Regulation reforms, credit growth and strong macroeconomic indicators bode well for Sri Lankan banking sector

 

Improving economic growth, an increasingly sophisticated domestic market and regulatory reform are the main factors shaping the Sri Lankan banking sector. Stability has become a watchword following a period of rapid credit growth, as a flourishing private sector boosted the development of a previously underbanked market. Although the sector has a healthy growth outlook, the central bank is keen to keep a lid on credit expansion, while higher regulatory standards may trigger long-awaited consolidation.

Sector Breakdown 

As of late 2017 there were 12 foreign and 13 local licensed commercial banks (LCBs) operating in Sri Lanka, and a further seven licensed specialised banks (LSBs). Only LCBs are able to issue current accounts or engage in trade financing and offshore banking, while LSBs are largely savings and development banks with limited involvement in the foreign exchange market, subject to central bank approval.

Banks as a whole contributed 70% of the financial sector’s assets as of the first quarter of 2017, according to First Capital Holdings, a Sri Lankan investment bank. Contractual savings institutions, such as insurance companies and pension funds, comprised 19%, followed by licensed financial companies (LFCs) and specialised leasing companies (SLCs) with a combined 6%, specialised financial institutions (4%) and cooperative rural banks (1%). There are 46 LFCs and 7 SLCs that play a notable role in lending, with some owned by banks.

Given the size of the market – with Sri Lanka’s population of 21.5m as of 2018 and per capita GDP of just under $4000, according to the IMF – the sector is regarded as overbanked, Ravin Basnayake, country officer for Sri Lanka at Citibank, told OBG. However, forthcoming regulatory changes in line with Basel III standards may increase cost pressures on banks and lead to mergers and acquisitions as smaller banks find it more challenging to comply.

The market is already dominated by a few big players: Bank of Ceylon (BoC), People’s Bank, National Savings Bank (NSB), Commercial Bank of Ceylon, Hatton National Bank and Sampath Bank. “There are only six systemically important banks – three public and three private – each with assets of over LKR500bn ($3.3bn),” Ravi Abeysuriya, group director of financial services group Candor Group of Companies and former president of the Colombo Stock Brokers Association, told OBG. “Between them they comprise 75% of all assets.”

State Role 

Following the 1956 election Sri Lanka was guided by policies that led to restrictions on foreign banks, and in 1961 the nationalisation of the BoC and establishment of People’s Bank as another state-owned lender. However, the period of strong state intervention ended in 1977, with restrictions on foreign banks and the private sector as a whole easing. This led to an jump in the number of foreign-owned institutions entering the market. The period between 1979 to 1980 alone saw 10 new foreign banks open branches in Sri Lanka.

Nonetheless, state-owned banks still play a major role, with the two largest banks by assets in state hands and the segment as a whole having a 46% banking market share by assets as of late 2017, according to First Capital. The biggest bank in the country, as of the third quarter of 2017, was BoG with assets of LKR1.88trn ($12.3bn), or around 18.7% of the sector’s LKR10.04trn ($65.6bn) then total asset base. People’s Bank ranks second, holding LKR1.46trn ($9.5bn) in assets, or around 14.5%, according to its quarterly reports.

Around 46% of sector assets are in the hands of private domestic commercial banks, with the remaining 8% comprised of foreign commercial banks.

Oversight 

The financial sector is regulated by the Central Bank of Sri Lanka (CBSL), with the exception of the stock market and associated institutions, and the insurance industry. The CBSL operates through a series of cornerstone laws including the Monetary Law Act of 1949, the Banking Act of 1988 and the Exchange Control Act of 1953. The growing diversity and complexity of the financial system has led to further legislation to address specific segments, with LFCs coming under the Finance Business Act of 2011 and SLCs under the Finance Leasing Act of 2000.

The sector is also represented by the Sri Lanka Banks’ Association, which includes all the country’s institutions, while organisations like the Leasing Association of Sri Lanka and the Lanka Microfinance Practitioners’ Association represent the interests of their specific segments of the financial services industry.

Strong Growth 

The sector as a whole has experienced healthy expansion over the years. Between 2011 and 2016 total banking sector assets – including LCBs and LSBs – grew at a compound annual growth rate (CAGR) of 16.87%. In 2017 combined assets were up 13.7%, from LKR9.05trn ($59.1bn) at the end of 2016 to LKR10.29trn ($67.2bn), according to the CBSL.

