## _cr07383 - Executive Summary ## Source details **Canonical URL:** [_cr07383 - Executive Summary](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07383.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07383.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07383.pdf.json) --- ### Executive summary overview - Authorities have embarked on a major reform program since the 2002 FSAP, with important legislative and regulatory reforms, strengthened banking and insurance supervision, strengthened central banking operations, and improved market infrastructure. - Less progress has been achieved in the restructuring of the state commercial banks, and reforms of the pension and provident funds have not been addressed. - Financial system resilience and recent performance: - Financial system has been remarkably resilient despite natural disasters, continued civil strife, high fiscal deficits, a widening current account deficit, and accelerating inflation. - Banking system financial performance has improved on the back of robust economic growth. - Near-term risks and supervisory gaps: - Stress tests suggest banks are relatively well positioned to deal with asset quality concerns. - Recent data indicates credit quality could begin weakening in the face of rapid credit growth. - Banks have increased reliance on less stable interbank borrowings; funding sources and stress tests point to relatively greater vulnerabilities to interest rate and liquidity shocks. - Lack of supervisory data precluded testing for contagion, FX rollover risk, and risks faced by nonbank credit institutions (finance companies and leasing companies). - Financial sector efficiency constrained by public sector involvement: - Authorities committed to maintaining a large role for public sector financial institutions; absent reform, this could weigh on system efficiency and support for growth objectives. - Steps needed: create a level regulatory playing field for private institutions; improve state bank efficiency through strong governance and management; better use development banks and microfinance institutions to address under-banked segments. ### Key findings and sectoral assessments - Bank supervision - Progress made, but risk-focused supervision framework is still evolving. - Risk-focused supervision is important for successful implementation of Basel II planned by Central Bank of Sri Lanka (CBSL). - Bank boards need encouragement to play a more effective role in risk-management. - Implementing consolidated supervision, including improved information sharing among regulators using the Inter-regulatory Institutions Council, is a key reform item. - State-owned licensed commercial banks - Two state-owned LCBs continue to face structural weaknesses and liquidity management problems. - High cost-income ratios driven by staff and pension costs continue to affect performance despite some restructuring. - Addressing capital deficiency in state banks should be a key policy priority. - Insurance sector - IBSL establishing a sound basis for effective supervision through risk-based supervision, improved reporting, and measures to improve transparency. - Effectiveness hampered by lack of resources (only two supervision professionals responsible for 15 insurance companies). - Targeted utilization of funds created for SRCC&T and Policy Holders Protection and Reinsurance is not ensured. - Absence of a comprehensive supervisory framework for pension funds is a matter of concern. - Liquidity management and monetary operations - CBSL has reserve requirements, standing facilities, open-market operations. - Volatility in the overnight-call money market has increased, in part because of very limited access to the reverse repo window. - Scope for CBSL to use existing instruments more effectively while adhering to reserve money targets. - Financial market infrastructure - LankaSettle (RTGS) commenced operation in 2003; LankaSecure (securities settlement) began work in 2004. - Check imaging and truncation introduced in 2006. - Remaining work: develop safe and efficient payment instruments and a nationwide noncash retail payment system; National Payments Council prepared a road map. - Capital markets - Untapped potential: fragmentation of T-bond issuance and cash-management practices hamper benchmark yield curve development. - Investor base narrow; captive government funding impedes enlargement. - Private securities market limited by state-owned enterprises’ dominance and captive institutional funds. ### Structure of the financial system (selected metrics and composition) - Banks dominate: bank assets account for around two-thirds of financial sector assets. - Provident funds hold around 20 percent of financial sector assets. - Insurance companies, finance companies, and leasing companies each account for around 3 percent of financial sector assets. - Banking system composition: - 23 licensed commercial banks (LCBs) and 14 licensed specialized banks (LSBs). - Of the LCBs, the two largest are state-owned. - Nine privately owned commercial banks and 12 branches of foreign banks. - LSBs not permitted to take demand deposits or undertake foreign currency business; mostly state owned; market share about one-fifth of the LCBs. - Pensions sector: - Employee Provident Fund accounts for nearly 15 percent of financial sector assets and is managed by CBSL. - Employees Trust Fund manages 2 percent of financial system assets. - Nearly all assets of these two institutions are held in the form of government debt. - Around 185 approved provident funds (APPFs) whose assets represent around 3 percent to 4 percent of the total financial system; privately administered with no specific supervisory agency. - Insurance sector: - Total insurance premiums represent about 1½ percent of GDP. - Less than 10 percent of the population are said to have any form of insurance. - 15 insurance companies: 12 composite insurers, 2 general insurers, 1 life company. - Capital markets: - Between 2001 and 2006 the All Share Price Index (ASPI) rose at an average annual rate of 35 percent. - Market capitalization rose from 8 percent of GDP to about 30 percent of GDP. - Corporate debt market small: only two debenture issues listed for 2006 for a value of Rs.2.3 billion. - State-owned institutions and exposures: - State banks account for nearly half of total banking system assets and nearly a quarter of total financial sector assets. - Government effectively controls nearly 40 percent of financial sector assets through management of the two main provident funds. - Government debt accounts for nearly a quarter of banks’ assets (loans and investments) and more than 90 percent of investments of the pension and insurance institutions. ### Main FSAP Update recommendations (selected items and timing) - 1. Strengthen bank supervisory and regulatory framework (Short term) - Provide supervisory guidance to banks on a comprehensive risk management framework and expedite move to risk-focused supervision. - Review and strengthen regulation on large exposure limits and related party lending. - Apply prudential requirements on a consolidated basis and improve communication with other supervisors. - Develop and announce approach to Pillar II well before Basel II implementation date. - Review the draft Micro Finance Law to address concerns of capacity and moral hazard. - 2. Expedite restructuring of state commercial banks - Shore up capital of weak state bank to meet required capital adequacy (Short term). - Implement SEMA recommendations on streamlining cost structures (Short term). - Improve the legal framework to expedite bank debt recovery (Medium term). - 3. Enhance supervision of insurance sector (Short term) - Enhance supervisory capacity in IBSL commensurate with supervisory approach. - Manage the proposed re-insurer as a separate entity operating on a commercial basis. - 4. Introduce supervisory framework for pension funds (Medium term) - Develop an overall pension strategy and introduce a robust supervisory framework for all pension funds. - 5. Address rigidities in inter-bank markets - Better-align policy rates with market rates and consider using price (and supervisory attention) instead of across-the-board quantitative restrictions to discourage frequent access to standing facility (Short term). - Consider lengthening the reserve maintenance period from one week at present and relax the daily minimum requirement (Medium term). - 6. Enhance robustness of payment systems (Short term) - Clarify legal jurisdiction risks in foreign bank participation. - Define access criteria and make them publicly available. ### Government role and macroeconomic environment - Government role and systemic implications: - State ownership provides an implicit guarantee for public deposits and confidence in support for institutions in difficulty. - State involvement risks undermining financial sector efficiency and development; heavy government reliance on local banks and the pension system for financing limits funding for private investment. - Bank exposure to the government is more than four times the capital, leaving the system exposed to a shock to the fiscal position. - Macroeconomic environment and implications: - Economic expansion robust four years in a row, reaching 7½ percent in 2006. - High public debt, accelerating inflation, and pressures on the current account and exchange rate pose challenges. - Fiscal position: Public debt at 90 percent of GDP; fiscal deficit reached 8½ percent in 2006; government revised 2007 budget deficit target down to 7¾ percent of GDP. - Monetary policy: flexible exchange rate; principal instruments are two rates at standing lending-and-borrowing facilities; operating target reserve money; intermediate target consolidated broad money (M2b). - Consumer price inflation: nearly 18 percent at end-2006; 16.6 percent (year-on-year) in June 2007; 21.7 percent in August 2007. - External accounts: Current account deficit rose to 5 percent of GDP in 2006 from 2¾ percent in 2005; exports grew 14½ percent (year-on-year) in first six months of 2007; current account deficit expected to be sustained at around 5 percent of GDP in 2007. ### Strengths and vulnerabilities of banking institutions - Improvements and remaining weaknesses: - Key financial soundness indicators (capital, asset quality, profitability) improved steadily. - Most commercial banks maintained capital in excess of the statutory CAR of 10 percent in 2006, except one private bank and one major state-owned bank. - Eleven LCBs and two LSBs had not met the new minimum capital requirements introduced in 2005 and were given until 2009 to do so. - Gross NPL ratio fell by more than half since 2002, but NPLs rose in the first half of 2007. - Provisioning cover: 50 percent in 2002; 67 percent in 2006; 63 percent in June 2007. - Note: Not requiring provisioning against off-balance sheet items and loans overdue between three to six months means capital remains somewhat overstated. - Credit growth and risk: - Credit growth around 25 percent over 2005 (trend growth of 15 percent); consumer credit increased 40 percent (including housing and credit cards). - Credit to the private sector is 35 percent of GDP. - CBSL introduced a general provisioning requirement of 1 percent and increased risk weights for consumer lending. - Recommendation: consider specific provisioning for the “watch” category of three to six months overdue loans. - Interest rate and liquidity pressures: - Loan-to-deposit ratio increased from 80 percent at end-2003 to 94 percent at end-2006. - Smaller private banks increased reliance on less stable interbank borrowings to fund asset growth. - Higher interest rates may adversely affect profitability of finance companies and banks with largely fixed-rate assets. - Foreign-currency exposure: - Open-position limits prohibit direct currency risk; exposure to foreign-currency risks limited. - Increase in short-term foreign currency liabilities of the government, financed largely through the banking system, may expose banks to default risk given bunching in maturities. - Large component of nonresident Sri Lankan deposits has tended to be stable through earlier stress periods. ### Stress test findings (highlights) - Sample: 12 banks (10 commercial and 2 specialized) representing about 91 percent of total assets; tests as of end-2006. - Credit risk sensitivity: - A 20 percent reclassification produced provisioning shortfalls; only one bank became insolvent in that scenario. - Credit concentration tests: default of two/three largest borrower groups left 10 banks representing 86 percent of the banking system undercapitalized; two banks became insolvent. - Central government is the single largest exposure accounting for more than a quarter of total assets and more than 4 times regulatory capital at end-2006; state banks alone had an exposure around 10 times capital. - Estimated recapitalization cost if state banks impacted in extreme stress: would range between 1 percent to 2 percent of GDP. - Interest rate risk: - Shocks equivalent to 5 percent and 10 percent increases in short-term interest rates led to a substantial decline in CAR below minimum in some important banks; two institutions became insolvent as CAR fell below zero. - Liquidity risk: - Banking system coped with scenarios assuming immediate availability of liquid assets to meet withdrawals. - When limited availability and discounts on certain instruments considered liquid are introduced, liquidity ratios were severely impaired; a 20 percent deposit withdrawal could render banks representing 80 percent of system assets illiquid and insolvent. ### Key