CENTRAL BANK OF SRI LANKA

Master Plan on Consolidation of the Financial Sector

Presented by Ajith Nivard Cabraal Governor, Central Bank of Sri Lanka 17 January 2014

Over the past 8 years, substantial progress has been achieved in all macro-fundamentals
Indicator
Real GDP Growth (Avg. for 5 years ending) GDP Unemployment Inflation (Annual Average) Current Account Deficit Tourist Arrivals Remittances FDI Inflows Gross Official Reserves Exchange Rate (End Period) Budget Deficit Public Debt

Unit
% US$ mn % % % of GDP 000 US$ mn US$ mn US$ mn Months of Imports Rs./US$ % of GDP % of GDP

2000
5.0 16,596 7.6 6.2 6.4 400 1,160 175 911 1.5 80.06 9.5 96.9

2005
4.0 24,406 7.2 11.0 2.7 549 1,968 272 2,735 3.7 102.12 7.0 90.6

2013 (Est/Proj)
6.7 67,374 4.5(1H) 6.9 3.9 1,274 6,650 1,459 7,216 4.5 130.75 5.8 78.0

Remarks
Substantially higher growth trajectory 176% increase in 8 years! Steady progress Almost 5 years at single digit levels Satisfactory progress being made Remarkable increase after the conflict Steady y-o-y growth, & 237% increase in 8 years Steady growth Consistent improvement and steady progress Stable levels maintained Important progress towards fiscal consolidation Moving steadily towards greater sustainability Close to projected levels Adequate and sustainable Reflects peace dividend and corporate sector vibrancy

Broad Money Growth (M2b)

Private Sector Credit Growth Stock Market Capitalisation

%
% Rs. bn

12.9
11.8 88.8

19.1
21.5 584.0

16.0
8.0 2,459.9

The Country's Per Capita Income has risen sharply, and is projected to increase well beyond US$ 4000 by 2016

A sound medium term macroeconomic framework is projected over the next several years
Indicator
Real Sector and Inflation Real GDP Growth Total Investment GDP Deflator Headline Inflation External Sector Trade Balance Current Account Balance Overall Balance Fiscal Sector Current Account Balance Overall Balance Government Debt Monetary Sector Broad Money Growth (M
2b)

Unit

2013 (Est) 2014

Projections 2015
8.2 32.5 5.5 4.5

2016
8.5 33.0 5.0 4.0

% % of GDP % %

7.2 31.0 7.0 4.7

7.8 32.0 6.0 5.0

% of GDP % of GDP US$ mn

-12.8 -3.9 990

-11.6 -2.4 1,500

-10.2 -1.0 1,750

-8.4 0.1 3,700

% of GDP % of GDP % of GDP

-0.5 -5.8 78.0

1.1 -5.2 74.3

1.6 -4.4 70.6

2.3 -3.8 65.0

% %

16.0 8.0

14.0 16.0

14.0 17.0

14.0 17.0

Private Sector Credit Growth (in M2b)

The following potential risks could pose challenges to the above projections: Uncertain weather conditions Geopolitical tensions Unwinding of accommodative monetary policies in advanced economies Slower growth in global demand

Going forward, the Central Bank is also preparing plans to ensure that the country will avoid the possible Middle Income Trap

* Estimate for 2013

By 2016, Sri Lanka will graduate to the Upper Middle Income category as per international classification

As some countries have stagnated at this middle income level, Sri Lankas medium term macroeconomic strategy will need to focus on avoiding this Trap as well

To deliver the envisaged results, the twin objectives of the Central Bank have to be secured
The Central Bank is charged with the duty of securing: a) Economic and Price Stability; and b) Financial System Stability
To achieve financial system stability, Monetary Law Act, Banking Act and Finance Business Act provide for directions to be issued to banking institutions with a view to protecting the public against any mismanagement, bank failures and loss of public confidence The Exchange Control Act, Payment and Settlement Systems Act, Prevention of Money Laundering Act, Convention on Suppression of Terrorism Financing Act, and Financial Transaction Report Act also provide additional regulatory and supervisory powers to the Monetary Board

This stability outcome was re-iterated by His Excellency the President in his Budget Speech on 21 November 2013

Maintaining single digit inflation for nearly 5 years has given the Central Bank confidence that price stability will be secured in the future

2014 Between 4% and 6% 2015 & 2016 Between 3% & 5%

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Going forward, Sri Lanka will also require a strengthened financial sector, which can steer the country towards continued financial system stability

