Sri Lanka: Banking sector stability and soundness

The overall soundness of the banking sector in Sri Lanka, as indicated by the Banking Soundness Index (BSI), improved at the end of Q3 of 2023 compared to the corresponding period of the previous year. The BSI is a composite indicator that reflects various aspects of the banking sector’s performance and stability, including asset quality, capital adequacy, profitability, efficiency, liquidity, and market risk.

Key points regarding the banking sector’s soundness as of Q3 2023 include:

  • Asset Quality: The banking sector experienced an increase in Stage 3 Loans to 13.4 percent of total loans at the end of Q3 2023, indicating a rise in non-performing loans. This was due to an expansion in gross Stage 3 loans and a contraction in credit on a year-over-year basis.
  • Capital Adequacy: The sector’s capital adequacy improved due to a decline in risk-weighted assets, primarily from reduced corporate and retail loan exposures.
  • Profitability: The banking sector reported a significant increase in cumulative profit after tax for the first nine months of 2023, with a year-over-year increase of 71.1 percent. This improvement was mainly due to a decline in new impairment allocations by banks.
  • Liquidity: Investments in government securities led to a significant increase in liquidity ratios, and the overall utilization of the Standing Lending Facility by the banking sector reduced significantly.
  • Market Risk: The banking sector’s foreign currency operations contracted, particularly due to a significant decline in core foreign currency assets, despite the accumulation of substantial foreign currency resources in the form of balances with financial institutions abroad.

These indicators suggest that the banking sector in Sri Lanka was relatively stable at the end of Q3 2023, with improvements in several key areas. However, the increase in Stage 3 Loans indicates that there are still challenges to be addressed, particularly in terms of asset quality.

The banking sector’s stability in 2022 and into 2023 can be summarized with the following points:

  • Resilience in 2022: Despite challenges such as declining credit quality, acute pressure on liquidity, low profitability, and deteriorating capital levels, the banking sector remained stable in 2022. It continued to grow and largely complied with prudential requirements, holding 61.9% of the total financial sector assets by the end of 2022.
  • Credit Growth Deceleration: There was a slowdown in credit growth during 2022 compared to 2021, influenced by the tight monetary policy of the Central Bank and challenging macroeconomic conditions.
  • Funding Sources: Deposits were the main source of funding for banks, while foreign currency borrowings decreased due to sovereign rating downgrades and the announcement of a standstill.
  • Performance in Early 2023: The banking sector operated with acceptable levels of capital and impairment coverage ratios during the eight months ending in August 2022. However, the capital position of banks was expected to be further strained due to ongoing macroeconomic challenges.
  • Profitability and Capital Adequacy: Profitability improved with reduced new impairment charges compared to the previous year, but this could have negative consequences for future profitability. Capital adequacy improved due to a decline in risk-weighted assets, primarily from reduced corporate and retail loan exposures.
  • Banking Soundness Index: The overall soundness of the banking sector, as indicated by the Banking Soundness Index (BSI), improved at the end of Q3 of 2023 compared to the same period in 2022.
  • Credit Risks: Credit risk remained elevated, reflecting deteriorated debt servicing capacities. However, stabilization of credit risk was observed in Q3 of 2023, with a slowdown in the increase of Stage 3 Loans.
  • Concentration Risk: The banking sector’s credit was concentrated in a few sectors, with some, like construction and agriculture, posing higher vulnerabilities due to economic and climate-related issues.
  • Investments in Government Securities: Banks increased their investments in government securities, which helped maintain capital adequacy above regulatory requirements despite some companies facing challenges in meeting the minimum liquidity requirement.
  • Impact of External Factors: The future stability of the banking sector was seen as dependent on various factors, including the successful implementation of the IMF-EFF programme, which aimed to address key imbalances and support sustainable economic recovery.

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