tables and selected indicators (preserved figures) - Table 1 (LCBs — Key Indicators by Banking Group, 2006) — selected preserved entries: - Market share among LCBs: State 40.6, Private 45.14.3, Foreign 100 - Capital adequacy ratio: State 7.31120, Private 12.7 - Gross NPL ratio: State 8.77.32, All 7.4 - Provisioning cover ratio: State 8564.371.9, All 74 - ROA (post -tax): State 0.91.42.1, All 1.3 - Cost Income ratio: State 83.777.561, All 77.5 - Liquid assets ratio: State 23.218.437.2, All 23.4 - Credit deposit ratio: State 85.698.4102.9, All 92.8 - Table 6 (Structure of Financial System — selected figures) — preserved entries: - Total Financial System 1/ — Assets Rs. Bn: 1,780.7; % of Total Assets: 100.0; % of GDP: 112.4 (06-Dec) - Total Financial System 1/ — Assets Rs. Bn: 2,373.1; % of Total Assets: 100.0; % of GDP: 116.9 (02-Dec) - Total Financial System 1/ — Assets Rs. Bn: 3,297.0; % of Total Assets: 100.0; % of GDP: 117.7 (04-Dec) - Commercial Banks: Number 23; Assets Rs. Bn 930.5; % of Total Assets 52.3; % of GDP 58.7 (06-Dec) - State banks: Number 2; Assets Rs. Bn 456.5; % of Total Assets 25.6; % of GDP 28.8 (06-Dec) - Memorandum Items: GDP (Rs bn): 1,584.8; 2,029.4; 2,802.0; GDP (USD bn): 16.4; 19.4; 26.0; Exchange Rate to USD (Year End): 96.7; 104.6; 107.6 - Table 7 (Financial Soundness Indicators — All Licensed Commercial Banks; In Percent) — selected preserved series: - Capital Adequacy (aggregate): 2002: 9.3; 2003: 8.9; 2004: 9.3; 2005: 12.2; 2006: 11.3; 6/2007*: 11.2 - Provision Coverage Ratio: 2002: 50.4; 2003: 58.7; 2004: 68.3; 2005: 72.1; 2006: 67.2; 6/2007*: 63.4 - Gross-Nonperforming Ratio (With interest in suspense): 2002: 19.1; 2003: 16.4; 2004: 11.3; 2005: 8.8; 2006: 7.4; 6/2007*: 7.4 - Liquidity and funding: Borrowings: 2002: 13.8; 2003: 13.8; 2004: 13.3; 2005: 16.8; 2006: 18.6; 6/2007*: 19.9; Ratio of Credit to Deposits: 2002: 81.8; 2003: 79.4; 2004: 81.4; 2005: 86.6; 2006: 92.8; 6/2007*: 95.8 - Source: Central Bank of Sri Lanka; * Provisional Data ### Insurance sector findings - Market-oriented reforms since 2002: state-owned insurance companies privatized; IBSL created as independent supervisor; tariff controls removed in several lines. - Recent legislative reversals: - Legislation requires insurance companies to place up to 50 percent of their reinsurance business with the National Insurance Trust Fund (NITF). - SRCCTF transferred to the NITF with transfers made from it to the government; new framework does not ensure resources previously held in SRCCTF remain available. - Recommendation: reinsurance business should be operated separately from the NITF on a commercial basis and subject to actuarial assessment and external scrutiny. ### Regulatory and supervisory framework — consolidated supervision and governance - Consolidated supervision: - Banks may invest in activities “not inconsistent with the business of banking” and may own nonfinancial businesses. - Framework for consolidated supervision is still developing; prudential regulations are not consistently applied on a consolidated basis. - Links with other domestic regulators are undeveloped; significant legal barriers to exchange of information domestically and abroad. - Supervisory independence and governance: - Operational independence of CBSL could be further strengthened. - Controller of the state banks participates on Monetary Board, potentially limiting supervisors’ ability to enforce compliance on state banks. - AML/CFT: - Progress including enactment of three key laws and establishment of Financial Intelligence Unit (FIU). - Priorities: prioritize APG recommendations; allocate resources to FIU; deepen staff skills; enhance cooperation with police and judiciary. - Microfinance regulation: - Proposed Micro Finance Institutions (MFI) Act would require MFIs with capital above an MB-notified amount to be licensed by CBSL. - Concerns: capacity and moral hazard; recommendation that smaller MFIs be outside CBSL purview and use certification authorities or a self-regulatory organization. ### Safety nets, crisis management, and deposit insurance - Operational continuity: - CBSL has disaster recovery and business continuity plans; a back-up site created; guidance issued to banks on business continuity planning. - Crisis preparedness shortfalls: - No separate framework for responding to a financial crisis; CBSL would benefit from procedural and operational guidelines for lender-of-last-resort under the Monetary Act. - Deposit insurance: - Authorities encouraged to discuss introducing a compulsory, funded deposit insurance scheme; existing voluntary scheme is not used. - A past bailout has created an expectation of a blanket guarantee. - Preconditions: resolve initial funding and legal impediment to paying insured depositors ahead of liquidation. - Timing: introduce when all banks meet regulatory capital requirements, risk-focused supervision is implemented, and supervisory independence is assured. ### Payment and settlement systems — LankaSettle RTGS assessment (summary) - Operational facts: - LankaSettle RTGS commenced operation in 2003; LankaSecure commenced in 2004; check imaging and truncation introduced in 2006. - LankaSettle RTGS has 34 participants: 23 licensed commercial banks (including 12 foreign banks), 8 non-bank primary dealers, Central Depository System of the Colombo Stock Exchange, EPF and the CBSL. - On average 760 daily payments settled; about 40 percent represent customer payments. - Key findings and recommended actions: - System is technically well functioning and reliable, but improvements needed in legal jurisdiction clarity for foreign bank participation, elaboration of rules for abnormal events, documentation of security objectives/policies/procedures, formalization of change management, and regular IT audits. - Liquidity rigidities noted: hesitation to transact same-day value after call money market closing around 9.00 am; recommendation to allow more flexibility in maintenance of required reserves and address liquidity barriers. - Access criteria not publicly available and currently bundled for LankaSettle RTGS and LankaSecure; recommendation to define separate full access criteria and make them publicly available. - Governance: internal governance arrangements need clearer formalization; recommendation to de-link LankaSettle RTGS and LankaSecure to have distinct system rules and governance arrangements. - CPSS Core Principles and CBSL responsibilities: - CBSL has not made its own assessment of RTGS compliance with Core Principles to date; recommended Monetary Board actions include formally adopting CPSS Core Principles and CPSS/IOSCO Recommendations as oversight standards and preparing a plan with milestones to address recommendations. - Authorities’ response: - CBSL broadly agrees with practical recommendations and will implement those suitable to Sri Lankan market conditions; CBSL indicated forthcoming publication of updated system rules and operational manuals and retention of discretion over participant eligibility given development stage. ### Stress tests — detailed scenario outcomes (selected exact figures) - Credit and concentration risk (effects on CAR; CAR at 12/31/2006: Average 12.1%; Minimum 5.6%; Maximum 15.7%): - CAR after shocks (averages): 5% Re-classification 11.5%; 10% Re-classification 10.7%; 20% Re-classification 9.0%; Largest Borrower's Default 6.6%; 2 Largest Borrowers' Default 2.8%; 3 Largest Borrowers' Default 0.1%. - CAR after shocks (minimums): 5% Re-classification 4.5%; 10% Re-classification 2.8%; 20% Re-classification -0.9%; Largest Borrower's Default -27.7%; 2 Largest Borrowers' Default -54.7%; 3 Largest Borrowers' Default -74.3%. - % of the system assets below minimum CAR (10-percent minimum): Baseline 22.1%; After 10% reclassification 58.1%; After 20% reclassification 77.7%; Largest borrower default 54.2%; 2 largest borrowers' default 76.8%; 3 largest borrowers' default 86.0%. - Interest rate and exchange rate shocks (effects on CAR): - CAR after exchange rate shocks (averages): 20% Appreciation 12.1%; 20% Depreciation 12.1%. - CAR after interest rate shocks (averages): 10% Decrease 16.1%; 5% Decrease 14.3%; 1% Decrease 12.6%; 1% Increase 11.6%; 5% Increase 9.4%; 10% Increase 5.7%. - % of the system assets below minimum CAR under interest rate scenarios: Baseline 22.1%; 1% Increase 33.2%; 5% Increase 60.1%; 10% Increase 70.7%. - Liquidity risk sensitivity (effects on Liquidity Ratios): - LR at 12/31/2006 (averages): All Liquid Assets 25.6%; Few Liquid Assets 17.6%. - LR after a 10% deposit withdrawal (averages): All Liquid Assets 6.5%; Few Liquid Assets 7.6%. - LR after a 20% deposit withdrawal (averages): All Liquid Assets -5.2%; Few Liquid Assets 18.4%. - After scenarios incorporating limited availability and discounts on liquid assets, a 20% deposit withdrawal resulted in banks representing 80 percent of the banking system asset becoming illiquid and insolvent (stress summary). ### Recommended regulatory and supervisory actions (selected) - Strengthen CBSL independence and reduce potential conflict of interest by limiting MOF representative’s shareholder role influence on Monetary Board decisions. - Publish licensing criteria and guidance on ‘fit and proper’ tests; broaden definition of significant ownership and introduce a suitability test. - Ensure all banks, including state-owned banks, are adequately capitalized; recapitalize the large state bank at the earliest and restrict growth in risk-weighted assets until recapitalization is done. - Move further from compliance-based to risk-focused supervision; introduce legally-binding requirement for banks to have proper risk-management processes and publish supervisory guidance. - Broaden large exposure and related-party definitions; reduce existing limits to internationally common levels; introduce reporting of asset and liability maturities by currency. - Amend the Banking Act to impose prudential standards on a consolidated basis and empower the supervisor to exchange financial and prudential information with other supervisors. - For payment systems: request independent legal country opinions from foreign RTGS participants; elaborate system rules for abnormal situations; conduct regular external IT/security audits; define and publish separate access criteria for LankaSettle RTGS and LankaSecure; de-link governance arrangements. *Source: FSAP Update mission conclusions (June/July 2007), _cr07383 - Executive Summary._* ### Executive Summary ...................................................................................................... ### _cr07383 - Executive Summary ### Executive summary overview - Authorities have embarked on a major reform program since the 2002 FSAP, with important legislative and regulatory reforms, strengthened banking and insurance supervision, strengthened central banking operations, and improved market infrastructure. - Less progress has been achieved in the restructuring of the state commercial banks, and reforms of the pension and provident funds have not been addressed. - The financial system has been remarkably resilient despite natural disasters, continued civil strife, high fiscal deficits, a widening current account deficit, and accelerating inflation; banking system financial performance has improved on the back of robust economic growth. - Near-term risks to banking system stability appear manageable, but challenges remain: - Stress tests suggest banks are relatively well positioned to deal with asset quality concerns. - Recent data indicates credit quality could begin weakening in the face of rapid credit growth. - Banks have increased reliance on less stable interbank borrowings; funding sources and stress tests point to relatively greater vulnerabilities to interest rate and liquidity shocks. - Lack of supervisory data precluded testing for contagion, FX rollover risk, and risks faced by nonbank credit institutions (finance companies and leasing companies). - Financial sector efficiency and development are challenged by large public sector involvement: - Authorities are committed to maintaining a large role for public sector financial institutions, which, absent reform, could weigh on system efficiency and its ability to support growth objectives. - Steps needed: create a level regulatory playing field to allow private institutions to develop; improve efficiency of state banks through strong governance and management; better use development banks and microfinance institutions to address under-banked segments. ### Key findings and sectoral assessments - Bank supervision - Progress has been made, but a framework for risk-focused supervision is still evolving. - Risk-focused supervision is an important condition for successful implementation of Basel II planned by Central Bank of Sri Lanka (CBSL). - Bank boards need encouragement to play a more effective role in the risk-management process. - Implementing consolidated supervision, including improved information sharing among regulators using the Inter-regulatory Institutions Council, is a key reform item. - State-owned licensed commercial banks - Two state-owned LCBs continue to face structural weaknesses and liquidity management problems. - Some improvement following government restructuring efforts, but high cost-income ratios driven by staff and pension costs continue to affect performance. - Addressing the capital deficiency in state banks should be a key policy priority. - Insurance sector - Positive developments, but further efforts needed to improve insurance supervision. - Insurance Board of Sri Lanka (IBSL) is establishing a sound basis for effective supervision through risk-based