Sri Lanka’s banking system resilient, strong despite conflict-Fitch

Sri Lanka’s banking sector has maintained profits and continues to be resilient despite a weak macroeconomic environment and prolonged internal conflict.

Fitch Rating Colombo, in a special report on the banking sector to be published soon, says banks have had little direct exposure to the conflict and its ramifications but was somewhat affected by the 2004 tsunami.

“However, the state's recent fiscal weaknesses, its resulting effect on monetary policy stability and overall policy consistency have been, and will be, the sector's primary concerns in the short to medium term,” Fitch said in a statement.

With the local capital markets being crowded out by large deficits and poor savings rates, the banking system remains the dominant component of the financial system, accounting for 57.5% of financial system assets at FYE06. For a relatively small nation of 20 million, Sri Lanka has a high number of different banks - 37 – although there is significant concentration, Fitch said.

The eight largest banks account for 80.5% of the banking system assets, while the remaining 19.5% of the market share is fragmented among 29 other banks. Fitch said it observed that although there is some rationale for consolidation within the banking system, its materialisation has been hampered by shareholder and employee issues.

It said net interest margins have been relatively stable at around 4.0%-4.5%, largely as a result of the short-term nature of assets and liabilities, which allows for quick re-pricing and pass-through. Effective taxation for the sector, however, has steadily increased during the last two to three years through additional taxes on the financial sector.

The effective tax rate was a very high 56% in 2006 for the 13 commercial banks rated by Fitch. “Although some, if not most, of such increases appear to have been passed on, Fitch is of the opinion that any continued increases to taxation will have a negative impact on capital accretion by way of both retention and infusions,” the statement said.

The sector has usually grown in line with real GDP and inflation, although growth has surged in recent years at a Compound Annual Growth Rate (CAGR) of 20.7% between FY02-FY06 and 28.1% during FY06, before declining to 11.2% during H107. Growth was initilly spurred by a relatively loose monetary policy and the financing of large revenue and fiscal deficits through the banking system.

There has been some improvement in asset quality since 2002, as most banks focused on improved risk management and recoveries, resulting in the NPLs to gross loans ratio improving to 5.7% at FYE06 from 14.3% at FY02.

Fitch says it expects the present weakening of the economic environment to affect asset quality, albeit moderately, as banks further tighten loan origination standards and enhance recovery efforts.

Overall, Fitch considers the Sri Lankan banking system to be more resilient than in the past, although it could be moderately affected by asset quality and profitability in the face of the current economic conditions and the effects of the government's weak fiscal position.