Meanwhile, assets at LCBs grew at a CAGR of 17.53% between 2011 and 2016, reaching LKR7.84trn ($51.2bn). In 2017 this number rose by 13.9% to LKR8.93trn ($58.3bn). LSBs had an asset CAGR of 13.06% from 2011 to 2016, reaching LKR1.2trn ($7.8bn), and growing by 14.2% in 2017 to reach LKR1.37trn ($8.9bn).

Loans & Deposits 

Net loans and advances grew 16.2%, from LKR5.44trn ($35.5bn) in 2016 to LKR6.32trn ($41.3bn) in 2017. This was on top of a strong period of expansion with an overall recorded CAGR of 18.98% between 2011 and 2016, and annual increases of 21.3% and 17.7% in 2015 and 2016, respectively.

LCBs’ net loans and advances also increased at an impressive rate from LKR4.91trn ($2.1bn) in 2016 to LKR5.69trn ($37.2bn) in 2017. LSBs’ loans and advances totalled LKR631.19bn ($4.1bn) at end-2017, up from LKR526.12bn ($3.4bn) at end-2016.

A number of top-performing sectors are responsible for bank balance increases. “Lending growth has been driven by real estate and construction,” Condor Holdings’ Abeysuriya told OBG. “Lending to small and medium-sized enterprises (SMEs) has become a key driver.” These sentiments were echoed by Citibank’s Basnayake. “SMEs have proved resilient against macroeconomic volatility, particularly in the food and beverage sector, agriculture and transport,” he told OBG.

Deposits remain the main funding base for banks. In the fourth quarter of 2017 deposits accounted for 71.9% of the sector’s asset base. Overall banking system deposits grew 17.5% in 2017 to reach LKR7.4trn ($48.3bn). This followed a CAGR of 15.99% from 2010 to 2016 – in line with loan growth. Deposits at LCBs rose from LKR4.64trn ($30.3bn) in 2015 to LKR5.45trn ($35.6bn) in 2016, and reached LKR6.42trn ($41.9bn) by end-2017. While deposits at LSBs increased from LKR764bn ($5bn) to LKR846bn ($5.5bn) and LKR943bn ($6.2bn), in 2015, 2016 and 2017, respectively.

The strong rise in deposits helped banks fund credit growth in recent years. Nonetheless, the credit-to-deposit ratio rose somewhat between 2013 and 2016, from 82.2% to 88%, though it had dropped back to 85.4% by the fourth quarter of 2017. PROFITABILITY: Bank profits in absolute terms have risen at a CAGR of 16.44% since the dip in 2013 in the wake of a financial sector downturn. Profit before tax (PBT) rose by 18% in 2017, from LKR164.97bn ($1.1bn) in 2016 to LKR194.67bn ($1.3bn). However, increased competition and tighter regulation, as well as slower economic growth, have caused profitability to fall since the beginning of the decade. Return on assets after tax stood at 1.4% in the fourth quarter of 2017, the same level as in 2016, but down from 1.7-1.8% in 2010-12. Return on equity (ROE) dropped from a peak of 22% in 2010 to 16% in 2013, before recovering unevenly to reach 17.6% in the fourth quarter of 2017.

Profitability has fallen partly because interest margins have been compressed, falling from 4.6% in 2010 to 4.1% in 2013 and 3.5% in 2014-17. However, the shift was not universal; First Capital notes that larger banks saw improving net interest margins (NIMs) in the first three quarters of 2017 thanks to their ability to capitalise on rising interest rates. These banks shifted their lending rates upwards more quickly than their deposit rates in response, widening their NIMs.

Cost-to-income ratios vary across the sector, with the bigger banks again performing best, with ratios around 50%, while smaller lenders average roughly 60%, Dimantha Mathew, head of research for First Capital Holdings, told OBG. Rising competition and a higher regulatory threshold are leading banks to reassess their operations to strengthen both capital buffers and profitability. “Bigger banks have been raising capital,” Basnayake told OBG. “I don’t think that local banks have had that much focus on ROE, but that will change. They need to look at which assets to prioritise.”