supervision, improved reporting, and measures to improve transparency. - Effectiveness is hampered by a lack of resources. - Targeted utilization of funds created for Strike, Riot, Civil Commotion and Terrorism (SRCC&T), and Policy Holders Protection and Reinsurance, is currently not ensured. - Absence of a comprehensive supervisory framework for pension funds is a matter of concern. - Liquidity management and monetary operations - CBSL has standard tools: reserve requirements, standing facilities, open-market operations. - Volatility in the overnight-call money market has increased significantly in recent months, in part because of very limited access to the reverse repo window. - There is scope for CBSL to use existing instruments more effectively while adhering to reserve money targets. - Financial market infrastructure - Considerable improvements: LankaSettle (RTGS) commenced operation in 2003; LankaSecure (securities settlement) began work in 2004. - Check imaging and truncation introduced in 2006. - Remaining work: development of safe and efficient payment instruments and a nationwide noncash retail payment system; a road map has been prepared by the National Payments Council. - Capital markets - Positive developments, but considerable untapped potential. - Fragmentation of T-bond issuance and current cash-management practices hamper development of a benchmark yield curve. - Investor base remains narrow, with large captive sources of government funding impeding enlargement. - Private securities market suffers from limited issuer and investor base due to state-owned enterprises’ dominant role and state-owned institutional funds as captive sources of funds. ### Structure of the financial system (selected metrics and composition) - Banks dominate: bank assets account for around two-thirds of financial sector assets. - Provident funds hold around 20 percent of financial sector assets. - Insurance companies, finance companies, and leasing companies each account for around 3 percent of financial sector assets. - The banking system composition: - 23 licensed commercial banks (LCBs) and 14 licensed specialized banks (LSBs). - Of the LCBs, the two largest are state-owned. - Nine privately owned commercial banks and 12 branches of foreign banks. - LSBs not permitted to take demand deposits or undertake foreign currency business; mostly state owned; market share about one-fifth of the LCBs. - Large number of finance companies (may take savings-and-time deposits) and leasing companies (funded by bank borrowings and debentures). - Pensions sector: - Employee Provident Fund accounts for nearly 15 percent of financial sector assets and is managed by CBSL. - Employees Trust Fund manages 2 percent of financial system assets. - Nearly all assets of these two institutions are held in the form of government debt. - Around 185 approved provident funds (APPFs) whose assets represent around 3 percent to 4 percent of the total financial system; privately administered with no specific supervisory agency. - Insurance sector: - Total insurance premiums represent about 1½ percent of GDP. - Less than 10 percent of the population are said to have any form of insurance. - 15 insurance companies: 12 composite insurers, 2 general insurers, 1 life company. - Capital markets: - Between 2001 and 2006 the All Share Price Index (ASPI) rose at an average annual rate of 35 percent. - Market capitalization rose from 8 percent of GDP to about 30 percent of GDP. - Corporate debt market small: only two debenture issues listed for 2006 for a value of Rs.2.3 billion. - State-owned institutions and exposures: - State banks account for nearly half of total banking system assets and nearly a quarter of total financial sector assets. - Government effectively controls nearly 40 percent of financial sector assets through management of the two main provident funds. - Government debt accounts for nearly a quarter of banks’ assets (loans and investments) and more than 90 percent of investments of the pension and insurance institutions. ### Main FSAP Update recommendations (selected items and timing) - 1. Strengthen bank supervisory and regulatory framework (Short term) - Provide supervisory guidance to banks on a comprehensive risk management framework and expedite move to risk-focused supervision. - Review and strengthen regulation on large exposure limits and related party lending. - Apply prudential requirements on a consolidated basis and improve communication with other supervisors. - Develop and announce approach to Pillar II well before Basel II implementation date. - Review the draft Micro Finance Law to address concerns of capacity and moral hazard. - 2. Expedite restructuring of state commercial banks - Shore up capital of weak state bank to meet required capital adequacy (Short term). - Implement SEMA recommendations on streamlining cost structures (Short term). - Improve the legal framework to expedite bank debt recovery (Medium term). - 3. Enhance supervision of insurance sector (Short term) - Enhance supervisory capacity in IBSL commensurate with supervisory approach. - Manage the proposed re-insurer as a separate entity operating on a commercial basis. - 4. Introduce supervisory framework for pension funds (Medium term) - Develop an overall pension strategy and introduce a robust supervisory framework for all pension funds. - 5. Address rigidities in inter-bank markets - Better-align policy rates with market rates and consider using price (and supervisory attention) instead of across-the-board quantitative restrictions to discourage frequent access to standing facility (Short term). - Consider lengthening the reserve maintenance period from one week at present and relax the daily minimum requirement (Medium term). - 6. Enhance robustness of payment systems (Short term) - Clarify legal jurisdiction risks in foreign bank participation. - Define access criteria and make them publicly available. *Source: FSAP Update mission conclusions (June/July 2007), _cr07383 - Executive Summary.* ### 8. The government’s significant role in the financial sector has been a source of ### _cr07383 - 8. The government’s significant role in the financial sector has been a source of ### Government role and systemic implications - State ownership provides an implicit guarantee for public deposits and confidence that the authorities would be willing to support institutions in difficulty. - State involvement risks undermining financial sector efficiency and development, and heavy reliance of the government on local banks and the pension system to meet its domestic and external financing needs limits the extent to which these institutions can provide funding for private investment. - Bank exposure to the government is more than four times the capital, leaving the system exposed to a shock to the fiscal position. ### Macroeconomic environment and implications for the financial sector - Recent performance and resilience: - Economic expansion has been robust four years in a row, reaching 7½ percent in 2006. - Emerging vulnerabilities and outlook: - High public debt, accelerating inflation, and pressures on the current account and exchange rate pose challenges to macroeconomic management. - Fiscal position: - Public debt at 90 percent of GDP risks crowding out private sector investment. - Fiscal deficit reached 8½ percent in 2006; government revised the 2007 budget deficit target down to 7¾ percent of GDP. - Monetary policy and inflation: - Monetary policy operates with a flexible exchange rate; principal instruments are the two rates at the standing lending-and-borrowing facilities; operating target is reserve money; intermediate target is consolidated broad money (M2b). - Consumer price inflation: nearly 18 percent at end-2006; 16.6 percent (year-on-year) in June 2007; 21.7 percent in August 2007 (the latter significantly contributed by pass-through of administrative price adjustments). - External accounts: - Current account deficit rose to 5 percent of GDP in 2006, from 2¾ percent in 2005. - Exports grew 14½ percent (year-on-year) in the first six months of 2007. - Current account deficit expected to be sustained at around 5 percent of GDP in 2007 due to higher world oil prices and increased imports for infrastructure projects. - Government resorted to foreign currency borrowing from banks, including issuance of domestic dollar-denominated bonds. ### Strengths and vulnerabilities of financial institutions — Banking - Improvements and remaining weaknesses: - Key financial soundness indicators (capital, asset quality, profitability) improved steadily in recent years. - Most commercial banks maintained capital in excess of the minimum statutory capital adequacy requirement (CAR) of 10 percent in 2006, with the exception of one private bank and one major state-owned bank. - Eleven LCBs and two LSBs had not met the new (higher) minimum capital requirements introduced in 2005 and were given until 2009 to do so. - Gross NPL ratio fell by more than half since 2002, but recent data shows NPLs rising in the first half of 2007. - Provisioning cover: 50 percent in 2002; 67 percent in 2006; 63 percent in June 2007. - Note: By not requiring provisioning against off-balance sheet items and loans overdue between three to six months, capital remains somewhat overstated. - Credit growth and risk: - Credit growth around 25 percent over 2005 (trend growth of 15 percent); consumer credit increased 40 percent (including housing and credit cards). - Credit to the private sector is 35 percent of GDP. - CBSL introduced a general provisioning requirement of 1 percent and increased risk weights for consumer lending. - Recommendation: consider specific provisioning for the “watch” category of three to six months overdue loans. - Interest rate and liquidity pressures: - Loan-to-deposit ratio increased from 80 percent at end-2003 to 94 percent at end-2006. - Smaller private banks increased reliance on less stable interbank borrowings to fund asset growth. - Higher interest rates may adversely affect profitability of finance companies and banks with largely fixed-rate assets; banks have increased spreads between deposit and lending rates to mitigate. - Foreign-currency exposure: - Exposure to foreign-currency risks limited by stringent open-position limits prohibiting direct currency risk. - Increase in short-term foreign currency liabilities of the government, financed largely through the banking system, may expose banks to default risk given bunching in maturities. - Large component of nonresident Sri Lankan deposits has tended to be stable through earlier stress periods. - Stress test findings (Appendix IV): - Banks less vulnerable to asset quality shocks than in 2002 (reflecting decreased NPLs and increased provisioning), but more vulnerable to liquidity and interest rate shocks. - Limits on large exposures are relatively lax, raising credit concentration risk and vulnerability to defaults by largest borrowers. - Banks representing more than half of banking system assets were more vulnerable to changes in interest rates. - Banks’ liquidity positions could not withstand standard shocks to deposits when market discounts on liquid assets are introduced. - Results underscore need for stronger risk-management framework and expedited move to risk-focused supervision. - State-owned commercial banks (SCBs): - Government abandoned earlier privatization plans and opted for operational and financial restructuring yielding some improvements over the past three years. - One large bank moved from negative net worth to positive, albeit low, CAR; provisioning cover improved to 85 percent. - Overhead expenses of state-owned LCBs remain high, driven by personnel costs (salaries and pensions). - Management and governance suffer from frequent board changes and gaps in finance and risk-management expertise. - Lack of operational autonomy has led to exposures to SOEs in excess of prudent limits and noncompetitive government business. - Governance codes under formulation; SEMA proposals include cost sharing, streamlining branch and ATM networks, and strategic alliances for cost reduction. - Recommendation: measures to address overstaffing and personnel costs need to go beyond waiting for attrition. - Key policy priorities: - Recapitalize the large state bank at the earliest and restrict growth in risk-weighted assets until recapitalization is done. - If government contribution is not forthcoming and privatization is ruled out, consider divesting part of government holdings to the public following successful restructuring strategies used elsewhere. - Design employee schemes to provide incentives and overcome entrenched resistance. - Improve governance standards, Board oversight, and provide impetus to capital markets. - Improve legal framework to hasten bank debt recovery; draft legislation for an Asset Management Company to acquire and manage nonperforming assets has been prepared but not passed. - Table 1. Sri Lanka: Licensed Commercial Banks—Key Indicators by Banking Group (2006) — key figures preserved exactly as presented: - Market share among LCBs: State 40.6, Private 45.14.3, Foreign 100 - Capital adequacy ratio: State 7.31120, Private 12.7 - Gross NPL ratio: State 8.77.32, All 7.4 - Provisioning cover ratio: State 8564.371.9, All 74 - ROA (post -tax): State 0.91.42.1, All 1.3 - Cost Income ratio: State 83.777.561, All 77.5 - Liquid assets ratio: State 23.218.437.2, All 23.4 - Credit deposit ratio: State 85.698.4102.9, All 92.8 - Source: Central Bank of Sri Lanka. ### Strengths and vulnerabilities of financial institutions — Insurance - Market-oriented reforms since 