Recent developments in the financial sector

CT Smith Stockbrokers has released a Banking Update analysing some of the recent developments in the financial sector. Here are excerpts of the report compiled by CT Smith Stockbrokers research team member Sanjeewa Fernando:

The Central Bank of Sri Lanka (CBSL) recently decided to reduce the general provision on performing loans and advances and credit facilities in the “special mention” category under non performing loans (i.e. overdue for more than 90 days but less than 120 days) from the current 1% to 0.5% by 31 December 2011.

As a result, banks can now reduce the existing general provision requirement of 1% to 0.5%, at a rate of 0.1% per quarter, over each of the five quarters commencing with the quarter ending 31 December 2010.

In November 2006, the CBSL introduced a 1% general provision against performing loans and loans in the “special mention” category under non performing loans, as a proactive prudential measure which consequently strengthened the balance sheet of the local financial system.

The aforesaid measures were helpful in overcoming the negative consequences of the adverse economic situations during FY2009. Amid improving macroeconomic fundamentals, the broader banking sector ratios reflected an improvement from mid 2009 levels.

Despite the improvement in asset quality, the whole banking system however witnessed slow credit growth during 1H2010.

This was mainly due to banks’ increasing their investments in Statutory Liquid Assets (SLAs: especially T-Bills and T- Bonds) as opposed to loans and advances. Thus, Sri Lankan banks reported higher Statutory Liquid Asset Ratios as at end June 2010 (which were well above the minimum requirement of 20%).

As the general provision requirement is reduced by 0.1% per quarter from the period commencing 31 December 2010 to 31 December 2011, the banking system is likely to reverse the provisions in the following manner (per quarter).

However, implementing globally practiced IAS 39 (Financial Instruments recognition and measurement) in 2011 will further require the banks to assess their respective loan books, to provide for any impairment as necessary.

Meanwhile, in order to increase public confidence in the local financial system, the CBSL recently introduced a deposit insurance scheme called the Sri Lanka Deposit Insurance Scheme (SLDIS) for all licensed banks and finance companies w.e.f. 1 October 2010. SLDIS is likely to increase the cost of deposits for member institutions by at least 0.10% - 0.15% p.a., and will be required to be paid on a monthly / quarterly basis.

Premiums paid by all institutions will be credited to the “Deposit Insurance Fund” which will be operated and managed by the Monetary Board of the CBSL. However, in the event of a “deposit run on the financial system” the liability of the fund will be limited to the extent of the total accumulated balance.

All deposits excluding deposits of:

• Member banks and finance companies
• Government of Sri Lanka
• Shareholders
• Directors
• Key management personnel
• Other related parties
• Collateral nature (deposits held as collateral against any accommodation granted)
• Abandoned property and dormant nature will be considered as eligible deposits under this scheme.

Apart from increasing public confidence in the financial system, the other objectives of this initiative include:

• Safeguarding interests of small depositors with low financial literacy
• Encouraging savings among small scale depositors
• Discouraging unauthorised deposit mobilising activities
• Reducing commitment of the Government in the case of failure of a financial institution

As per the directive, in the event the licence or registration of a member institution is suspended or cancelled by the Monetary Board, depositors will be compensated up to a maximum of Rs.200,000 per depositor. While the initial capital of Rs.1.1bn will be provided by the CBSL, depositors will be entitled to compensation only after 1 January 2012.

In view of the reduced policy rates since February 2009 (Repurchase rate and Reverse Repurchase rates were reduced by 325 bps and 300 bps respectively during the same period), the Central Bank has also requested all banks to take appropriate measures to reduce interest rates to at least the following levels by end of October 2010:

Interest rates on housing loans to 14 % p.a.

Interest rates on credit card advances to 24 % p.a.

Interest rates on other loans and advances to be adjusted downwards by a further 1-2 % p.a.

While these measures are likely to impact the banking sector Net Interest Margins (NIMs) negatively starting from 4Q2010, stimulating demand for credit is likely to transfer the benefits of the low interest rate environment towards the general public from the government (as the investments in SLAs are likely to be liquidated to re-invest in high yielding consumer and housing loans and advances).

Any negative impact on bank NIMs is however likely to be limited due to banks’ repricing of their liabilities swiftly lower to compensate for lower lending rates.