The future path of NIMs will be partly determined by the CBSL’s interest rate policy. The three-year IMF programme launched in June 2016 has helped create a more stable macroeconomic environment, lessening the need for sudden and frequent central bank interventions. According to Condor Holding’s Abeysuriya, as Sri Lanka continues its IMF-backed fiscal consolidation programme, the interest rate environment will become more predictable and benefit financial institutions.

Getting Smart 

Technology is playing an increasingly important role in both broad asset growth and by improving profitability and efficiency. The country’s relatively small size and the accessibility of banks and ATMs has meant that mobile money has not gained as much traction as in other emerging markets. However, increasing internet penetration and the rise in smartphone usage is creating a market for new services.

“Consumer loans will continue to drive the growth of local banks, but e-banking and other innovative digital financial services are expected to take off,” Aswin De Silva, chairman at NSB, told OBG. “In the short to medium term the government and banks need to focus on digital literacy related to financial services.”

Indeed, increasing the banked population, especially in the non-urban countryside, could offer a huge benefit to the sector; however, more must be done to overcome cultural proclivities towards paper money. “While cash is still the preferred method of payment in Sri Lanka, there is room for growth in electronic payments,” Santosh Kumar, country manager of Sri Lanka for MasterCard, told OBG. “The public and private sector should collaborate to educate the population – especially in rural areas – on the use of e-payments and financial services technology. Only then will the growth of e-payments really take hold.”

Standing Solid 

The banking sector as a whole is well capitalised. The Tier-1 capital adequacy ratio (CAR) stood at 12.4% as of the fourth quarter in 2017, while overall CAR was 15.2%. This represented a slight decline from 12.5% and 15.6% in 2016, respectively. Nonetheless, these were still well above the CBSL’s Tier-1 and overall CAR minimums of 5% and 10%, respectively.

Non-performing loans (NPLs), sometimes known as non-performing assets in South-east Asia, have fallen since 2013 to the lowest levels in 20 years, despite rapid credit growth and concerns about risk in some sectors. The NPL ratio has declined steadily from the most recent high of 5.6% in 2013 to 2.6% in the fourth quarter of 2016. However, 2017 saw a slight uptick in the NPL ratio to 2.7% in its first nine months, before falling back down to 2.5% at year-end.

Factors behind the short-lived rise in NPLs included poor weather early in the year (see Agriculture chapter), rising inflation and subsequent increases in interest rates. The sector’s overall stability was also enhanced by larger banks’ increasing focus on lower-risk corporate lending, rather than the more volatile retail market, according to First Capital’s Mathew.

Monetary Tightening 

The rapid growth of credit to the private sector in the middle of the decade reflected strong confidence in the economic outlook despite clear downside risks, while also being a by-product of loose monetary policy and ample global liquidity. The rate of growth of credit to the private sector soared from 9% in 2014 to 25% in 2015 and 22% in 2016.

In response to rising inflationary pressures, including the weaker rupee driving up import costs and floods causing food supply challenges, the CBSL has pursued a policy of reining in excess credit growth.

The central bank hiked its base rate by 100 basis points (bps) in 2016, followed by another 25 bps increase in 2017. This followed moves in early 2016, which saw the bank raise its statutory reserve ratio (SRR) – the percentage of deposits that commercial banks must hold as reserves rather than lending out – 150 bps to 7.5%. As a result, credit to the private sector was expected to moderate to 16% in 2017 and 2018, before rising slightly to a respective 17% and 18% in 2019 and 2020, thanks to GDP growth and fewer NPLs, according to forecasts from First Capital.

Even so, private sector credit was estimated at 37% of GDP in 2017, up from 27% in 2014, 31% in 2015 and 36% in 2016. First Capital forecasts it to reach 39% in 2018 and increase steadily to 44% in 2020.

The overall economic outlook, coupled with the government’s goals of boosting the private sector, increasing trade and attracting more foreign investment, underpin the optimistic position for the coming years. “In its next growth phase the economy is going to be driven by foreign direct investment and exports,” Basnayake told OBG. “The government has organised its financial affairs and now needs to close deals like its free trade agreement with India. Banks are keeping a close eye on how it pans out.”