2002: - State-owned insurance companies privatized; Insurance Board of Sri Lanka (IBSL) created as an independent supervisor. - Tariff controls removed in several lines (e.g., fire and motor insurance), allowing market-based pricing. - Recent legislative reversals and concerns: - Recent legislation requires insurance companies to place up to 50 percent of their reinsurance business with the National Insurance Trust Fund (NITF). - NITF created to provide health and accident benefits for public servants and operate schemes for “needy persons.” - Strike, Riot, Civil Commotion and Terrorism Fund (SRCCTF) transferred to the NITF with transfers made from it to the government. - New legislative framework does not provide certainty that resources previously held in SRCCTF would be available. - Recommendation: reinsurance business should be operated separately from the NITF on a commercial basis and subject to proper actuarial assessment and external scrutiny. ### Risk mitigation in the financial system — Systemic liquidity management framework - CBSL tools and recent developments: - CBSL uses reserve requirements, standing facilities, and open-market operations to manage liquidity. - Restrictions on the reverse repo facility introduced in early 2007 increased overnight interest rate volatility. - Limited room for averaging reserves and limited access to central bank overnight lending caused banks to keep large safety margin of liquidity and placed limits on money market activity. - Call-money-market rates have been consistently, and sometimes considerably, above reverse repo rates of the CBSL in recent months, undermining the signal value of the policy rate. - Policy suggestions: - Use higher rates and supervisory measures, instead of quantitative restrictions, to deal with repeated access by banks. - Over the medium term, consider increasing the length of the averaging period (currently one week) and gradually relax the daily minimum limit on reserve balances to help reduce volatility in the overnight rate. ### Regulatory and supervisory framework — Banking supervision - Progress and remaining needs: - Since 2002 legal framework and prudential regulations strengthened; supervision practice improved. - Move from compliance-based to risk-focused supervision is in early stages. - Framework for overall risk assessment is still evolving; current practice insufficiently focuses on management and internal systems and controls. - Risk-management systems and processes are uneven across banks; supervisory guidance in this regard has yet to be issued. - Bank boards not seen as effective nor central to guiding the risk-management process. - Basel II implementation (Box 1): - Banks in Sri Lanka required to move to Basel II by January 2008. - Approaches allowed initially: standardized approaches to credit risk and market risk; basic indicator approach to operational risk. - Draft guidelines issued March 2006; draft consultative policy document issued June 2007. - Parallel computations of capital in 2006 suggest capital ratios remain largely unchanged as operational risk charge is largely balanced by lower risk weights on certain exposures. - CBSL cautious in implementation; has not lowered risk weight on mortgages and should apply similar caution to retail exposures. - With limited ratings penetration, enhancements in risk sensitivity under the standardized approach in Pillar I will be limited; implementing Pillar II supervisory review process is emphasized. - CBSL encouraged to develop Pillar II implementation thinking and share with banks well in advance. - Credit-risk supervision recommendations: - Adopt a more forward-looking approach to supervision of credit risk. - Recognize dependence on collateral and absence of reliable financial statements in some borrower segments. - Existing loan-loss classification and provisioning regime is formula-based on delinquency criteria. - Large exposure and related-party regimes enhance credit concentration risk; single-borrower limits are unusually large relative to capital and not always applied to major SOEs. - Establish robust and reliable tests of single exposure and enable supervisor to determine this on a case-by-case basis. *Source: International Monetary Fund (content as provided in the supplied PDF excerpt).* ### 25. The framework for consolidated supervision also needs to be strengthened to ### _cr07383 - 25. The framework for consolidated supervision also needs to be strengthened to ### Consolidated supervision - Banks are permitted to invest in any activity “not inconsistent with the business of banking and the provision of finance,” and banks may own not just financial institutions but also nonfinancial businesses, such as property development companies. - A framework for consolidated supervision is still developing, and prudential regulations are not consistently applied on a consolidated basis. - Although the CBSL has begun to establish links with other domestic regulators, these are still undeveloped and there remain significant barriers to the exchange of information, which also apply to relations with overseas authorities. ### Supervisory independence and governance - The operational independence of the CBSL as the supervisory agency could be further strengthened to enhance its credibility and assist it in imposing true remedial action. - The participation of the controller of the state banks in supervisory decisions on the banking system through membership of the Monetary Board could limit the ability of the supervisors to enforce compliance, particularly with respect to the state owned banks. - This lack of independence and potential conflict of interest could, in turn, affect the supervisors’ relationship with the rest of the market. ### AML/CFT - Progress has been made, including the enactment of three key laws and the setting up of the Financial Intelligence Unit (FIU) last year. - Priorities going forward: - Prioritize the Asia Pacific Group (APG) recommendations and formulate a road map for implementing the recommendations. - Allocate sufficient resources to enhance the capacity of FIU and assure its independence. - Deepen the knowledge and skills of FIU staff; continue training and raising awareness of licensed institutions and the public. - Enhance cooperation of the police and judicial officers to improve enforcement of the AML/CFT regime. - The ROSC, prepared by the APG, will be circulated to the Board for information. ### Microfinance regulation - A new Microfinance Law seeks to bring together regulation of diverse micro finance institutions (MFIs). - Some 14,000 providers of microfinance, both formal and informal, are estimated to be operating in Sri Lanka. - Participation of private commercial banks in the micro finance sector is minimal, although some banks have begun downscaling. - Currently, several ministries are involved in supervising microfinance; the proposed Micro Finance Institutions (MFI) Act seeks to consolidate responsibility for microfinance under CBSL. - Proposed requirements: - All MFIs with a capital base greater than an amount to be notified by the Monetary Board (MB) will be required to apply for a license from CBSL, which will also be responsible for supervision. - Concerns and recommendations: - Raises concerns relating to the capacity and reputation risk of CBSL, consequential moral hazard, and regulatory cost on the industry. - While oversight would provide legal recognition and build capacity, it is advisable for smaller MFIs to be outside the purview of the CBSL; certification authorities or a self-regulatory organization could be used to certify or register smaller micro credit providers. ### Insurance supervision - Considerable strengthening has taken place, but operationalizing risk-based methods has been constrained by limited resources. - The Insurance Board of Sri Lanka (IBSL) began operation as a division of the SEC in 2001, and moved out as an independent agency in May 2005. - IBSL has taken steps to introduce a modern risk-based supervisory framework with assistance of a full-time IMF consultant. - Resource shortfall: - There are currently only two supervision professionals responsible for 15 insurance companies, which undermine the ability of the IBSL to perform effectively. - Solvency and enforcement: - Solvency rules for life insurance companies have been in place for some time. - New solvency rules for nonlife insurance companies became effective in May 2007; the first formal reporting will occur for June Quarter 2007. - Proposals to increase the minimum capital of insurers for each line of business in 2010 may lead to industry consolidation or the exit by some firms. - Amendments to the Act are proposed to provide IBSL with a sufficient range of corrective and remedial powers and should be implemented expeditiously. - The law does not yet provide for the supervision of offshore activities of insurance companies, although several of the larger insurance companies have oversees operations. ### Pension and provident funds - Little progress since the 2002 FSAP recommendations; initiatives to move the public service pension scheme to a funded basis have been reversed. - Key shortfalls: - Need for the Employees Provident Fund (EPF) to develop a sound, robust, and independent governance structure focused on seeking the best investment returns for members while accounting for reasonable risk tolerance and individual preferences. - Need to create a strong regulatory framework for the licensing and supervision of approved private provident funds (APPFs). - Overarching need: - Develop a comprehensive retirement income objective for the pensions sector. - Concerns about multiple objectives and uses: - EPF balances can be used as security for housing loans; defaults occur. - Employees Trust Fund (ETF) is often considered an employee benefit program rather than a retirement income program. - APPFs have multiple objectives and many offer low interest loans to members. - Various other pension arrangements exist (for example, universities offer a defined benefit scheme). - Reiterates the 2002 FSAP recommendation to bring the entire gamut of pension arrangements within an independent supervisory framework and establish pension adequacy as a key objective. ### Securities regulation - The SEC is well-resourced, but capacity needs further strengthening. - Effectiveness hampered by lack of staff to undertake duties fully and effectively; situation will be exacerbated by new amendments to the Securities Law which add responsibilities: - (i) regulating five new types of intermediaries: underwriters, clearing houses, portfolio managers, credit rating agencies, and margin providers; and - (ii) implementing enhanced investigative powers. - Governance concerns and options: - SEC board composed of ten people: four ex officio and six appointed by the ministry of finance; quorum is five; non-executive and meets once a month; members are essentially unpaid. - Options to strengthen governance: - Reduce the number of Commissioners and require full-time paid Commissioners who give up other affiliations on appointment (U.S. model); or - Maintain structure but require all decisions of the SEC to be made public (possibly including votes of individual commissioners). ### Safety nets and crisis management - Operational continuity: - CBSL has prepared for operational disruptions: disaster recovery and business continuity plans documented; coordination with law enforcement and emergency officials discussed; succession arrangements drawn up; a back-up site created where transactions are backed up in real time and periodic tests carried out. - Guidance has been issued to banks on business continuity planning and are commented upon in supervisory discussions. - Crisis preparedness shortfalls: - No separate exercise or framework for responding to a financial crisis. - CBSL would benefit from drawing up procedural and operational guidelines, and clarifying the role and operational guidelines for the lender of last resort under the Monetary Act to facilitate speedy action. - Deposit insurance: - Authorities are encouraged to continue discussions on introducing a compulsory, funded deposit insurance scheme. - The existing voluntary scheme is not used. - A past bailout has created an expectation of a blanket guarantee. - High number of small depositors suggests a credible deposit insurance scheme could lessen moral hazard. - Prerequisites: resolve initial funding, and legal impediment to paying insured depositors ahead of liquidation. - Timing: introduction should be timed when all banks can meet regulatory capital requirements, risk-focused supervision is effectively implemented, and supervisory independence is assured. ### Payment and settlement systems - Major reforms since 2002: - LankaSettle RTGS commenced operation in 2003. - LankaSecure securities handling system commenced in 2004. - Check imaging and truncation introduced in 2006. - National Payments Council working on a nationwide noncash retail payment system. - Discussions underway to move settlement of the cash leg of Colombo Stock Exchange securities transactions to the central bank’s RTGS. - LankaSettle RTGS performance and issues: - RTGS has proved technically well-functioning and reliable and works well with LankaSecure allowing DvP settlement in central bank money. - Remaining issues: - Clarify legal jurisdiction risks in foreign bank participation. - Elaborate rules and procedures for handling abnormal events. - Document RTGS security objectives, policies, and procedures. - Review need to further formalize change-management procedures. - Conduct regular