52.3% of the sector total and LSBs 8%. Other deposit-taking financial institutions comprise 8% of the sector total, specialised financial institutions 2.3% and contractual savings institutions 19.9%.

As part of the CBSL’s Roadmap 2019, the central bank is currently drafting a new banking act, which will strengthen regulations and encourage further developments in digital banking, while also tackling issues with corporate governance, ringfencing, mergers, subsidiarisation of foreign banks and the differentiated regulatory framework for a tiered banking system. A banking sustainability rating index will also be introduced in 2019 for risk-based supervision, alongside additional standards in IT risk resilience.

Structure

As of the third quarter of 2018 there were 26 LCBs operating in the country, of which 13 were domestic and 13 were foreign, according to the CBSL. This was an increase of one from 2017 as Bank of China entered the market in March 2018, opening a single branch in Colombo. The total number of LCB branches grew from 2863 in 2017 to 2881 at end-September 2018. There were also seven LSBs as of the third quarter of 2018, with some 696 branches between them. The largest LSB by assets is National Savings Bank (NSB).

Six of the country’s LCBs are characterised as systemically important banks: Bank of Ceylon (BoC), Commercial Bank of Ceylon (ComBank), Hatton National Bank (HNB), People’s Bank, Sampath Bank and Seylan Bank. As of June 2018 the largest bank by assets was BoC, with LKR1.98trn ($12.5bn), or 18% of the sector total. This was followed by People’s Bank, with LKR1.63trn ($10.3bn, 15%); ComBank, with LKR1.21trn ($7.6bn, 11%); NSB, with LKR1.08trn ($6.8bn, 10%); HNB, with LKR1trn ($6.3bn, 9%); Sampath Bank, with LKR866bn ($5.5bn, 8%); and Seylan Bank, with LKR429bn ($2.7bn, 4%). HSBC is the largest foreign bank, comprising 4% of sector assets. In addition to HSBC and Bank of China, foreign banks operating in the country include Standard Chartered Bank, Citibank, Deutsche Bank, India’s Axis Bank, State Bank of India and Pakistan’s Habib Bank.

Big State

The state is heavily involved in the banking sector, with the two largest LCBs by assets – BoC and People’s Bank – being state-run companies. The biggest LSB by assets, NSB, is also publicly owned. These three banks, combined with five state-owned LSBs, represented around 43% of the banking sector’s total assets as of June 2018. State-run banks also accounted for 44% of the entire sector lending portfolio at the beginning of 2018, at LKR2.8trn ($17.6bn) – up 16% on the previous year. Partly, this is due to their closeness to other state-owned enterprises (SOEs), with government entities taking up much of the state banks’ loan books. This is sometimes considered a double-edged sword, however, as it hinders their ability to extend loan facilities to new sectors of the economy.

In the past, this relationship with the state has also led to the use of the banks to settle public debts. As an example that recently came to light, in 2007 money from BoC was used to pay around LKR1bn ($6.3m) in debts accrued by the now defunct Mihin Lanka airline.

At the same time, however, linkages to the state have also helped give BOC, PB and NSB strong, long-term ratings, with global ratings agency Fitch grading the first two “AA+” and NSB “AAA+” with stable outlooks in October 2018 with the expectation that support is available to them from the state.

Up until 2015 all state-run banks had been under the purview of the Ministry of Finance (MoF), until the newly elected government transferred responsibility to the Ministry of Public Enterprise Development (MPED), which was mandated to restructure all the country’s SOEs. Progress on this has been slow, however, and while moves will likely be made to continue this process in 2019, it is expected to be a long-term project. In May 2018 a proposal to begin with the smaller state banks, specifically Lankaputhra Development Bank (LDB), using a public-private partnership model was reported by local media. Later in the year, however, the MPED suggested that LDB, Regional Development Bank and the Sri Lanka Savings Bank could potentially be merged with NSB. The year ahead will likely see further developments in this field.

Islamic Banking

With an approximate Muslim population of around 10%, sharia-compliant banking, while still a relatively modest affair, is growing fast. Amana Bank is the first and only LCB involved solely in Islamic banking, and its principle shareholder is the Jeddah-based IDB Group. It has some 250,000 customers, a network of 28 branches and is listed on the Colombo Stock Exchange. As of the third quarter of 2018 Amana Bank held LKR73.2bn ($461m) in assets, up 14% on LKR63.5bn ($399.9m) registered at end-2017.

