Expansion of Sri Lanka's stable banking sector could be limited by reluctance to diversify

Well capitalised, well regulated and fast-growing, the Sri Lankan banking sector has faced no collapses in recent years and has benefitted from strong economic growth and relative stability following the end of the civil war in 2009. However, the sector remains fragmented, and some of the non-bank financial institutions are seen as potentially troubled, while attempts to force consolidation have been put aside due to the change in political direction that occurred at the end of the Mahinda Rajapaksa administration in early 2015.

Financial stability is not seen as a major concern, and any problems related to the health of institutions are seen as manageable, and the regulators are keeping a close watch on the sector. However, Sri Lanka’s banks are more challenged in terms of innovation, efficiency and value added. The market remains relatively underdeveloped and not yet up to international standards in terms of products and services. For example, institutions largely make loans based on the total assets of the borrowers. “From the regulatory point of view, we are there. We just have to be more innovative,” Aswin De Silva, chairman of National Savings Bank (NSB), told OBG. “Our lending tends to be more collateral than cash-flow based. Most banks are in their comfort zone.”

Since 1841

For years, the sector was dominated by foreign banks and some are still present and active in Sri Lanka. The first institution to emerge was the Bank of Ceylon, founded in 1841 in what was then Ceylon. But in 1845 this was closed and acquired by the Bank of Western India, which simultaneously changed its name to Oriental Bank. Oriental Bank subsequently renamed itself again, to Oriental Bank Corporation, before closing in 1884. In 1854 the Mercantile Bank of India, London and China opened its doors and was followed by Standard Chartered, in 1858. Hatton National Bank (HNB) was founded in 1888 to serve the tea plantations, while HSBC has been in the country more than 100 years, having entered the market in 1892. The modern-day Bank of Ceylon was formed in 1939, while Commercial Bank of Ceylon – the largest private-sector bank in the country today and which is known locally as Commercial Bank – was formed in 1969. Sampath Bank was established in 1987 and Seylan Bank entered the market in 1998. For its part, the sector regulator, the Central Bank of Sri Lanka (CBSL) was founded in 1950.

Growing & Healthy

The banking sector in Sri Lanka is large and quickly expanding in terms of coverage, though state institutions hold a large share of total assets, with Bank of Ceylon, People’s Bank and NSB holding over 40% of total assets. In total, the country has 25 licensed commercial banks (LCB) as of December 2015. According to CBSL statistics, a total of 76.6% of all deposits were held by the LCBs, as of the end of 2014. Licensed specialised banks (LSBs) have 13.7% of the total while licensed finance companies (LFCs) have 8.0%. Meanwhile, rural banks and thrift and credit cooperatives, which are not regulated by the central bank, hold just 1.8% of total deposits.

The number of total branches for LCBs has increased significantly in recent years. Actual branches grew from 2064 in 2008 to 2904 by the end of 2015, while total branches plus other banking outlets rose from 4748 to 5774 over the same period, according to the CBSL. For LFCs and specialised leasing companies, the combined total has increased from 1060 to 1216 between December 2013 and December 2015.

Decline In NPLs

Meanwhile, non-performing loans (NPLs) have been on the decline in recent years. They hit a recent peak of 6.2% in the second quarter of 2014 following a drop in gold prices, and fell to 3.2% in the fourth quarter of 2015 for all banking institutions. The figure hit a recent high of 8.8% in 2009. For LCBs, the drop was from a recent high of 5.7% in the first quarter of 2014 to 2.9% in the fourth quarter of 2015. For LSBs, the fall was from a high of 12.5% in the second quarter of 2014 to 6.4% in the fourth quarter of 2015.

Capital Levels

For their part, capital ratios have been falling somewhat, due to strong credit growth and a shift from gold-backed loans to risk-weighted loans. The CBSL mandates that banks maintain a total risk-weighted capital adequacy ratio of 10% and a core capital ratio of 5%. For all banks, ratios for core capital dropped from 14.7% in 2014 to 11.9% in 2015; however, they remain in position to meet the Basel III capital adequacy requirements when they are introduced in 2019.

While capital adequacy levels are generally considered good at most of the banks in the sector, some assets are zero-weighted, and this raises concerns. Fitch notes that gold loans and foreign currency loans to the sovereign are not properly characterised, and the lack of capital against these risks is a potential source of problems.