IT audit of the RTGS system. - Recommendation: CBSL should separately define objectives and fair access criteria for LankaSettle RTGS and LankaSecure, and make such criteria publicly available. ### Capital market development - Government actions to promote government securities market: - Introduction of RTGS, Scripless Security Settlement System (SSSS), and Central Depository System for government securities. - Decision to allow foreign investors to invest in a maximum of 5 percent of the total value of T-bonds outstanding. - Result: marked increase in proportion of marketable government securities to total domestic government debt from about one-half to two-thirds. - Constraints on market development: - Narrow investor base and captive sources of large funds. - EPF and National Savings Bank (NSB) alone holding 43 percent of government securities. - Excessive fragmentation of T-bonds (there are 52 series) impedes benchmark yield curve development. - Medium-term policy measures suggested: - Diversify investor base by promoting collective investment schemes. - Gradually further relax restrictions on foreign investors’ participation. - Develop a medium-term, benchmark-oriented issuance strategy. - Private securities market constraints and measures: - State-owned institutions play a dominant role but do not participate in capital markets. - EPF, ETF, and NSB capture significant funds but invest mainly in government securities. - Limited free float of stocks and lack of corporate debt supply restricts collective investment schemes. - Suggested measures: - Explore new sources of private issuance, e.g., securitization of housing loan portfolios. - Gradually divest equity in state-owned enterprises and list them. - Promote collective investment schemes to attract retail investors. - Permit large pension funds to expand private securities portfolios. ### Basel Core Principles assessment — methodology and setting - Assessment carried out from June 18 to July 3, 2007 by Peter Hayward and Dr. Jörg Genner on the CBSL banking supervision function as part of an FSAP Update by the IMF and World Bank. - With CBSL agreement, assessors used the new 2006 Basel Committee methodology and based assessment on the essential criteria, with comments on additional criteria where appropriate. - Information sources included the Monetary Law (MLA), the Banking Act (BA), CBSL Regulations and circulars, responses to a questionnaire, a self-assessment, and meetings with CBSL officials, bank managements, and external auditors. ### Institutional, macroeconomic setting and market structure — key facts - Macroeconomic environment characterized by: - Large fiscal deficit with consequent financing needs imposed on banks. - Relatively high inflation and strong demand for credit. - Recent tighter monetary policy leading to rising interest rates. - Banking system composition: - 23 Licensed Commercial Banks (LCBs) and 14 Licensed Specialized Banks (LSBs). - Of the LCBs, the two largest are state-owned. - 9 privately owned commercial banks, two of which are much larger than the rest. - 12 branches of foreign banks. - LSBs are mostly state owned, not permitted to take demand deposits or undertake foreign currency business, and have a market share about one fifth of the LCBs. - Large number of finance companies (take savings and time deposits) and leasing companies (funded by bank borrowings and debentures). - CBSL responsibilities: - Licensing and supervision of all deposit-taking institutions except some very small cooperatives. - Will be responsible for supervision of microfinance institutions under a new law; several have the right to take deposits. - LCBs entitled to operate foreign currency banking units (FCBUs); these are treated as an integral part of banks for supervisory purposes. ### Preconditions for effective banking supervision — identified issues - Soundness and sustainability of macroeconomic policy: - The Sri Lankan economy has been growing above 6% in the recent past, amidst challenging external and domestic developments. - Rising inflationary pressures and high fiscal deficits have led monetary policy to remain tight necessitating interest rates in double digits. - Government borrowing from the banking system is high. - Taxation of banks is high: corporate income taxes supplemented by a so-called VAT on financial services; together the effective tax rate is over 50 percent of operating profits. - Legal infrastructure: - Registration of collateral is at a basic level though banks have power to seize and dispose of real estate collateral without litigation in many cases. - Court system tends to favor rights of individuals and banks’ actions are frequently challenged. - Accounting and auditing standards for banks are high and will shortly meet international standards in all significant respects. - Quality of financial statements by borrowers is mixed; banks tend to rely more on collateral than borrower cash flow assessment. - Payments system recently modernized and functions well. - Market discipline: - Banks are subject to substantial disclosure requirements (published quarterly statements in prescribed format). - Most private banks are quoted on the Colombo Stock Exchange which imposes further disclosure requirements. - Additional disclosure requirements will be imposed with the implementation of Basel II from January 2008. - Systemic protection mechanisms: - No compulsory deposit insurance scheme although one is under consideration. - Little need to date for emergency liquidity assistance and bank resolution procedures are untested. *Italic: Source — _cr07383 - 25. The framework for consolidated supervision also needs to be strengthened to* ### 48. The main findings of the assessment can be briefly summarized under the following ### 48. The main findings of the assessment can be briefly summarized under the following headings: ### Objectives, independence, powers, transparency, and cooperation (CP1) - Objectives of the CBSL are well laid out. - Monetary Board’s independence potentially constrained by presence of the Secretary of the Treasury who: - acts as shareholder of the two largest banks, - is responsible for appointing members of their boards and approving them as ‘fit and proper’. - Exchange of information with other supervisory authorities, domestically and abroad, is inhibited by legal barriers. ### Licensing and structure (CPs 2–5) - Distinction between licensed banks and certain other categories of institution that can undertake almost all banking functions is beginning to look outdated. - Licensing criteria need more detailed specification for new applicants and to guide licensed banks on continuing obligations. - Cap on shareholdings in banks provides incentive to disguise controlling interests and is no substitute for a well designed suitability test. ### Prudential regulations and requirements (CPs 6–18) - Credit and market risk-related computations, capital charges, and reporting requirements are in force. - Risk-weighted capital adequacy requirements are applied on a “solo” basis only, but reported on a “consolidated” basis as well. - Capital adequacy ratios and risk weights for certain exposures were increased recently. - CBSL has issued regulations (directions) setting detailed prudential standards for: - capital adequacy, - large exposures, - liquidity, - share-ownership, - classification of assets, - general provisions. - Neither law, nor regulations or directions explicitly stipulate general requirements for risk-management processes and procedures dealing with specific risks in greater detail. - Determining efficacy and efficiency of risk management, management oversight, and assessing institution risks are integral to CBSL’s off-site and on-site supervision. - Credit risk is the predominant risk; interest rate risk is significant and increasing due to rising interest rates and the funding structure. - CBSL requires senior management to address significant internal operations and has inspection procedures to assess adequacy of banks’ internal control systems, but CBSL has not yet issued guidance. - A nonmandatory Corporate Governance Code Sri Lanka has been issued and a mandatory code will be imposed in 2008. ### Methods of ongoing supervision (CPs 19–21) - CBSL performs off-site analysis and on-site inspections. - Full-scope on-site inspections are mandatory and scoped from off-site analysis of regulatory reporting; inspections use standardized procedures. - Inspections cover: - compliance with prudential regulations, - accuracy of regulatory reporting, - quality of risk management and internal control processes and procedures. - Formal and informal contacts with senior managements are increasing; there are no regular meetings with internal audit or risk managers. - Measures to enhance supervision quality have improved understanding of bank risks and emerging separate risk-management functions. - CBSL has started shifting focus from a compliance-based to a more risk-focused supervisory approach. ### Accounting and disclosure (CP 22) - International accounting standards will shortly be introduced, posing problems of consistency with existing prudential rules that are seemingly more objective but do not well reflect actual risks. ### Remedial measures (CP 23) - A wide range of tools is available, although their use can be subject to legal challenge. - Implementation in major state-owned institutions is difficult and problems have persisted for many years. ### Consolidated and cross-border banking supervision (CPs 24–25) - CBSL has legal powers to exercise supervision on a solo basis only. - Consolidated capital adequacy ratios are reported by banks, but prudential requirements are not applied on a consolidated basis. - Supervisors have access to information on banks’ subsidiaries. - Confidentiality provisions inhibit exchange of information with other supervisors, domestically and abroad, hampering assessment of risk from limited nonbanking activities of Sri Lankan banking groups. - CBSL is able to perform supervisory tasks for foreign activities of domestic banks and domestic activities of foreign banks by applying the same regime in place for domestic banks. ### Table 2 — Selected summary observations from the Basel Core Principles assessment - Principle 1: Deficiencies on independence and exchange of information; rationale for supervisory distinctions between banks and NBFIs is unclear; Minister’s role as MB member and shareholder could present conflict of interest. - Principle 2: No clear distinction between banks and NBFI. - Principle 3: Guidance needed on detailed licensing criteria. - Principle 4: Cap on shareholdings but no suitability test. - Principle 6: Not all banks comply with capital requirement. - Principle 7: Risk-management processes just developing; reliance on mechanical formulae; ineffective identification of significant risk. - Principle 9: Provisioning is not forward looking. - Principle 10: Rules are lax and coverage partial for large exposure limits. - Principle 11: Related parties not properly identified; no arms length requirement. - Principle 17: No formal guidance on internal control and audit. - Principle 19–21: Supervisory approach shifting but risk focus yet to be further developed; mix of tools needs to be more risk focused; supervisory reporting needs to cover subsidiaries and affiliates. - Principle 22: IAS to be fully implemented soon. - Principle 23: Rehabilitation of state banks still to be completed. - Principle 24–25: No consolidated supervision powers; limited oversight and constrained information sharing; some oversight of activities abroad. ### Recommended action plan (selected recommendations from Table 3) - Principle 1: Limit conflict of interest in Monetary Board posed by MOF representative’s role as shareholder of SCBs. Remove legal barriers for exchange of information. - Principle 3: Publish licensing criteria and guidance on definition of ‘fit and proper’. - Principle 4: Broaden definition of significant ownership to encompass exertion of control; introduce a suitability test. - Principle 6: Ensure that all banks, including state-owned banks are adequately capitalized. - Principle 7: Move further from compliance-based to a more risk-focused approach. Introduce an explicit legally-binding requirement that banks have proper risk-management processes and procedures and publish supervisory guidance. Incorporate analysis of banks’ risk and internal audit reports in off-site analysis. - Principle 10: Broaden definition of large exposures; introduce definition of connected group of counterparties based on correlated risks rather than shareholdings; revise and reduce existing limits for large exposure to levels common internationally. - Principle 11: Broaden definition of related parties to encompass owners and others who exert control; introduce requirement for prior unanimous Board approval for such exposures; require exposures to related parties not be granted on more favorable terms than to non-related parties. - Principle 14: Introduce reporting of asset and liability maturities by currency. - Principle 20: Reduce heavy reliance on mechanical formulae; recognize and encourage expert judgment in supervisory framework and banks' risk management. - Principle 21: Use risk profiles to manage supervisory process, especially frequency and scope of on-site inspections; leverage internal auditor's and risk management's work. - Principle 22: Assess implications for provisioning of move to IAS 39. - Principle 23: Keep Monetary Board's legal powers of enforcement under continuous review to ensure effectiveness and resistance to court