Accordingly, over the next few years, the financial sector will be actively encouraged and supported to move towards a new vision
The Central Banks policies will be forward looking and designed to balance potential worldwide policies and adjust to sudden volatilities, and to pre-empt , as much as possible, any possible financial distress and/or any possible failure in the future Adequate capital and other buffers will be put in place to prepare the Sri Lankan financial sector to withstand business cycles, without sacrificing investment potential during periods of global economic downturn The Central Banks role will be that of a pragmatic systemic risk mitigator, and a guide that encourages innovation in order to ensure the overall goal of financial system stability

The failures of the past were costly and painful

During 1988-90, 13 Registered finance companies failed; 2 such companies were revived by new investments; 11 companies were liquidated. In 2002, a Bank failed; It was only in 2007 that the deposits of that Bank were transferred to a new Savings Bank In 2009, 8 NBFIs faced liquidity problems, mainly because of the collapse of a related company in a particular group; Those NBFIs were gradually revived under restructuring processes, as agreed with the Central Bank In 2013, an NBFI faced liquidity problems due to certain directors of that company siphoning out funds; the Central Bank started a process of restructure, although that has now been interrupted as a result of an stay order by Court.

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In 1997, Malaysia realized the importance of consolidation and initiated a Merger Programme to consolidate the financial industry
Within one year, the sector was strengthened and the number of banks and financial institutions was rationalized: By 1998, the number of finance companies was reduced from 39 to 8 Today, all finance companies have been merged with commercial banks. By 2000, 50 out of 54 banking institutions were consolidated into 10 banking groups.

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Singapore also consolidated its banks, leading to bigger and stronger banks whose interests were aligned to the long term interests of the economy
In the early 2000s, Singapore launched its bank consolidation process, together with the liberalization of the banking industry. A major move in the local banking sector was the consolidation of the 6 local banking groups into the present 3 main local banking Groups (DBS, OCBC and UOB), thereby leading to the strengthening of the banks capabilities, building their management teams and enhancing operational effectiveness. The move strengthened the economic viability of all banks, and provided Singapore with better services and a competitive edge in the region.

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Other key ASEAN countries also followed this lead

Indonesia has highlighted the importance of small banks consolidating to address their weak capital positions. The number of participants in Thailands banking sector is due to shrink from 14 to 5 as competition and cost cutting has promoted consolidation.

Sri Lankas present financial system now needs some structural changes to ensure that Banks & NBFIs are well positioned in the envisaged US$100 bn economy
Banks and NBFIs account for 64% of the entire Financial System assets: Banks - 57% ; NBFIs - 7%
Consolidation in the banking and the NBFI sectors will have to take place, using the attractive tax concessions provided by the Government The regulatory framework will have to be re-designed to monitor the emerging business models of banks and NBFIs The regulatory regime will have to be strengthened, while encouraging diversification of sources of funding and business operations, including through foreign sources The risk profiles of banks and NBFIs will have to be identified and regulated in order to ensure overall stability of the financial sector

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At present, only 5 domestic banks have asset bases of over Rs. 500 bn
Assets size Number of Banks 5 Capital (Rs Bn) 172.3 Total Assets (Rs. Bn) 3,891.0 Market share % 66.3

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Over Rs 500 Bn

Rs 250 Bn to Rs 500 Bn

21.5

369.8

6.3

Rs 100 Bn to Rs 250 Bn

45.0

540.7

9.2

Rs 50 Bn to Rs 100 Bn

31.0

307.6

5.2

Less than Rs 50 Bn

33.6

183.3

3.1

The small State-owned Banks with assets less than Rs. 100 bn account for just 2.6% of total assets of the Banking sector
Assets size Rs 50 Bn to Rs 100 Bn Less than Rs 50 Bn Number of Total Assets Market share Banks (Rs. Bn) % Capital (Rs Bn)

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1 4

79.7 68.1

1.4 1.2

4.3 12.9

12 Foreign Banks account for only 10% of market share, although many have been in operation in Sri Lanka for many decades!
Assets Size Rs 250 Bn to Rs 500 Bn

Number of Total Assets Market share Banks (Rs. Bn) %

Capital (Rs Bn)

297.2 107.3

5.1 1.8

26.8 16.0

Rs 100 Bn to Rs 250 Bn
Below Rs 50 Bn

1
10

173.8

3.0

40.8

The current NBFI sector, which is about 7% of the financial sector, is also dominated by just a few NBFIs
Assets Number of Total Assets NBFIs (Rs. Bn) Market Share % Capital (Rs. Bn)

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Over Rs 20 Bn

10

433.0

61.5

64.1

Rs. 8 Bn to 20 Bn
Less than Rs 8 Bn Under Litigation

7
40 1

97.4
169.3 3.8

13.8
24.1 0.5

8.5
3.5 0.1

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In this background, pre-emptive strategies are needed to establish a strong and dynamic banking and NBFI sector in the future...

