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June 20, 2018

IMF published its staff report and selected issues report under the 2018 Article IV consultation with Sri Lanka. Directors welcomed efforts to further strengthen the resilience of the financial sector, including with Basel III implementation. They noted that macro-prudential tools could be used to rein in excessive credit growth in the real estate sector and encouraged the authorities to address identified weaknesses in non-bank financial institutions (NBFIs).

The staff report highlights that the authorities viewed the financial system as well-capitalized and stable. Financial soundness indicators are generally sound for the banking sector, although weaknesses remain in non-banks. Banks account for two-third of total financial sector assets. Despite rapid credit growth, the capital adequacy ratio (CAR) of banks stabilized at 15.2% in 2017, with non-performing loan (NPL) and provision coverage ratios improving to 2.5% and 70%, respectively. NBFIs—the leasing and financing companies that account for about 9% of the financial sector assets and cater to high-risk borrowers—are well-capitalized, with CAR at 13.1% by the end of 2017. However, 10 NBFIs (out of 52 in total and not systemic in size) are either in negative equity or show other financial strains. Further macro-prudential measures can help contain excessive credit growth.

Sri Lankan banks are strengthening their capital positions under Basel III migration. The migration timeframe imposes a minimum CAR of 14% for six systemic banks and 12.5% for others by January 2019. Although the banking sector appears well-prepared to meet the requirements, risks remain that an adverse shock could weaken asset quality and compel banks to raise additional capital. Staff recommended preparing contingency plans, including through consolidation of banks that may not meet the requirement to raise additional capital. A Financial System Stability Review is planned for the financial year 2019. Staff welcomed steps to strengthen NBFI supervision. The Central Bank of Sri Lanka's (CBSL) six-fold increase in the end-2020 minimum equity capital requirement for NBFIs is expected to strengthen capital positions, while promoting consolidation of small institutions. The authorities are committed to swiftly implement the recommended action plan of Financial Action Task Force to address weaknesses in the anti-money laundering and combating the financing of terrorism (AML/CFT) regime. 

The selected issues report reveals that stress tests do not point to systemic risks. An illustrative stress test of banking system shows that the system would be able to withstand an adverse shock to the housing and construction sectors. Risks from rapid credit growth in Sri Lanka are further complicated by the growing importance of NBFIs. The aggregate financial soundness indicators of NBFIs do not point to vulnerabilities and this sector is too small to constitute a systemic risk. Nevertheless, NBFI’s regulation and supervision need to be strengthened as the riskiness and importance of these companies increases. Banks are implementing Sri Lanka’s Basel III requirements, with all banks scheduled to abide by the criteria set by CBSL by January 01, 2019, strengthening the banking sector by increasing capital buffers and requiring consolidation of banks that do not meet the thresholds. Additionally, Sri Lanka will benefit from ongoing efforts to strengthen supervision, macro-prudential framework, and the crisis management and resolution frameworks.


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Keywords: Asia Pacific, Sri Lanka, Banking, Basel III, Macro-prudential Framework, NPLs, CAR, Stress Testing, Article IV, IMF

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