HNB also offers Islamic banking services through a separate Islamic window. While figures for the sector as a whole are not currently collated, Hisham Ally, the head of Islamic banking at HNB, told local media that Islamic finance contributed around 4% to the group’s income.

Pakistan’s Muslim Commercial Bank (MCB) – Sri Lanka’s first Islamic banking licence holder – now has eight branches in-country. The latest reports for MCB show that at end-June 2018 assets contributed by Sri Lankan operations totalled LKR26.3bn ($165.6m).

NBFIs

The NBFI segment includes licensed finance companies (LFCs) and specialised leasing companies (SLCs). SLCs are not permitted to accept money from customers as deposits, but may issue debt instruments with the permission of the CBSL’s Supervision of NBFI unit. In 2017 there were some 52 NBFIs, accounting for around 9% of total financial sector assets, according to the IMF. The sector was servicing around 7m customers as of mid-2018, with the average loan size coming in at approximately LKR250,000 ($1580).

As around 85% of the segment’s assets are held by the top-20 companies, the CBSL has pursued a policy of consolidation by increasing capital requirements in the run-up to the implementation of Basel III. From year-end 2017 all NBFIs were required to have LKR1bn ($6.3m) in core capital, with this set to rise by LKR500m ($3.1m) per year to LKR2.5bn ($15.7m) in 2021. At the same time, no new licences for NBFIs are being issued. “Smaller financial companies are under significant pressure,” Dimantha Mathew, head of research at First Capital, told OBG. “Raising capital for this is stressful, particularly when the capital market is not performing well and NPLs are on the rise,” he added.

Government moves to restrict auto imports during 2018 also negatively affected NBFIs, due to the major role car loans play in the segment. The CBSL also issued a number of new regulations for NBFIs during the year, including standardisation guidelines regarding the outsourcing of business operations as well as the valuation of immovable property. Regulations for winding up LFCs were also brought in, along with the cancellation of licences for two distressed NBFIs, as well as the activation of the Sri Lanka Deposit Insurance and Liquidity Support Scheme to compensate depositors.

Performance

The most recently available central bank figures show that the overall sector had total risk-weighted assets (RWAs) of LKR6.65trn ($41.9bn) in the third quarter of 2018, up 17.9% year-on-year (y-o-y) from LKR5.56trn ($35bn). Of this, LCBs had total RWAs of LKR6.09trn ($38.4bn), while the LSBs accounted for LKR459.1bn ($2.9bn). Both of these figures represented y-o-y increases from LKR5.13trn ($32.3bn) and LKR429.7bn ($2.7bn), respectively.

Net loans and advances have also been steadily increasing, with data from the central bank showing figures reaching LKR7.13trn ($44.9bn) in the third quarter of 2018, a 15.8% y-o-y increase from LKR6.09trn ($38.4bn). Breaking this down, total net loans and advances for LCBs stood at LKR6.45trn ($40.6bn), up from LKR5.48tn ($34.5bn) y-o-y, while the figures at LSBs expanded from LKR606.7bn ($3.8bn) to LKR677bn ($4.3bn) over the same period.

Total liabilities, including equity, have also been rising. As of the third quarter of 2018 they stood at LKR11.29trn ($71.1bn), a 11.7% y-o-y increase from LKR10.04trn ($63.23bn). Of this, LCBs and LSBs accounted for LKR9.91trn ($62.4bn) and LKR1.38trn ($8.7bn), respectively. Local currency deposits amounted to LKR6.88trn ($43.3bn) in the same period, with LCBs responsible for LKR5.85trn ($36.8bn) and LSBs for LKR1.03trn ($6.5bn). Total foreign currency deposits stood at LKR1.31trn ($8.3bn) for the sector overall, with LCBs accounting for LKR1.3trn ($8.2bn) of the total. The Tier-1 capital adequacy ratio (CAR) for the overall sector was 12.6% of RWAs as of the third quarter of 2018, a slight y-o-y increase from 12.3%, with LCBs averaging an overall CAR (all tiers of capital) of 15.9%, up from 15.1% in the same quarter of 2017. The CAR for LSBs in the same period was 15.2%, up from 14.4%.