Capital will have to be increased in order to

ensure that sufficient buffers are built during good times, to strengthen resilience of the financial sector The banking and NBFI sectors will have to be consolidated through mergers and absorption of businesses

To ensure Financial System Stability, the expected outcome in consolidation is expected to result in a banking sector where

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At least 5 Sri Lankan banks will have assets of Rs. 1 trillion or more, with such banks also having a strong regional presence There will be a reduced number of banks as a result of mergers and absorptions There will be a large Development Bank that will provide a substantial impetus to development banking activities in the country Banks will rely on new and effective IT applications Banks will have substantially lower interest margins through increased efficiency and prudent management of assets and liabilities Foreign banks in Sri Lanka will demonstrate a greater participation in economic activities, and will be making significant contributions to the economy Domestic banks which had assets less than Rs.100 bn, will have assets of Rs.100 bn or more, through organic growth and merger/absorption with other banks/NBFIs over a reasonable time horizon.

and an NBFI sector where

There will be about 20 NBFIs, of which around 3 would be specialized in Micro finance Each NBFI will have an asset base of over Rs 20 Bn NBFIs will have improved loss absorbency capabilities and enhanced resilience to internal and external shocks, due to the increase of the quality and quantity of capital NBFIs will be able to attract low cost, long term funds in the form of deposits and debt instruments NBFIs will have improved cost efficiencies in order to be competitive NBFIs will be able to diversify their business models and be ready to deal with market volatilities NBFIs will be able to manage risks in an integrated manner NBFIs will have improved governance, and fit and proper directors and senior management Accordingly, the objective of merger/absorption plan would be to fashion an NBFI sector that comprises of a smaller number of large NBFIs, which are fully compliant with the Central Banks regulatory framework.

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The State Banks will be expected to contribute significantly towards building a strong and dynamic banking sector

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The two large state commercial banks, BOC and PB, will be encouraged to grow and expand towards a stronger regional presence, and to operate with higher levels of capital

They will also be expected to strengthen their Off-shore banking operations, and be able to attract funds, as well as conduct private banking on a wider scale The NSB will be encouraged to broad base their banking activities to contribute to the economy on a larger scale The Pradeshiya Sanwardhana Bank will be encouraged to serve the niche market of microfinance, targeting inclusive growth in the provinces The other smaller state banks will be encouraged to merge with the bigger state banks or with one another, and play a more cohesive role, since at present these banks account for just 1.1% of the market share!

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Foreign banks in Sri Lanka will be expected to demonstrate greater participation, and make a useful contribution to the economy
Larger foreign banks will be expected to further strengthen operations Smaller foreign banks will be expected to develop new strategies to grow, and to increase participation in the domestic economic activities via:
Expansion of the necessary skills Product development Display of greater enthusiasm: private banking, off-shore banking, infrastructure financing; support for 5 + 1 Hub activities

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The present 58 NBFIs will be identified as Category A, B and C in preparation for the consolidation
NBFIs with :

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Category A

Assets more than Rs. 8 bn Core Capital more than Rs. 1 bn High degree of compliance with Directions issued by CBSL

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13

Category B

LFCs or SLCs or Groups of LFCs and/or SLCs that do not fulfill one or more of the criteria of the Category A.

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35

Category C

NBFIs where business is at a standstill. No action pertaining to the consolidation is possible due to the stay order issued by the Court of Appeal in respect of the restructuring plan

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The Consolidation Approach would be

Local Banks and Category A NBFIs to discuss with Category B NBFIs and identify merger partners and agree terms and conditions for Mergers/Absorptions All Category B NBFIs to merge with local Banks or Category A NBFIs, or merge among themselves, so that they fulfill conditions of the Category A NBFIs In the event that a Category B NBFI requires a capital infusion by the acquiring bank or Category A NBFI as per a plan that is approved by the Central Bank, a matching support to the acquiring entity, via the Deposit Insurance & Liquidity Support Fund, would be provided The local banks and Category A NBFIs would be encouraged to acquire and absorb 1 to 3 Category B NBFIs

Initially, the local banks and Category A NBFIs will be given a time period of until 31st March, 2014 to identify partners of their choice from within the Category B NBFIs for such mergers/absorptions..

