Macro Analysis /
Sri Lanka

Sri Lanka Macro: Banking Act to be enacted in 2021

    Asia Securities
    8 January 2020
    Published byAsia Securities

    “The Roadmap for 2020 and Beyond” which outlines the Central Bank’s key monetary and financial sector policies for 2020 was presented by the new Governor, Prof. Lakshman yesterday. Overall, the roadmap is centred on continuing to strengthen regulations within the Central Bank (CB) and overall financial sector, while offering greater transparency and confidence within the economy. 

    The key highlight is the CB’s enactment of the new Banking Act by 2021, which will also outline regulations on banks in the Colombo International Financial Center. Furthermore, the CB looks to continue its stance in maintaining mid-digit inflation amidst a flexible exchange rate mechanism and continue the Active Liability Management Act. 

    We expect these policies to have a positive impact in terms of greater transparency and long-term policy implementation. The CB forecasts GDP growth for 2019 to come in at 2.8% YoY, marginally above our forecast of 2.5% YoY. We forecast overall growth to pick up to 4.0% YoY in 2020 while we expect higher consumer demand to push inflation up to 6.2% YoY in 2020.

    While the Roadmap for 2020 outlined the key themes of the Central Bank’s (CB) policy direction and actions expected for the year, the Governor also acknowledged the challenges faced in 2019 due to spillover effects of the Easter Sunday attacks combined with a sluggish growth backdrop. As such, the CB expects a subdued GDP growth of ~2.8% in 2019, 0.3pp higher than our forecast of 2.5% for the year.

    Going into 2020, the key theme is improving consumer and investor sentiment. With the stage set for a pickup in growth amidst a low-interest rate environment and fiscal stimulus, the potential for sustained economic activity is positive.

    The outline of the 2020 roadmap is broadly based on the following pillars;

    • The CB’s monetary policy strategy and policies for 2020 and beyond
    • Policies related to the financial sector performance and stability
    • Key policies related to agency and ancillary functions

    Monetary policy strategy and other policies for 2020 and beyond

    One of the key themes running through the CB’s monetary policy strategy is the continuation of key policy directives from 2019. As such, the CB will look to;

    • Continue to implement monetary policy in a forward-looking manner, with a view to maintain stable inflation at 4.0%-6.0%
    • Greater flexibility for exchange rate mechanism, with minimal intervention by the CB
    • Strengthening the technical and institutional capacity of the CB, thereby continuing to rely on model-based forecasting
    • Continued focus on assisting fiscal consolidation
    • Using open market operations as a major policy instrument, similar to previous years

    In terms of new policies for the year, the Governor noted that the CB is currently in the process of introducing a mid-day benchmark reference rate, in-line with International Organisation of Securities Commission’s (IOSCO) principles. This is aimed to benefit stakeholders including the general public and foreign investors.

    Steps are also underway to introduce a cost-reflective benchmark interest rate for pricing loan products. This is aimed at improving healthy competition among banks, while supporting efficient transmission of monetary policy measures.

    The CB expects credit growth of 12.0%-13.0% in 2020, below our forecast of over 15.0%. In our view, the low base effect from 2019 and improved investor sentiment would drive overall credit growth for 2020.

    Overall, we are positive on the CB’s stance in continuing with the inflation-targeting regime, and low intervention in the currency markets.

    Financial sector – Banks

    The key highlight under the financial sector is the expectation of a new Banking Act in 2021, and its inclusion of regulations for banks in the Colombo International Financial Center (CIFC).

    According to the Governor, key concepts of the proposed Article in addition to containing provisions and regulations for banks which are to be established in the CIFC include the following;

    • Provisions to introduce a single type of banking license for Licensed
    • Commercial Banks (LCB) and Licensed Specialised Banks (LSB)
    • Adoption of proportionality in banking regulations in-line with bank’s size, it nature of operations etc.
    • Subsidiarisation of banks incorporated outside Sri Lanka and allowing to ringfence subsidiaries from adverse external shocks
    • Streamlining approval for the establishment of branches and other banking outlets
    • Strengthening consumer protection, deposit insurance, and governance
    • Amalgamating both offshore banking unit (OBU) and domestic banking unit (DBU) operations into a single banking business
    • Improving resolution, enforcement and supervisory actions

    Furthermore, the roadmap outlined the need for banks to implement efficient recovery plans to minimise the adverse impact of this in the overall financial system. In addition, information security-related regulations would also be implemented enabling stronger risk management.

    While we are positive the on steps taken to strengthen consumer protection, recovery measures, and information security, we believe that further clarity is required on the implementation of the single type of banking license and the proportionality of banking regulations.

    Financial Sector – Non-banking Financial Institutions (NBFI)

    On the NBFI sector front, the Governor highlighted the completion of the first draft of the Credit Regulatory Authority Bill aimed at regulating and supervising money lending and microfinance businesses. Looking ahead, the CB expects to reinforce the stabilisation of the NBFI sector through the Finance Business Act.

    As such, through this Act, the main proposal is to issue directions on ownership limits for Licensed Finance Companies. This is expected to be done with a reasonable timeline, with flexibility granted ownership limits for distressed companies. However, no timeline was provided for this.

    Furthermore, the Governor noted that voluntary consolidation within the NBFIs will continue with the minimum capital requirements in place.

    Core capital requirement (LKR bn)
    1st Jan 20181.0
    1st Jan 20191.5
    1st Jan 20202.0
    1st Jan 20212.5

    We take a neutral view on the NBFI sector given that the tighter regulation and further consolidation has already been factored into our outlook. We perceive the stricter regulation and higher capital requirement to be a positive in the longer term for the stronger NBFIs who will remain resilient amidst these initiatives.

    Policies to strengthen the broader economy

    In addition to the core functions of the CB pertaining to Monetary Policy and the Financial Sector, the Roadmap outlined the CB’s plans for the following;

    Public debt management – through the Active Liability Management Act, the CB will continue to raise additional funds for liability management purposes. According to the CB, plans are already underway to strengthen buffers through the issuance of tbonds in the domestic market. The governor also noted that possibilities to raise funds from alternative bond markets are also being considered.

    In our view, external funding will be a key requirement given the ~USD 4.8bn repayment schedule in 2020. Our discussions indicate that almost half of this is foreign repayments, with the largest being the USD 1.0bn International Sovereign Bond maturing in October 2020.

    Foreign exchange management – according to the Governor, current foreign exchange regulations are being revisited to further facilitate transactions in the domestic foreign exchange market, while improving clarity in Foreign Exchange Act regulations.