Additionally, as state-owned banks play such a key role in the sector, and much of their loans are to other state-owned enterprises, many of which are loss making, this further compounds risk. In January 2016 the reserve margin was increased from 6.0% to 7.5%, having been lowered at the end of 2013 from 8.0% to 6.0%. The increase in reserve margins could have an effect on profits going forward.

Net Interest Margins Squeeze

lending rate has overwhelmingly been in decline since 1995, when it stood at over 20%. By 2011 it had reached 14.1% and by end-2015 it had dropped to 11%. However CBSL data shows that lending rates have inched up 100-150 basis points in the six months leading up to February 2016. Likewise, over the same period, the average weighted deposit rate at most banks rose around 200 basis points, reflecting the pickup in credit demand. “While there was very low credit demand in 2013 and 2014, since the third quarter of 2014 we have seen an uptick and liquidity gradually coming down,” Jegan Durairatnam, managing director of Commercial Bank, told OBG. “This credit growth is largely attributed to small and medium-sized enterprise (SME) lending, consumption from increased public sector salaries and increased importation of automobiles.”

Sri Lankan banks are highly profitable institutions, although profits have been declining. In the first quarter of 2013, return on equity for all banks, after taxes, was 23.3%. That fell to 16.1% by the fourth quarter of 2015. For LCBs, that ratio fell from 25.6% to 15.7% over the same period.

Some banks, however, have done especially well in recent years. In 2014 profits at Sanasa Development Bank doubled and, according to local media, in September 2015 quarter profits were up 59%. Seylan Bank, meanwhile, witnessed a year-on-year rise in post-tax profit in the first quarter of 2015 of 27%, while Pan Asia’s net profits doubled in the same period. HNB reported a profit increase of 28% in the year ended December 31, 2014. Larger banks have reported more modest growth. Commercial Bank, the largest private institution by market value, said that in the first half of 2015 profits were up 15% on the same period in 2014. For Sri Lanka’s banking sector overall, loan growth has lagged and margins have declined due to increased competition. HNB reported an 85 basis point drop in its net interest margins in 2014, while similar drops in performance have been noted across the sector and yield compression has been observed.

Branching Out

Banks in the country are largely focused on collateralised loans and, as a result, their earnings will be squeezed as interest margins decline. “To improve asset quality and prudent credit management, financial institutions should concentrate more on cash-flow driven lending rather than credit expansion through collateral-based lending,” Aswin de Silva, chairman of NSB, told OBG. “This will also assist customers, as it will minimise excessive borrowing by considering a borrower’s structured repayment capability.”

Indeed, the only remaining choice for the banks is to pursue strategies that will bring in new, higher-value business. Some banks are fighting the declining margins by embracing diversification. A number of banks have been looking into regional expansion for quite some time, at first to seek out growth during the final phases of the civil war, but now to seek out higher profits in the face of stability and falling margins at home. In 2014 Commercial Bank became the first Sri Lankan bank to receive a licence from the Central Bank of Myanmar to operate a representative office in the country. A number of other banks and finance companies have expressed similar interests.

Some innovation is also beginning to take place. Sri Lanka is often considered overbanked in terms of the total number of branches, and therefore efforts to encourage lower-cost online operations are being pursued, which should help improve cost-to-income ratios. Commercial Bank is now offering instant deposits around the clock, seven days a week. It is using a system being supplied by Tranfast. The programme allows for money to be sent to any person with a bank account, globally. Additionally, Xoom, the international digital money-transfer company, has joined with Sampath Bank to provide transfer services to Sri Lanka.

Still, overall innovation and improved efficiency remains a challenge for the sector, with most banks – and particularly the country’s state-owned institutions – focusing solely on lending. “Profitability shows that, of course, you are making money, but it is not the best indicator of how a bank is doing,” Jim McCabe, CEO of Standard Chartered Bank, told OBG. “Cost-to-income ratios are a stronger metric, and most banks in Sri Lanka sit at over 50%. This indicates there is a lot of room for banks to conduct operations more efficiently.”

Regulation

The sector, regulated under the Banking Act and the Monetary Law Act, has not experienced a commercial bank failure since the 2008 global financial crisis. However, it has been historically prone to corporate governance problems due to conflicts of interest in the ownership structures of some institutions.

The sector also suffers from a degree of concentration risk, with so much of its banking assets in the hands of just a few players and skewed heavily towards the two dominant state-owned banks. Six LCBs have been recognised as systemically important in Sri Lanka’s banking sector, according to the CBSL. These banks – Bank of Ceylon, People’s Bank, Commercial Bank, HNB, Sampath Bank and Seylan Bank – were reported by the Economic Intelligence Unit to have, at end-March 2015, an estimated two-thirds of the total market share in the sector, 75% of LCB assets, 64% of sector assets and around 36% of the assets of the entire financial system.