challenge. - Principle 24 and 25: Amend the BA to impose prudential standards on a consolidated basis; empower the supervisor to exchange financial and prudential information with other supervisors; establish a banking group approach for continuous supervision and on-site inspection. ### Authorities’ response - CBSL broadly agrees with the assessment and is working on implementing several issues identified. - Examples of actions under way: - Integrated risk-management guidelines under preparation. - Draft mandatory code of corporate governance for banks has been issued. - Implementation of Basel II and IAS 32 and 39, and IFRS 7. - On government representation on the Monetary Board: authorities state the arrangement facilitates co-operation and coordination and does not hinder independence. - On secrecy provisions: authorities assert legal provisions allow information sharing in the performance of duties and that information sharing has occurred when needed. - Two committees established by the Central Bank to facilitate information sharing: - Inter Regulatory Institutional Council (IRIC) at policy level. - A working group representing all regulators. - CBSL is strengthening the FIU: procuring IT system for on-line data reporting and maintaining a database, providing training, and expanding coverage of institutions reporting to FIU. - Large exposure limits will be addressed when the Banking Act is amended; authorities note higher exposure limits can be justifiable in a bank-based economy provided concentration risks are managed prudently. ### Assessment of LankaSettle RTGS and payment system infrastructure (Appendix II — Summary, Key Findings and Recommendations) - LankaSettle RTGS commenced operation in 2003; LankaSecure commenced in 2004. - LankaSettle RTGS is technically well functioning and reliable but several issues remain to improve soundness and efficiency: - Clarify legal jurisdiction risks in foreign bank participation. - Elaborate rules and procedures for handling abnormal events. - Document RTGS security objectives, policies and procedures. - Review need to further formalize change management procedures. - Conduct regular IT audit of the RTGS system. - Assessment basis: - Conducted by Tom Kokkola of the European Central Bank in the context of the joint IMF/World Bank FSAP Update mission which visited Sri Lanka between June 20 and July 3, 2007. - Based on CBSL-provided information, a Sveriges Riksbank assessment from February 2005, documents, statistics, meetings with CBSL officials, representatives of three participant banks and LankaClear (Pvt) Ltd, and CBSL questionnaire responses. - Institutional and market structure facts: - LankaSettle RTGS, owned and operated by the CBSL, is the backbone for payment and securities transactions in Sri Lankan rupees. - Noncash payment systems include: - LankaSettle RTGS: currently has 34 participants: 23 licensed commercial banks (including 12 foreign banks), 8 non-bank primary dealers, the Central Depository System of the Colombo Stock Exchange, the Employees’ Provident Fund and the CBSL. - LankaClear (Pvt) Ltd. operates four clearing systems: Cheque Imaging and Truncation System (CIT); Sri Lanka Interbank Payment System (SLIPS); Rupee Draft Clearing System; US Dollar Cheque Clearing System. The first three settle net clearing balances in the RTGS system; US Dollar Cheque Clearing System balances are settled at a commercial bank. - Two commercial banks provide settlement services for domestic VISA and MasterCard transactions. - Operational details: - Payment submission: via SWIFT FIN Copy service; system checks funds in correspondent account; if sufficient, funds debited from ordering bank and credited to receiving bank; payment final from moment of debiting. - Insufficient funds: payment placed in waiting queue; queued payments processed first by priority, then by time of input. - Participants can prioritize payment requests; real-time information management allows continuous monitoring of account balance, queued payments, and changing priority or cancelling queued payments. - Activity statistics and patterns: - On average 760 daily payments are currently being settled, with some 40 percent representing customer payments. - Day characterized by two peaks: morning peak at system opening at 08.00 and an afternoon peak between 1.00 and 3.00 pm. - A trough generally between 09.00 and 11.00. - No observable concentration of payment flows to or from particular participants. - Five most active participants generate 36.07 percent (35.06 percent in terms of value) of total traffic. - Governance and development: - A National Payment Council (NPC) was established in 2006; NPC meets at least six times a year and has a broad mandate from the CBSL Monetary Board. - CBSL with NPC prepared a Road Map for the four years period 2007-2010. - A local SWIFT Service Bureau, the Lanka Financial Service Bureau Ltd. (LFSB), is being established to provide, by end 2007, a common connectivity point for LankaSettle participants’ secondary sites to communicate with CBSL using the SWIFT network; LFSB will be an independent legal entity owned by SWIFT users in Sri Lanka. - Main finding on LankaSettle RTGS: - System is generally technically well functioning; assessment identifies opportunities for further improvements to ensure full adherence to the Core Principles. *Source: Assessment text as provided in the content unit.* ### 62. Legal foundation (CP I). While there is a sound legal basis for the system, since ### _cr07383 - 62. Legal foundation (CP I). While there is a sound legal basis for the system, since ### Legal foundation (CP I) - The system has a sound legal basis, but about one third of all RTGS participants are branches of foreign banks, exposing the system and its participants to conflict of law risk despite some protective regulatory measures. - Recommendation: Foreign participants should be requested to provide independent legal country opinions for the jurisdictions concerned. - Recommendation: The CBSL should consider maintaining regular contacts with the supervisory authorities of the different foreign participants’ home countries. - Table note: "12 RTGS participants are branches of foreign banks" is identified as a source of conflict of law risk. ### Understanding and management of risks (CPs II–III) - LankaSettle RTGS is a real-time gross settlement system with central bank money as settlement asset; credit risk does not arise for participants. - The CBSL is subject to credit risk to the extent it provides credit to participants; this risk is mitigated by requiring collateral (to which haircuts are applied). - Main risks to participants: legal risk, operational risk and liquidity risk. - System rules and procedures do not fully cover the handling of abnormal situations and leave excessive discretionary powers to the CBSL; the report recommends further elaboration and removal of wide discretionary powers. - Recommendation: The CBSL should from time to time release new sets of complete and updated system rules (and possibly make them available on-line for participants). - Liquidity rigidities noted: - Hesitation among participants to transact with same day value after the closing of the call money market at around 9.00 am. - Consideration: allow more flexibility in the maintenance of required reserves to enable efficient and flexible liquidity management. - Recommendation: Address liquidity and other barriers to smooth RTGS functioning and increased financial markets activities. ### Settlement (CPs IV–VI) - Individual payments are settled on a real-time gross basis, in central bank money, in the LankaSettle RTGS. - Payments that cannot be settled due to lack of funds are put in a waiting queue; queued payments are processed first by priority, then by time of input to the queue. - CP IV: The system provides for real-time gross settlement. - CP V: Not applicable (multilateral netting not applicable). - CP VI: Transactions are settled in central bank money. ### Security, operational reliability and contingency arrangements (CP VII) - The LankaSettle RTGS is a stable and reliable system with a good track record as regards availability. - Improvements recommended: further refine and formalize system rules and procedures, RTGS security objectives, policies and procedures, change management procedures, and comprehensive documentation on internal operational rules and procedures. - Recommendation: Conduct regular end-to-end security audits by well-qualified external experts. - Operational staff resources are very limited and do not allow for unexpected unavailability of individuals. ### Efficiency and practicality of the system (CP VIII) - Current users are satisfied, but the system does not yet serve to its full potential for financial markets and the economy at large. - Key constraint: liquidity issues (see CP III). - Recommendation: Investigate whether and to what extent cumbersome procedures impact the use of intraday credit facility (ILF). - Note: The system will serve to its full potential when liquidity issues are addressed and secondary market trading in public debt securities develops. ### Criteria for participation (CP IX) - Access rules to payment and securities settlement systems are not publicly available and currently leave the CBSL a large degree of discretion to decide on eligibility for participation. - Access is presently bundled for LankaSettle RTGS and LankaSecure. - Recommendation: Define separate full access criteria for each of the two systems and make such criteria publicly available. ### Governance of the payment system (CP X) - External governance is good; internal governance arrangements show room for improvement. - Internal governance for LankaSettle as a whole is unclear due to distribution of responsibilities and lack of formalization of functions and procedures. - Recommendation: De-link LankaSettle RTGS and LankaSecure to have two distinct systems with independent system rules and governance arrangements; further clarify and formalize system ownership, responsibility allocation and procedures. ### Central Bank responsibilities in applying the CPSIPS - The CBSL has not made its own assessment of the RTGS compliance with the Core Principles to date. - Many shortcomings were previously identified by the earlier assessment by the Sveriges Riksbank team about two and a half years ago; some action taken, but no systematic follow-up. - The CBSL does not require independent legal country opinions and does not maintain regular contacts with the home country supervisors of the 12 foreign banks that participate in LankaSettle RTGS — this must be addressed to improve management of liquidity or solvency problems with those banks. - Recommendations for the Monetary Board and CBSL: - If the Payment and Settlement System Act No.28 of 2005 is amended, amend references to the Ministry of Finance so they refer to the CBSL to clarify CBSL independent authority on payment and settlement issues. - The Monetary Board should formally adopt the CPSS Core Principles and the CPSS/IOSCO Recommendations as the applicable oversight standards and clarify application to low-value (retail) payment systems of system-wide importance; make such information public. - Continue oversight capacity building to enable assessment of external systems against CBSL oversight standards. - Responsibility B: Set up a plan, with key milestones, for addressing the recommendations made in this assessment. - Responsibility D: Maintain regular contacts with the home country supervisors of each of the foreign banks in the system. ### Table summary of observance (selected findings) - Legal foundation (CP I): 12 RTGS participants are branches of foreign banks; conflict of law risk exists. - Understanding and management of risks (CP II–III): System rules/procedures incomplete for abnormal situations; substantial rigidities in liquidity markets inhibit full potential; consolidated up-to-date system rules to be released. - Settlement (CP IV–VI): Real-time gross settlement in central bank money; multilateral netting not applicable. - Operational reliability (CP VII): RTGS stable and reliable; IT audit not conducted for some time. - Practicality/efficiency (CP VIII): Current users satisfied; system potential contingent on addressing liquidity and developing secondary market trading in public debt securities. - Access and governance (CP IX–X): Access rules bundled and not publicly available; bundling contributes to lack of clarity in internal governance arrangements. - Central bank responsibilities (A–D): CBSL has disclosed payment systems objectives; has attempted implementation consistent with Core Principles; external systems are subject to oversight; CBSL does not maintain regular contacts with home supervisors of the 12 foreign banks. ### Recommended actions (summary) - Legal foundation: Request independent legal country opinions from foreign participants. - Risk management: - Elaborate system rules and procedures for abnormal situations and remove wide discretionary powers of the CBSL. - Release consolidated, updated system rules regularly (possibly online). - Address liquidity barriers; consider allowing more flexibility in required reserves. - Security and contingency: - Elaborate and formalize RTGS security objectives, policies, change management, and internal operational documentation. - Conduct regular external IT/security audits. - Efficiency: - Investigate cumbersome procedures affecting ILF usage. - Participation criteria: - Define and publish separate objective access criteria for LankaSettle RTGS and LankaSecure. - Governance: - De-link LankaSettle RTGS