Risk Profile 

Nonetheless, sector leaders are aware of downside risks to the outlook. Most of these stem from the broader economic environment. As Fitch Ratings noted in a February 2018 assessment of Sri Lanka, the budget deficit – though falling – remains elevated, and its external balance sheet is a concern. Growth in 2017 surprised on the downside due to weather-related disruptions to supply, and the economy still remains vulnerable to such risks, which could potentially impact the IMF’s three-year fiscal consolidation programme. Sri Lanka’s ability to refinance its debt may also be affected by global monetary tightening.

There are also concerns about asset price bubbles in the real estate sector. Up to 5000 new luxury units are set to come onto the market before 2020, with 2800 units expected in 2018 alone, presenting a risk for some banks. Sri Lankan is still a middle-income country, and locals are not seeing their real incomes growing as quickly as they might due to inflationary pressures. “The real estate sector is a growing concern for the banks, especially with the number of high-end units being developed,” Basnayake told OBG. “However, while there may be some deterioration in asset quality, it’s unlikely to have far-reaching consequences.”

A further increase in interest rates could also cause more credit delinquencies, with some financial institutions steadily becoming more exposed to unsecured loans. While bigger banks with more balanced and diversified lending portfolios are generally better equipped to deal with a property crunch, those with a cautious eye on the market have already begun to reduce their real estate exposure.

Basel III 

The implementation of Basel III regulatory reforms to strengthen capital adequacy and liquidity are expected to have a notable impact over the coming years, potentially serving to catalyse the long-awaited consolidation of smaller banks. Basel III reforms were introduced in the wake of the 2008-09 global financial crisis to extend and replace Basel II standards. In line with global implementation, the CBSL issued the new capital requirements in 2016, and they are currently in the process of being rolled out.

By the start of 2019 Sri Lankan banks will have to maintain a minimum common equity Tier-1 CAR of 7% of risk-weighted assets, a Tier-1 CAR of 8.5% and an overall CAR of 12.5%. Banks with assets exceeding LKR500bn ($3.3bn) have been classified as domestic systemically important banks, and will be required to retain an additional buffer of 1.5 percentage points on top of each of these minimums.

While most Sri Lankan banks already meet these requirements, there may be a need for some banks to reassess their operations. More pressure is likely to come from the CBSL’s decision to raise minimum capital requirements for banks by the end of 2020. Finalised in October 2017 following an announcement in 2016, the measures require minimum capital of LKR20bn ($130.6m) for domestic LCBs, LKR7.5bn ($49m) for domestic LSBs, LKR5bn ($32.6m) for foreign-incorporated banks with assets of up to LKR100bn ($653m), and LKR10bn ($65.3m) for foreign banks with assets of more than LKR100bn ($653m).

According to a statement released by the CBSL, “Enhancing the minimum capital requirement will support the implementation of the Basel III framework in Sri Lanka to strengthen the resilience of banks and may lead to consolidation in the banking sector.” The move effectively means that the minimum capital requirement will have been increased fourfold in just over a decade, following hikes in 2010 and 2014, which previously set the minimum at LKR5bn ($32.6m) and LKR10bn ($65.3m), respectively.

“In my opinion, this will put significant pressure on banks to merge,” Basnayake told OBG. “We’re in a period of transition, and the next two to three years will very likely see a period of consolidation.”

Sri Lanka’s banks are expected to face more regulatory pressures, this time from a new accounting standard which came into effect on January 1, 2018. The International Financial Reporting Standard 9 (IFRS 9) for financial instruments outlines how institutions should classify financial assets and liabilities. One of the most important changes requires that banks set aside additional funds in anticipation of loan losses.

Consolidation 

The government is in favour of consolidation in order to build up local banks that are capable of financing the large public and private sector projects expected to drive medium-term growth.

According to Abeysuriya, when Sri Lanka acquired middle-income status it lost some of the international development funding it received as a low-income country, necessitating the local banking sector to play a larger role in financing; however, few local banks have the scale or capacity to lead big-ticket projects.

“The policy is to encourage consolidation, rather than force it,” Abeysuriya told OBG. “There is so much potential for big banks to acquire the less systemically important ones. The number of non-bank financial institutions (NBFIs) can be scaled down. It’s also possible that smaller banks will merge.”