In general, this designation is seen as both significant for the sector and for the individual banks themselves. The systemically important banks have attracted greater deposits, as they are seen as safe havens during times of trouble, while also being regarded by the international community as having superior credit ratings due to the implicit government backing. Still, there are concerns about the real meaning of the support being offered, for example whether the CBSL has the ability to step in and rescue so many large institutions in the event of a crisis. This is further compounded by the fact that two of the systemically important banks – Bank of Ceylon and People’s Bank – are state-owned, which could place additional pressure to government resources should one of these face difficulties. Indeed, in early 2016 Fitch and Standard & Poor’s downgraded Sri Lanka’s sovereign rating, with Fitch subsequently downgrading both Bank of Ceylon and NSB, as well as other state-owned financial institutions, to reflect the higher sovereign risk profile.

Rate Changes

In April 2015 Sri Lanka cut its benchmark interest rate from 8% – a level that had remained steady since early 2014 – to 7.5%, surprising analysts at the time. It subsequently cut the money-market repurchase rate, which had held steady since 2013, to 6%. CBSL interpreted low inflation in 2015 as leeway for relaxed monetary policy to spur credit flows and investments. The results were immediate. By October 2015, private sector credit growth had increased by 26.3% over a year earlier, and up from 13.9% in March.

The surge in credit, however, had an adverse effect on Sri Lanka’s import bill, putting heavy pressure on the exchange rate. The currency, which fell 9% in 2015 and continued to decline into 2016, hit repeated record lows. While the CBSL had actively intervened in the currency market at the expense of its reserves over the year, in September 2015 it said it would no longer set a rate. It was essentially floating the currency; however, the country is still not allowing the rupee to trade freely.

Sri Lanka’s foreign reserve profile thus faces challenges. In January 2016 reserves fell by $1bn to a five-year low of $6.3bn, according to press reports, even atop two sovereign bond issuances and currency swaps with India during 2015. With concern over a balance of payment crisis, the government solicited the IMF to bolster its financial position.

In response to these macroeconomic challenges, in February 2016 the CBSL raised the benchmark rate by 50 basis points to 8% for the first time in four years. Additionally, the standing deposit facility rate was upped to 6.5%.

In their policy statement, the Monetary Board concluded that, “The continued upward trend in underlying inflation requires pre-emptive policy measures to contain further build-up of demand-driven inflationary pressures.” The move is likely to bolster the country’s ailing currency, taming what some analysts have described as a situation of overheated credit growth.

Gold Loans

Gold loans play a significant role in the Sri Lankan banking sector, as the precious metal is one form of collateral that banks will always take. Farmers and fishermen will often use gold as collateral in order to buy seed, supplies and hire crews, paying the loan back after the harvest or the fishing trip and retrieving the gold then. When the price of gold started falling, NPLs rose, with the total increasing from 3.7% in 2012 to 5.6% in 2013, according to a 2015 “Sri Lankan Banking Sector Update” by Fitch Ratings. NPLs increased somewhat into 2014, but gold loan NPLs started to stabilise, as banks improved their processes for managing collateralised and margin lending.

In 2014 the CBSL introduced a credit-guarantee scheme to encourage banks to grant pawning advances, which declined significantly with the price of gold. Under the programme, borrowers can get pawn advances of up to LKR500,000 ($3600) at a 15% rate. They will also be able to borrow 15% more than the loan-to-value ratio being imposed by the banks. Fitch issued a statement saying that it was in favour of the plan and that, if carried out, it would improve the stability of the institutions and help in their development. Overall, the pressure of asset quality from gold-backed loans is expected to diminish going forward, in part because the banks have collectively focused on reducing their exposure to pawn loans, despite the government’s guarantee for gold-backed loans.

Vehicle Lending

Likewise, vehicle leasing has grown to represent a sizeable portion of portfolios. Following relaxed duties on different classes of car imports under the new administration, as well as credit extension by financial institutions, car imports shot up dramatically from the fourth quarter of 2014, reaching over 230,000 units total in 2015 (both new and pre-owned), a 55% increase over the year before. By September, the CBSL responded with macroprudential measures to ease the burden of these imports on its balance of payments, placing a 70% loan-to-value (LTV) ratio on automobile loans. In October 2015 the bank then adjusted valuations, introduced a 100% margin duty on letters of credit for auto imports and raised the LTV ratio back to 90%. As a result of these measures, automobile imports are expected to decline throughout 2016.