and LankaSecure; formalize ownership and responsibility allocation. - Central bank responsibilities: - Prepare a plan with milestones to address assessment recommendations. - Maintain regular contacts with home country supervisors of foreign banks in the system. ### Authorities' response (summary of CBSL positions) - CBSL broadly agrees with practical and relevant recommendations and will implement those suitable to Sri Lankan market conditions. - CP I: Foreign participants are local branches of foreign banks licensed under Banking Act No. 30 of 1988; Section 3 (1) (c) (i) provides for a written undertaking by the foreign bank to the Monetary Board to meet obligations; agreements and contracts (Mandate, Accession, RTGS, Repo and reverse Repo agreements etc.) are in place. - CP II: CBSL will release new sets of complete and updated system rules at the beginning of each year; hard copies circulated to participants and soft copies on the CBSL website; further precision on abnormal situations to be included in the forthcoming update of the System Rules envisaged for January 2008. - CP III: Measures taken on liquidity management: - Participants can obtain (free of charge) or repay at any time during the day the Intraday Liquidity Facility (ILF) without restriction on number of instances or amount; process fully automated and similar to a DvP transaction. - Call market is more active during the first two hours, but no restriction prevents banks dealing in call money transactions during the day until the RTGS system is open. - Standing facility is open until 1500 hours of each day. - CP VII: Each operational department has internal operational manuals; CBSL will incorporate these and prepare a comprehensive single document common for the RTGS and SSS systems; Public Debt Department is further elaborating the operational manual for the SSS; change management procedure documented for both systems and will be reviewed if required. - CP VIII: CBSL states LankaSettle serves its users and has potential for future needs; CBSL sees no clear relevance between the liquidity issues mentioned under CP III and the observance of CP VIII. - CP IX: CBSL wishes to retain discretion over eligibility of participation given development level and nature of Sri Lanka's financial system; rationale is to minimize risks as the RTGS system has been in operation only since 2004. Primary Dealers require an RTGS account for DvP settlements; RTGS participants are given SSS accounts to facilitate ILF. - CP X: CBSL asserts RTGS and LankaSecure operate as two independent systems (RTGS operated by Payments and Settlements Department; LankaSecure by Public Debt Department); governance arrangements are claimed to be clearly separated though technical infrastructure is closely linked; IT Department, with Payments and Settlements Department, will prepare an escalation procedure with clearly defined responsibilities in addition to documented RSOG operations group responsibilities already shared with WB/IMF FSAP mission. *Source: IMF assessment excerpt from the LankaSettle RTGS CPSIPS evaluation.* ### 84. It is possible to maintain independent system rules and governance arrangements for ### It is possible to maintain independent system rules and governance arrangements for the two systems. ### Linkage and operational arrangements of SSSS and RTGS - Transactions relating to the new issues of government securities and to the secondary market of the government securities are settled through SSSS. - Securities are transferred from one account to another in the form of an electronic data entry as instructed by the participants involved. - The corresponding fund transfers take place through the Real Time Gross Settlement (RTGS) System. - Settlements of securities through SSS and funds through RTGS are confirmed electronically to the participants involved. - These transactions take place in real time and on the concept of Delivery vs. Payment (DvP). - The Central Bank’s Intra day Liquidity Facility is also given on the concept of DvP basis. - Since these two systems are linked, it facilitates DvP transactions on real time basis. ### Central Bank responsibilities and CPSIPS implementation - Responsibility B – CBSL has implemented the Sveriges Riksbank team’s recommendations, which are practical to the Sri Lankan financial market conditions. ### Banking system restructuring and regulatory reforms (implementation status) - Restructure State Banks - The original proposal to privatize People’s Bank (PB) and Bank of Ceylon (BC) has been abandoned, and implementation of restructuring plans has been slow. Main remaining issues include the large stock of bad debts, inadequate IT, and overstaffing. - Improve the capital position and management of private domestic banks - CBSL has enforced the regulatory CAR, introduced market risk capital charge and increased minimum capital requirements for all banks. - CBSL is also planning to introduce mandatory corporate governance standards for banks. - Promote consolidation of the banking system - The pace of consolidation has been slow. Acquisitions are inhibited by the limit on bank shareholdings, while mergers have faced resistance by unions. - Upgrade and modernize financial regulation and supervision - Several prudential requirements based on international standards have been issued. - The process of introducing a risk-based approach for supervision has just begun, integrated risk-management guidance is being prepared and the development of a consolidated supervision framework is in its embryonic stages. - A web-based reporting system has been developed to improve continuous surveillance. - Improve coordination among financial supervisory bodies - An Inter-Regulatory Institutions Council was established earlier this year to promote cooperation and information sharing among domestic agencies. - A working group for financial sector regulators was also established to monitor the systemic risk of financial conglomerates. - CBSL has signed MOUs with the SEC and IBSL as well as appointed a Deputy Governor to the Boards of these institutions. - The need to remove legal barriers preventing the exchange of information has not been addressed, significantly hampering coordination efforts. - Devise framework for problem bank management, including prompt corrective action - Amendments to the Monetary Law Act were introduced in 2002 which included liquidation procedures for specialized banks. - A first draft of new banking and central banking laws were prepared with Fund/Bank assistance in 2003 which among other things covered a regulatory response policy on banking problems. - Do not introduce deposit insurance until preconditions for effective banking supervision are in place - A Deposit Insurance Scheme was introduced in 1987, but the scheme remains voluntary and seldom used. - In 2004, the central bank approved a more extensive scheme, but it is yet to be implemented due to a reluctance to commit the initial funds needed before the scheme can be financed exclusively by the premium. - Larger banks are reluctant to participate until risk-based contribution is introduced. - Define price and financial stability as primary objectives of the Central Bank of Sri Lanka - Implemented by amending the Monetary Law Act No. 58 of 1949 in December 2002. - Advance the modernization of the legal and accounting framework - The Payments and Settlement Systems Act, Electronic Transactions Act, Payment Devices Frauds Act, the New Companies Act, and legislation pertaining to Anti-Money Laundering, Terrorist Financing and Financial Transactions Reporting have been enacted. - The Monetary Law Act and Banking Act have been amended in 2005/06, though the need to have more streamlined, modern, and comprehensive laws remain. - In accounting, CBSL is planning to introduce key internationally accepted accounting and reporting standards. - CBSL’s own accounts are audited by an international auditing firm in line with IAS and IFRS, and there have been no qualified audits in the past two years. ### Development of nonbank financial sector (implementation status) - Enhance primary securities market efficiency and secondary market liquidity - The inter-bank call market, the secondary market for treasury bills and bonds, and the central bank’s Repo and Reverse Repo windows have been introduced and developed. - Direct administrative controls—such as the restriction of Reverse Repo facility and the government’s exclusive use of state-owned banks to manage its liquidity needs—are not transparent, restricting private commercial banks’ ability to effectively manage their liquidity. - Policy signaling is weak. - Restructure and modernize insurance and provident sectors - The insurance sector has been privatized. - Capital requirements for insurance companies were revised in 2005. - The pension reform process has stalled. - Promote access to financial services by SMEs and low-income groups - Commercial banks have established links with Sri Lanka Post to increase outreach to rural areas for remittances, credit delivery, and credit payment. - Rural development banks have improved their financial viability for long term sustainability. - A legal framework has been proposed under the MFI Act for supervision of micro finance institutions. - Finalize AML law after revising draft law - Several steps have been taken to adopt the Financial Action Task Force recommendations, including the promulgation of the Convention on the Suppression of Terrorist Financing Act, the Prevention of Money Laundering Act, and the Financial Transaction Reporting Act. - The FIU has been established within the CBSL. ### Structure of Financial System — selected figures (Table 6; preserved exactly as presented) - Total Financial System 1/ — Assets Rs. Bn: 1,780.7; % of Total Assets: 100.0; % of GDP: 112.4 (06-Dec) - Total Financial System 1/ — Assets Rs. Bn: 2,373.1; % of Total Assets: 100.0; % of GDP: 116.9 (02-Dec) - Total Financial System 1/ — Assets Rs. Bn: 3,297.0; % of Total Assets: 100.0; % of GDP: 117.7 (04-Dec) - Commercial Banks (number and assets) - Number 23; Assets Rs. Bn 930.5; % of Total Assets 52.3; % of GDP 58.7 (06-Dec) - Number 22; Assets Rs. Bn 1,219.8; % of Total Assets 51.4; % of GDP 60.1 (02-Dec) - Number 23; Assets Rs. Bn 1,851.2; % of Total Assets 56.1; % of GDP 66.1 (04-Dec) - State banks - Number 2; Assets Rs. Bn 456.5; % of Total Assets 25.6; % of GDP 28.8 (06-Dec) - Number 2; Assets Rs. Bn 526.5; % of Total Assets 22.2; % of GDP 25.9 (02-Dec) - Number 2; Assets Rs. Bn 752.3; % of Total Assets 22.8; % of GDP 26.8 (04-Dec) - Private banks - Number 9; Assets Rs. Bn 352.0; % of Total Assets 19.8; % of GDP 22.2 (06-Dec) - Number 9; Assets Rs. Bn 523.2; % of Total Assets 22.0; % of GDP 25.8 (02-Dec) - Number 9; Assets Rs. Bn 833.7; % of Total Assets 25.3; % of GDP 29.8 (04-Dec) - Foreign banks - Number 10; Assets Rs. Bn 122.0; % of Total Assets 6.9; % of GDP 7.7 (06-Dec) - Number 11; Assets Rs. Bn 170.1; % of Total Assets 7.2; % of GDP 8.4 (02-Dec) - Number 11; Assets Rs. Bn 265.2; % of Total Assets 8.0; % of GDP 9.5 (04-Dec) - Institutional Investors — Assets Rs. Bn: 464.1; % of Total Assets 26.1; % of GDP 29.3 (06-Dec) - 612.4; 25.8; 30.2 (02-Dec) - 784.2; 23.8; 28.0 (04-Dec) - Securities market capitalization - 1,121.3; 70.8 (06-Dec) - 1,538.0; 75.8 (02-Dec) - 2,310.3; 82.5 (04-Dec) - Domestic Bond Market - 958.7; 60.5 (06-Dec) - 1,155.9; 57.0 (02-Dec) - 1,475.5; 52.7 (04-Dec) - Government Debt - 948.4; 59.8 (06-Dec) - 1,143.4; 56.3 (02-Dec) - 1,475.5; 52.7 (04-Dec) - Memorandum Items - GDP (Rs bn): 1,584.8; 2,029.4; 2,802.0 - GDP (USD bn): 16.4; 19.4; 26.0 - Exchange Rate to USD (Year End): 96.7; 104.6; 107.6 - Note: Sources: Sri Lankan authorities; staff estimates and calculations 1/ Does not include CBSL assets ### Financial Soundness Indicators — selected figures (Table 7; All Licensed Commercial Banks; In Percent) - Capital Adequacy (aggregate) - 2002: 9.3 - 2003: 8.9 - 2004: 9.3 - 2005: 12.2 - 2006: 11.3 - 6/2007*: 11.2 - Core Capital Ratio (Tier 1) - 2002: 10.3 - 2003: 10.3 - 2004: 10.3 - 2005: 12.8 - 2006: 12.7 - 6/2007*: 12.6 - Capital Adequacy Ratio (CAR) [preserved as presented] - 2002: 93.7 - 2003: 52.3 - 2004: 29.8 - 2005: 16.5 - 2006: 13.1 - 6/2007*: 13.5 - Gross-Nonperforming Ratio (With interest in suspense) - 2002: 19.1 - 2003: 16.4 - 2004: 11.3 - 2005: 8.8 - 2006: 7.4 - 6/2007*: 7.4 - Gross-Nonperforming Ratio (Without interest in suspense) - 2002: 14.5 - 2003: 12.5 - 2004: 8.9 - 2005: 6.8 - 2006: 5.5 - 6/2007*: 5.4 - Net Nonperforming Ratio (Net of interest in suspense and loan loss provisions) - 2002: 7.2 - 2003: 5.1 - 2004: 2.8 - 2005: 1.9 - 2006: 1.8 - 6/2007*: 2.0 - Provision Coverage Ratio - 2002: 50.4 - 2003: 58.7 - 2004: 68.3 - 2005: 72.1 - 2006: 67.2 - 6/2007*: 63.4 - Profitability indicators (selected) - Return on Assets (ROA)-Before Tax: 2002: 1.1; 2003: 1.4; 2004: 1.4; 2005: 1.7; 2006: 1.8; 6/2007*: 1.8 - Return on Assets (ROA)-After Tax: 2002: 0.9; 2003: 1.1; 2004: 1.1; 2005: 1.2; 2006: 1.3; 6/2007*: 1.2 - Return on Equity (ROE): 2002: 20.5; 2003: 21.1; 2004: 18.3; 2005: 16.8; 2006: 17.4; 6/2007*: 16.5 - Cost to Income Ratio: 2002: 82.5; 2003: 77.2; 2004: 77.5; 2005: 78.6; 2006: 77.5; 6/2007*: 78.8 - Staff Cost to Operating Expenses: 2002: 47.4; 2003: 48.7; 2004: 46.4; 2005: 44.4; 2006: 42.7; 6/2007*: 42.2 - Interest Margin: 2002: 3.2; 2003: 4.2; 2004: 4.0; 2005: 4.1; 2006: 4.4; 6/2007*: 4.4 - Interest Income to Total Income Ratio: 2002: 82.4; 2003: 76.6; 2004: 75.3; 2005: 79.9; 2006: 83.4; 6/2007*: 85.9 - Liquidity Indicators (selected) - Statutory Liquid Asset Ratio — DBU: 2002: 33.2; 2003: 26.1; 2004: 26.3; 