Financial system remains stable - CBSL

Sri Lanka's financial system remained stable and resilient the Central Bank's financial system stability review 2010 said.

The stability of the financial system strengthened with the resurgence in domestic economic growth and the recovery in international trade, and underpinned by a more stable macroeconomic environment and improved investor confidence. The soundness and resilience of domestic financial institutions was maintained with adequate capital and liquidity buffers and improvements in asset quality and earnings, within a regulatory framework with prudential safeguards to mitigate excessive risk-taking. Overall, credit risk, market risk and liquidity risk in financial institutions declined during the year. Conditions in domestic financial markets improved as interest rates have come down with the decline in inflation and the easing of monetary policy.

Financial markets also became more liquid largely due to an increase in capital inflows.

The price indices, capitalization and turnover of the stock market soared to record levels. Prudential policies were introduced to address a possible build-up of an asset price bubble in the market. The systemically important payment and settlement systems operated smoothly and safely, with improvements to business continuity arrangements and the introduction of a new regulatory framework for electronic payment cards thereby further enhancing the security of the payment system. An early warning system covering the key financial sectors was also put in place to alert the Central Bank of Sri Lanka (CBSL) on developments that could trigger an adverse impact on the financial system.

The banking sector recorded an increase in credit growth and remained financially strong and resilient with a high capital position and lower risk levels. Bank lending recovered and rose significantly in the first nine months of 2010 from negative growth in the previous year.

The profitability of the banking sector improved, with the net interest margin being maintained at a stable rate for a number of years.

The banking sector remained well capitalized with the predominant capital component being loss absorbing common equity.

The capital adequacy ratios (CAR) have increased after migration to Basel II under the Standardised Approach for credit and market risk and the Basis Indicator Approach for operational risk in 2008. Both the total and Tier 1 CAR are well above the regulatory minimum requirements.

The asset quality of the banking sector improved from mid 2010 signaling a decline in credit risk. The statutory liquid asset ratio of the banking sector comprised substantial holdings of government securities was almost double the required minimum, which provided an ample cushion to mitigate liquidity risk.

The credit to deposit ratio was at a comfortable level indicating that banks had a stable source of funds. The leverage ratio was also at an acceptable level demonstrating that banks were not unduly dependent on borrowings. The exposure to market risk was also not significant due to the low level of trading book activities. Stress tests indicated that the banking sector has sufficient capital and liquidity buffers and would be resilient to large credit risk, market risk and liquidity risk shocks. The review said performance and soundness of other financial institutions improved.The finance and leasing company sector recorded significant growth in accommodations and earnings, owing to the better macroeconomic environment.

The financial soundness indicators of the two sectors, excluding the distressed companies, have shown an improvement.

Directions on corporate governance and effective risk management systems have also been introduced.