The International Monetary Fund (IMF) called for further strengthening in the financial sector supervisory and regulatory framework, as the recent rapid growth seen in credit has slightly lowered the capital adequacy ratios (CARs) of banks and finance companies. The local authorities have also welcomed technical assistance from the IMF on financial supervision and regulation and asked for further coordination with other technical assistance donors. 
Sri Lanka loosened both its fiscal and monetary policies from the beginning of 2015 in a myopic policy decision aimed at re-election at the parliamentary polls.
However, these policies fuelled the demand for cheaper credit, causing faster growth in the risk weighted assets of banks, which dented the CARs while creating macroeconomic instability.
“Going forward, there is a need to strengthen the supervisory and regulatory framework and identify (and) mitigate the vulnerabilities in the financial sector,” said IMF Mission Chief Jaewoo Lee.
Lee also expressed his concerns over private credit continuing to grow by over 25 percent monthly on a year-on-year (YoY) basis, while noting that a level below 20 percent is favoured by the IMF.
“We think it is more prudent to avoid another round of vulnerability through too high credit growth. So, it would be preferable to be a lot more conservative on credit growth,” he told the reporters from a live teleconferencing from Washington, D.C. recently.
Sri Lanka’s banking and finance companies gave Rs.692 billion in credit in 2015, the highest recorded in a single year.
In the first nine months of 2016, private sector credit has grown by Rs.515.8 billion compared to Rs.398.1 billion YoY, but the Central Bank said the provisional data points to a deceleration in credit growth in October.
However, if the situation does not show any sign of improvement, the Central Bank might resort to imposition of more tightened loan-to-value (LTV) ratios on selected sectors as they have indicated their willingness to do so to the IMF officials.
“The authorities noted that if necessary, the loan-to-value ratio can be tightened in sectors with rapid credit growth, following a successful experience for vehicle loans in 2015,” a recent IMF Staff report following discussions with local authorities said.
In 2006, authorities had increased risk weights on housing loans to address excessive credit growth.
According to the Central Bank data, the banking sector Tier I and Tier II CARs have edged down to 11.8 percent and 14.1 percent, respectively at end-September from 13.0 percent and 15.4 percent at the beginning of the year.
Despite slight weakening CARs, they still remain above the minimum requirement and financial soundness indicators are generally adequate for the banking system, the IMF said.
However, the minimum CARs are expected to increase considerably from the current 5 percent and 10 percent for Tier I and Tier II, respectively when the new rules under the BASEL III comes in to full effect.
While the banks have already been issued with a consultative paper with higher CARs to be maintained during the transition period, a directive is yet to be issued by the Central Bank. However, the Central Bank monitors the compliance with BASEL III CARs by the banks.
The Central Bank is now in the process of estimating the possible implications of the capital position of state-owned banks from the BASEL III implementation, since the national treasury as their sole shareholder might find it a challenge to inject fresh capital as the government coffers remain shallow.
Meanwhile, the IMF has also highlighted the need to monitor the impact of the ongoing state-owned enterprise (SOE) reforms on the financial soundness of these banks.
The Central Bank recently announced that they were preparing a resolution plan of some 15 distressed non-bank finance companies using a special-purpose vehicle and in mid-October the Monetary Board approved a resolution mechanism for the repayment to depositors of four insolvent non-bank financial institutions.
It has been found that of the 46 licensed financial companies in Sri Lanka, 15 are facing liquidity issues, with six at a high level of distress with non-performing loans ranging from 50 to 90 percent.
“In addition to the mismanagement and irregular practices, the rapid growth of the non-bank financial sector has often led to excessive risk taking which has led to the deterioration of the financial position of these companies,” the IMF noted.
However, the cost of resolution is expected to be minimal as the total assets of the distressed companies are about one percent of gross domestic product.