2005: 24.2; 2006: 23.9; 6/2007*: 25.8 - Statutory Liquid Asset Ratio — FCBU: 2004: 35.2; 2005: 37.3; 2006: 43.1; 6/2007*: 39.2 - Liquid Assets (Average)/ Total Assets: 2002: 27.7; 2003: 21.8; 2004: 26.6; 2005: 24.2; 2006: 23.4; 6/2007*: 24.2 - Assets/Funding Structure (selected) - Capital Funds: 2002: 4.7; 2003: 5.8; 2004: 5.9; 2005: 7.2; 2006: 7.3; 6/2007*: 7.5 - Deposits: 2002: 74.4; 2003: 74.0; 2004: 75.8; 2005: 71.3; 2006: 69.4; 6/2007*: 68.0 - Borrowings: 2002: 13.8; 2003: 13.8; 2004: 13.3; 2005: 16.8; 2006: 18.6; 6/2007*: 19.9 - Loans and Advances: 2002: 60.8; 2003: 58.7; 2004: 61.7; 2005: 61.7; 2006: 64.5; 6/2007*: 65.1 - Investments: 2002: 20.3; 2003: 23.3; 2004: 20.3; 2005: 17.9; 2006: 16.6; 6/2007*: 16.1 - Ratio of Credit to Deposits: 2002: 81.8; 2003: 79.4; 2004: 81.4; 2005: 86.6; 2006: 92.8; 6/2007*: 95.8 - Source: Central Bank of Sri Lanka - * Provisional Data ### Stress tests — methodology and key results (Appendix IV) - Sample and scope - Sensitivity tests conducted on a sample of 12 banks (10 commercial and 2 specialized banks) representing about 91 percent of total assets. - Tests performed on exposures, on a bank-by-bank basis, as of end-2006. - Bank solvency tested against isolated movements in the exchange rate, interest rate, and deterioration in asset quality. - Data to test for contagion in banks and for risks in finance companies and leasing companies were not available. - Credit risk sensitivity test - Examined changes required in banks’ provisioning if a percentage of all debtors in each loan category were reclassified and downgraded by one notch in all banks. - Current loans were downgraded by two notches. - The resulting provisioning shortfall caused a reduction in capital, affecting the CAR and bank solvency. - While CARs were affected, only one bank became insolvent in the case of 20 percent reclassification. - Credit concentration stress - Two different assumptions: default of the single largest, and the two and three largest borrower groups (excluding central government) in each bank. - The second and third assumptions had a direct bearing on the CAR; 10 banks representing 86 percent of the banking system were undercapitalized, of which two banks were found to be insolvent. - While such a systemic default is an unlikely event, it highlights concerns on the large exposure regime. - Note on central government exposure: the central government is the single largest exposure of the banking system accounting for more than a quarter of total assets and more than 4 times regulatory capital at end-2006, with state banks in the sample alone having an exposure around 10 times capital. - If exposure to SOEs is also taken into account, this figure is even higher, with some SOEs accounting for two to four times the capital of one state LCB. - Estimated recapitalization cost if state banks in the sample are impacted in extreme stress scenarios: would range between 1 percent to 2 percent of GDP. - Exchange rate risk - Exposure measured by the net open position of individual institutions. - The effects of an appreciation or depreciation in the exchange rate on the CAR were insignificant. - Caveat: marginal effects do not take into account indirect effects on borrowers’ capacity to repay foreign currency–denominated loans. - Interest rate risk sensitivity - Assessed using a simplified GAP analysis affecting net interest income. - Sensitivity tests incorporating increases in short-term interest rates equivalent to 5 percent and 10 percent changes over a year (corresponding to two- and four-standard deviations over a year in the period 1995–2006) led to a substantial decline in the CAR below the minimum capital requirement in some important banks. - Two institutions became insolvent as their CAR fell below zero. - Note: the test assumes banks maintain the size of the gaps during the year and that changes in deposit and loan rates remain constant. - Liquidity sensitivity tests - Identified sources and uses of funds under the assumption of increased likelihood of deposits and other funds being withdrawn and assets becoming illiquid. - The banking system coped well with three scenarios in which 10 percent and 20 percent of total deposits and all nonresident deposits, respectively, were withdrawn, assuming all liquid assets were immediately available to meet the deposit withdrawal. - However, when assumptions incorporate limited availability and discounts on certain instruments considered liquid for regulatory purposes, liquidity ratios were severely impaired. - Under this scenario, a 20 percent deposit withdrawal resulted in banks representing 80 percent of the banking system asset becoming illiquid and insolvent. *Italic: Source: _cr07383 - 84. It is possible to maintain independent system rules and governance arrangements for* ### 92. The reported increase in short-term foreign currency borrowings of the banking ### _cr07383 - 92. The reported increase in short-term foreign currency borrowings of the banking ### Short-term foreign currency borrowings and rollover risk - The reported increase in short-term foreign currency borrowings of the banking system can lead to rollover risks, and any disruption to funding in foreign currency can affect bank solvency. - The supervisors do not currently monitor maturity by currency. - Data were available for only six private banks (representing half the banking system assets) in the sample. - Analysis of maturity data highlights rollover risk: net short-term foreign currency liabilities of less than a month represented above 30 percent of regulatory capital of these banks, as of end-2006. - Rollover risks are mitigated as nonresident foreign currency deposits have proved to be relatively stable. ### Credit and concentration risk sensitivity tests (Table 8) — effects on the Capital Adequacy (CAR) Ratio - CAR at 12/31/2006: Average 12.1%; Minimum 5.6%; Maximum 15.7%. - CAR after shocks (averages): - 5% Re-classification of Outstanding Loans: 11.5% - 10% Re-classification of Outstanding Loans: 10.7% - 20% Re-classification of Outstanding Loans: 9.0% - Largest Borrower's Default: 6.6% - 2 Largest Borrowers' Default: 2.8% - 3 Largest Borrowers' Default: 0.1% - CAR after shocks (minimums): - 5% Re-classification: 4.5% - 10% Re-classification: 2.8% - 20% Re-classification: -0.9% - Largest Borrower's Default: -27.7% - 2 Largest Borrowers' Default: -54.7% - 3 Largest Borrowers' Default: -74.3% - CAR after shocks (maximums): - 5% Re-classification: 15.6% - 10% Re-classification: 15.6% - 20% Re-classification: 15.6% - Largest Borrower's Default: 14.6% - 2 Largest Borrowers' Default: 12.7% - 3 Largest Borrowers' Default: 12.7% - Number of financial institutions (12 banks included: 10 commercial and 2 specialized banks representing 91 percent of the banking system assets): - CAR above 20%: 0 (across scenarios) - CAR 10% to 20%: baseline 10; after shocks ranges include 10, 6, 4, 7, 3, 2 - CAR 5% to 10%: baseline 2; after shocks ranges include 1, 5, 7, 3, 6, 6 - CAR 0% to 5%: entries include 0, 1, 1, 0, 1, 2, 2 - CAR below 0%: entries include 0, 0, 0, 1, 1, 1, 2 - Total banks in each scenario: 12 - Below minimum CAR (10-percent minimum capital adequacy ratio): - % of the system assets under scenarios: - Baseline: 22.1% - After 5% reclassification: 22.1% - After 10% reclassification: 58.1% - After 20% reclassification: 77.7% - Largest borrower default: 54.2% - 2 largest borrowers' default: 76.8% - 3 largest borrowers' default: 86.0% - % of the public bank assets: - Baseline: 15.8% - After 5% reclassification: 15.8% - After 10% reclassification: 26.9% - After 20% reclassification: 44.6% - Largest borrower default: 44.6% - 2 largest borrowers' default: 44.6% - 3 largest borrowers' default: 44.6% ### Interest rate and exchange rate risk sensitivity tests (Table 9) — effects on the Capital Adequacy Ratio - CAR at 12/31/2006: Average 12.1%; Minimum 5.6%; Maximum 15.7%. - CAR after exchange rate shocks (averages): - 20% Appreciation of the Exchange Rate: 12.1% - 20% Depreciation of the Exchange Rate: 12.1% - CAR after interest rate shocks (averages): - 10% Decrease in Interest Rates: 16.1% - 5% Decrease in Interest Rates: 14.3% - 1% Decrease in Interest Rates: 12.6% - 1% Increase in Interest Rates: 11.6% - 5% Increase in Interest Rates: 9.4% - 10% Increase in Interest Rates: 5.7% - CAR after shocks (minimums): - 20% Appreciation: 5.5% - 20% Depreciation: 5.7% - 10% Decrease in Interest Rates: 10.5% - 5% Decrease: 10.3% - 1% Decrease: 6.6% - 1% Increase: 4.6% - 5% Increase: -6.2% - 10% Increase: -34.6% - CAR after shocks (maximums): - 20% Appreciation: 15.9% - 20% Depreciation: 15.6% - 10% Decrease in Interest Rates: 35.0% - 5% Decrease: 25.4% - 1% Decrease: 15.8% - 1% Increase: 15.5% - 5% Increase: 15.3% - 10% Increase: 15.1% - Number of financial institutions by CAR bands (total banks per scenario vary 11–12): - Above 20%: typically 0; e.g., under 10% decrease in interest rates: 1 - 10% to 20%: baseline 10; ranges include 9, 9, 11, 11, 11, 9, 7, 6 - 5% to 10%: baseline 2; ranges include 2, 2, 0, 0, 1, 2, 3, 4 - 0% to 5%: mostly 0; appears for some shocks 1 - Below 0%: appears for larger interest rate increases (e.g., 5% and 10% increases) - Below minimum CAR (10-percent minimum): - % of the system assets under scenarios: - Baseline: 22.1% - 20% Appreciation: 22.1% - 20% Depreciation: 22.1% - 10% Decrease in Interest Rates: 0.0% - 5% Decrease in Interest Rates: 0.0% - 1% Decrease in Interest Rates: 15.8% - 1% Increase in Interest Rates: 33.2% - 5% Increase in Interest Rates: 60.1% - 10% Increase in Interest Rates: 70.7% - % of the public bank assets: - Baseline: 15.8% - 20% Appreciation: 15.8% - 20% Depreciation: 15.8% - 10% Decrease: 0.0% - 5% Decrease: 0.0% - 1% Decrease: 15.8% - 1% Increase: 26.9% - 5% Increase: 44.6% - 10% Increase: 44.6% - Notes on channels: - Effects through the net open position (NOP): 20% exchange rate shocks. One specialized institution does not have a NOP. - Effects through the cumulative gap in assets and liabilities with maturities less than a year: interest rate shocks. ### Liquidity risk sensitivity tests (Table 10) — effects on Liquidity Ratios (LR) - LR at 12/31/2006 (averages): - All Liquid Assets: 25.6% - Few Liquid Assets: 17.6% - LR after a 10% deposit withdrawal (averages): - All Liquid Assets: 6.5% - Few Liquid Assets: 7.6% - LR after a 20% deposit withdrawal (averages): - All Liquid Assets: -5.2% - Few Liquid Assets: 18.4% - LR after a 100% nonresident deposit withdrawal (nonresident deposits represent 10 percent of total deposits in the 11 systemically important banks) (averages): - All Liquid Assets: 7.8% - Few Liquid Assets: (value shown: 7.8% in table) - LR minimums and maximums (selected): - LR minimum baseline All Liquid Assets: 20.6%; Few Liquid Assets: 12.2% - LR minimum after 10% withdrawal All Liquid Assets: -5.1%; Few Liquid Assets: 1.6% - LR minimum after 20% withdrawal All Liquid Assets: -17.2%; Few Liquid Assets: 2.9% - LR maximum baseline All Liquid Assets: 38.2%; Few Liquid Assets: 32.1% - LR maximum after 10% withdrawal All Liquid Assets: 14.2%; Few Liquid Assets: 24.7% - LR maximum after 100% nonresident withdrawal All Liquid Assets: 38.2%; Few Liquid Assets: 13.6% - LR: Number of Financial Institutions by bands (11 banks included: one specialized and 10 commercial representing 80 percent of the banking system assets): - Baseline (LR, All Liquid Assets): Above 20%: 11 banks; 10% to 20%: 0; 0% to 10%: 0; Below 0%: 0; Total 11. - Baseline (LR, Few Liquid Assets): Above 20%: 4; 10% to 20%: 7; 0% to 10%: 0; Below 0%: 0; Total 11. - After 10% withdrawal (All Liquid Assets): Above 20%: 0; 10% to 20%: 1; 0% to 10%: 9; Below 0%: 1; Total 11. - After 10% withdrawal (Few Liquid Assets): Above 20%: 1; 10% to 20%: 2; 0% to 10%: 8; Below 0%: 0; Total 11. - After 20% withdrawal (All Liquid Assets): Above 20%: 0; 10% to 20%: 0; 0% to 10%: 1; Below 0%: 10; Total 11. - After 20% withdrawal (Few Liquid Assets): Above 20%: 3; 10% to 20%: 7; 0% to 10%: 1; Below 0%: 0; Total 11. - After 100% nonresident deposit withdrawal (All Liquid Assets): Above 20%: 0; 10% to 20%: 0; 0% to 10%: 1; Below 0%: 10; Total 11. - After 100% nonresident deposit withdrawal (Few Liquid Assets): Above 20%: 0; 10% to 20%: 7; 0% to 10%: 5; Below 0%: 1; Total 11. - Below minimum LR (20-percent minimum liquidity ratios): - % of the system assets under scenarios: - Baseline All Liquid Assets: 0% - Baseline Few Liquid Assets: 66.6% - After 10% deposit withdrawal All Liquid Assets: 79.9% - After 10% deposit withdrawal Few Liquid Assets: 77.9% - After 20% deposit withdrawal All Liquid Assets: 79.9% - After 20% deposit withdrawal Few Liquid Assets: 71.6%79.9% (table shows concatenated values) - After 100% nonresident withdrawal All Liquid Assets / Few Liquid Assets: 79.9% (table entries reflect high asset shares below minimum) - % of public bank assets shown as 0% in some baseline entries and 33.5% in withdrawal scenarios (table entries include repeated 33.5% values). - Definitions: - All Liquid Assets include balances with domestic and correspondent banks, balances with own FCBUs, 50 percent of commercial papers and promissory notes, money at call, good receipts, import bills, export bills, inland bills, cash items in collection, treasury, and Sri Lanka Development Bonds. - Few Liquid Assets include balances with domestic and correspondent banks, balances with own FCBUs, export bills, treasury and Sri Lanka Development bonds. The latter bonds are discounted at the same percentage as the deposit withdrawal. *Source: Central Bank of Sri Lanka and FSAP staff calculations.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07383.pdf_