NBFI 

Higher capital requirements are also being applied to NBFIs, as the government and the CBSL look to strengthen a sector that has been more loosely regulated in previous years, leading to concerns about asset quality and corporate governance. The new regulations require finance companies to achieve core capital of LKR2.5bn ($16.3m) by the end of 2020 in incremental steps – LKR1bn ($6.5m) by January 2018, LKR1.5bn ($9.8m) by end-2018 and LKR2bn ($13.1m) by end-2019. According to Fitch, the regulations will require smaller companies to either seek capital injections or merge with competitors. “We think it’s a good thing that banks and finance companies are better regulated and monitored, and have better asset management,” Prasanna Senani Rajiv Casie Chitty, COO of finance company Commercial Credit and Finance, told OBG. “Generally speaking, Sri Lanka is overbanked.”

New Taxes

Adding to the pressure that Basel III implementation and CBSL reforms are putting on the sector, banks have been targeted for a new tax aimed at addressing the country’s debt. The levy, which took effect in April 2018, will add a charge of LKR0.20 ($.001) per LKR1000 ($6.50) worth of bank transactions, and in return, banks will receive an income tax waiver. In November 2017 Mangala Samaraweera, the minister of finance and media, said that he expects the charge to be shouldered by banks and not passed on to clients.

However, the tax is not without controversy. Even though the fee is targeted at banks, industry analysts feel that it may drive down interest rates paid on accounts and place added stress on the sector. “The banking sector’s PBT grew at a CAGR of about 16% in 2014-17, and the tendency to tax money-generating sectors is understandable. However, it should be noted that the sector is already subject to high taxes, with the effective tax rate standing at around 43%,” Mark G Prothero, CEO of HSBC for Sri Lanka and the Maldives, told OBG. “This additional levy will only further burden the sector while it adapts to major changes such as the implementation of IFRS 9 and Basel III standards.”

Microfinance 

Reforms to the NBFI sector were followed shortly by the landmark Microfinance Act, which came into force in July 2016. The legislation aims to improve the regulation and formalisation of microfinance institutions (MFIs), while also increasing their ability to expand. The act limits itself to MFIs, not including LCBs, LSBs, NBFIs, specialised community-based banks and co-operatives, though many of these operate microlending services.

All other MFIs, from small family outfits to financing arms of NGOs, can register for a licence under the new legislation, thereby putting them under the direct authority of the Department of Supervision of MFIs, which was established by the CBSL’s Monetary Board. Those choosing to join will be allowed to accept savings, thus giving them access to an important new source of capital, and linking their accounts to the Credit Information Bureau of Sri Lanka, allowing for better screening of loan applicants. Smaller companies will also be permitted to monetise family assets, including traditional stores of value such as gold and jewellery.

Microfinance companies are seen as an important asset in developing the banking sector as a whole. By financing grassroots entrepreneurs, they are supporting the growth of domestic businesses that will migrate to larger commercial banks when they reach appropriate size. However, questions remain over the regulation, risk profile and business practices of MFIs, with some thinking more could be done to strengthen oversight. “Microfinance continues to be attractive for many banks,” De Silva told OBG. “However, it is constrained by the lack of regulation. While the Microfinance Act is a positive move by the government, there are still regulatory gaps that create uncertainty.”

Nevertheless, steps made by the government and the sector regulator are in the right direction. “The central bank’s attempts to regulate microfinance is indicative of how important this segment is,” Roshan Egodage, CEO of financial services firm Commercial Credit and Finance, told OBG. “However, it isn’t easy to regulate such a complicated segment, and more work is required. Regardless, existing regulations help banks and NBFIs feel more secure to participate in microfinance.”

Outlook 

Sound monetary policymaking has helped rein in credit growth to an extent, though respectable economic growth and increasing demand from SMEs will ensure the rate remains in the double-digits for the coming years. Stakeholders are aware of the risks associated with overexposure to high-end real estate and unsecured lending; however, bigger banks have more diversified portfolios, risk-management capabilities and capital buffers to withstand all but a major crisis. Regulatory reform is likely to shape the sector over the medium term, albeit incrementally, as higher capital requirements are phased in and their effects felt.

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The Report: Sri Lanka 2018

Banking chapter from The Report: Sri Lanka 2018

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