Non-Performance

While these are all signs of sustained growth, one area of concern is the steady rise in NPLs. These accounted for 3.6% of total loans and advances for the sector overall in the third quarter of 2018, up from 2.7% in the same period in 2017, with LCBs and LSBs registering NPL rates of 3.5% and 5.1%, respectively, in the same period.

These figures have emerged during a slowdown in GDP growth, from around 5% in 2015, according to the IMF, to 4.5% in 2016, 3.3% in 2017 and an expected 3.7% in 2018. Monetary and fiscal policy tightening during the 2017-18 period, combined with local currency depreciation and rising political uncertainty, also contributed to rising defaults. On a sector basis, due in part to adverse weather conditions and delays for government contracts, both agriculture and construction reported higher rates of NPLs. Of the hardest hit were small and medium-sized enterprises (SMEs), with smaller companies more susceptible to the fallout of general economic stresses. The hike in NPLs has, in turn, caused a rise in impairment charges in the first half of 2018 compared to the same period in 2017, as provisions were made for deteriorating loan books. The implementation of IFRS 9 also had an impact, since its expected credit-loss model generally introduces higher impairment provision ratios (see analysis).

The introduction of the new Inland Revenue Act from April 1, 2018 also affected profitability, by removing both a notional tax credit of Treasury bill and bonds, as well as tax exemptions on a range of interest income sources, including professional loans, US dollar-denominated bonds and SME loans. These changes amounted to a statutory industry income tax rate of 28%.

In addition, the Inland Revenue Act made financial institutions liable for a value-added tax and a nation building tax, while the new Finance Act of 2018 imposed a temporary debt repayment levy to cushion the impact of the heavy repayment schedule the country is facing over the 2018-21 period (see Economy chapter).

To lessen to the tax burden, in January 2019 the MoF announced a number of amendments to the act. These included the introduction of an exemption from income tax for foreign earnings remitted to Sri Lanka through formal financial institutions, along with exemptions from interest income on any resident or non-resident foreign currency account with an LCB.

Financial Inclusion

According to the CBSL, there were 18.6 bank branches per 100,000 people as of March 2018. Efforts to boost access to formal services have seen ATM and branch networks expand, with the former rising from 3851 in 2016 to 4416 in 2017. The CBSL has also worked with the International Finance Corporation to create a National Financial Inclusion Strategy. With an implementation date set for mid-2019, the strategy prioritises increasing electronic and mobile banking penetration, as well as access to credit. This requires improvements in the national payment-settlement system, and the CBSL announced in its Roadmap 2019 that it was looking to implement the National Transit Card and Infrastructure Framework for transport ticketing, as well a regulatory sandbox for fintech (see analysis). The LankaPay National Card Scheme was also launched in 2018, and is now the country’s largest interbank payment network.

Cashless transaction systems address the fact that credit and debit cards remain generally underused in Sri Lanka; cash is still the dominant means of payment. Some 1.4m credit cards and 19m debit cards were in circulation in 2018 – yet, according to the CBSL, the 45,000 point-of-sale terminals distributed around the country received less than 50m transactions, or less than three per day per terminal. Cashless transactions via smartphone may thus be a more effective means of switching away from physical currency while also increasing inclusion. “Technology should simplify some of the complexities associated with financial services,” Santosh Kumar, country director for Mastercard, told OBG. “As financial inclusion efforts increase throughout the country, opportunities for cashless transactions will become more prevalent.”

Outlook

For the sector, much depends on economic and political stability in the year ahead. Upcoming elections bring with them a widespread expectation of fiscal and monetary loosening, with GDP also set to grow more strongly. This may lead to an uptick in credit growth and general banking activity. At the same time, the rollout of Basel III and IFRS 9 requirements are likely to keep banks busy fulfilling new obligations. Some of the smaller entities may struggle in this, particularly in the NBFI segment, with the CBSL already signalling a proactive approach to dealing with those facing difficulty. Banks will also be keeping a watchful eye on asset quality, as NPLs continue to encumber balance sheets. Sector consolidation will thus likely continue, potentially accelerating in the years ahead. At the same time, fintech is set to make more of an impact, with electronic and mobile banking use likely to increase.