Loans For SMEs

Lending to SMEs, outside of gold loans, has long been an issue in Sri Lanka. Historically, very little money has been handed to smaller companies without established track records or collateral. There also remains a sizeable mismatch between rural depositors and urban lending. “When the economy was liberalised in 1978, a number of new domestic commercial banks tried to follow the pattern of established lenders, taking deposits from the rural economy and mobilising them for traders and urban lending,” Samadanie Kiriwandeniya, chairperson of Sanasa Development Bank, told OBG. “This remains a mismatch today.”

A 2010 World Bank study found that the People’s Bank loaned only 1.56% of its portfolio to SMEs. The figure was 3.15% for Bank of Ceylon and 6.33% for National Development Bank. This is particularly notable considering these three state-owned banks constitute a combined share of more than 40% of total assets in the country. Private bank HNB loaned the most to SMEs, with 49.4% of its portfolio going to smaller companies.

Small firms tend to lack the collateral required by the banks, and often have a have a poor understanding of finance and lack transparency. Meanwhile, banks are seen as unfriendly towards SME borrowers. They tend to be risk averse and lack the information and skills to lend effectively to small-scale businesses. An SME white paper was published in 2002, but because of the skills and financial mismatch, and the perception gap, the situation has not improved much.

The Credit Information Bureau of Sri Lanka is working to make it easier for individuals and SMEs to borrow money. It is hoping that by keeping records of small, regular payments, such as those to utility companies, it will be able to help people establish credit based on their reputations – a few years of recorded payments would indicate that the individuals are responsible and can be trusted. So far, the bureau has helped the banks by providing the information to avoid making bad loans. But it would like to do more in helping them to extend credit to people without collateral. “If you pay on time, a small credit window can become available,” Gamini Karunaratne, the general manager of the bureau, told OBG. “Once we get that working, you can go to a bank and use reputational collateral.”

Break With The Past

The transition from the previous administration to the new government in 2015 resulted in a major shift in policy with respect to the banking sector. Most significantly, the plan to consolidate the sector has been discontinued in favour of more organic combinations though, as of early 2016, nothing has been specifically outlined. It is felt that most of the sector, on a total asset basis, is in good shape and that forcing mergers between weak banks and strong ones has the potential to transfer problems onto the balance sheets of the country’s better institutions.

In July 2015 the government also started to make payments to depositors in the defunct Golden Key (GK) credit card company. Funds will be provided by the Treasury and be recovered by the Treasury out of the proceeds from the liquidation of the company. GK collapsed in 2008 with 9000 depositors and deposits of LKR26.5bn ($190.8m), and had offered interest rates of up to 35%. Providing compensation constitutes a major policy shift. The previous government had not responded to repeated requests for assistance, leading to protests. The new government decided to go ahead with the current plan, in part because the majority of the deposits are small at under LKR3m ($21,600) and most of the depositors are senior citizens.

In other ways, the sector is trying to put the past behind it. State-owned Lankaputhra Development Bank, which the local press says was forced to give policy loans to associates, only to have them default, is pursuing people who have failed to repay. It wants to recover the money so the funds can be used for the bank’s primary mission of development. The bank says its NPL ratio is near 50% because it was forced to make loans that could not be repaid.

Outlook

Given its economic headwinds, Sri Lanka is in for a challenging time in the near and mid-term. Working together with international partners will be necessary in order to stabilise the balance-of-payments situation and prevent capital outflows from harming the country’s fundamentals.

The banks, however, are well set to weather the storm and prosper. Most have good capital bases and stable businesses and some are beginning to innovate and expand. Nevertheless, interest rates are at risk and balance sheets need some work. Too much is zero-rated and will require correcting over time with the introduction of more stringent standards and some weaker institutions need to be absorbed without weakening the system. Furthermore, the high concentration of assets in state-owned institutions is a concern, which has direct implications on how the industry will consolidate and reshape itself going forward (see analysis).

Sri Lanka is making a significant shift, with a new government heading the process. The world economy is changing, with investors in developed markets cooling on developing markets. The country is lessening its dependence on China and is diversifying its investor base. Banks will have to adjust to these changes, prepare for some instability and take advantage of the opportunities that arise.