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All Banks and NBFIs will be expected to adhere to a rather focussed time-line...
Consolidation/Merger Strategy Merger of NBFIs within a Group Submission of the Plan of Action to Central Bank 31 March 2014 Target Date for Completion 30 June 2014 The majority of Category B NBFIs are expected to be absorbed by December 2014, while any remaining are expected to be completed by first half of 2015 1 January 2016 1 January 2018

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Merger/Absorption of Category B NBFIs by Banks or Category A NBFIs

31 May 2014

Increase of minimum core capital of NBFIs to Rs. 1 bn Increase of minimum core capital of NBFIs to Rs. 1.5 bn

31 December 2014 31 December 2014

All Banks and NBFIs will be expected to play their role actively and effectively, to achieve the expected outcome as specified
Local Banks and NBFIs will be required to submit broad plans by the date as specified for possible mergers/absorptions Foreign Banks to submit broad plans, by the dates as specified for the greater participation in the economy Merger/Absorption plans that are submitted by Banks and NBFIs would be evaluated and approved by the Central Bank The required Financial, Tax and HR Due Diligence will need to be carried out by reputable firms, preferably with international expertise in such processes, while the purchase consideration must be based on sound internationally accepted, market-based principles

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If it is observed that any Category B NBFIs may remain unabsorbed after 31st March 2015, the Central Bank may consider such a situation as a possible threat to financial system stability
In such an event, the Central Bank will issue Directions to any Banks or NBFIs, directing such institutions to implement and/or undergo a suitable consolidation process, under the provisions of the Monetary Law Act, Banking Act or Finance Business Act.

In the merger/absorption process, the Accounting, Valuation, Tax, Human Resources and other due diligence practices will be supported
Firms of Accountants with international connections and the Institute of Personnel Management have been invited to provide advice and guidance to Banks and NBFIs, to assist them in this process The payment of consultancy fees for necessary advice/guidance that will be provided by the Consultants on accounting, tax, valuation of businesses, HR issues etc. in the merger and absorption processes, will be met by the Central Bank. At the same time, all Banks and NBFIs will be free to obtain any advice and/or guidance from any other source they prefer as well, at their own cost.

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The tax concessions and benefits proposed in the Budget 2014 are expected to facilitate the consolidation process
In support of this initiative, I propose to give qualifying payment status for acquisition expenditure of banks or finance companies, if they have acquired any finance company. President Mahinda Rajapaksa, Minister of Finance & Planning 21st November 2013 Budget Speech

The seriousness of the envisaged consolidation process is confirmed by having tax benefits provided in the Budget 2014. The exact details and implementation of such benefits are now being finalised with the Ministry of Finance and the Department of Inland Revenue, and will be notified soon.

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This merger/absorption process must not adversely affect the staff of the respective institutions
No staff member is to be forcibly retrenched as a result of these merger/absorption processes No salary of any employee is to be reduced from that prevailing as at 31st December 2013. Those involved in the merger/absorption process will be encouraged to appoint competent Human Resource Consultants to perform independent reviews on senior management

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The capital infusion as a result of a merger or absorption of any Category B NBFI, in accordance with a plan as approved by the Central Bank during the process of merger/absorption, will qualify for funding support
In the case of any capital infusion by the acquiring Bank or Category A NBFI as a result of a plan that is acceptable to the Central Bank, a matching long term advance will be made through the Sri Lanka Deposit Insurance and Liquidity Support Scheme, on concessionary terms.

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The Central Bank will closely guide the merger/absorption process to ensure that it will be smooth and constructive
Each Bank and NBFI must form a Steering Committee for this purpose. The relevant Banks/NBFIs must submit monthly reports on their progress re. the mergers/absorptions to the Central Bank Banks and NBFI sectors will be expected to align their immediate future business expansion, new recruitment and other capital expenditure in keeping with the new developments. A Special Unit of the Central Bank headed by an Assistant Governor, will liaise between all stakeholders to ensure the successful implementation of the merger/absorption process. The Central Bank will issue public notifications from time to time, to apprise the overall progress of the process The Central Bank will also liaise with other authorities such as Securities and Exchange Commission, Colombo Stock Exchange, Registrar of Companies, wherever such support is needed.

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In the meantime, banks capital will be strengthened significantly

Increase in minimum capital requirement for existing banks by 1st January 2016: Licensed Commercial Banks - minimum Rs. 10 bn Licensed Specialized Banks - minimum Rs. 5 bn Migrate to the advanced approach under the Basel II Capital Adequacy Framework by the implementation of Standardized Approach for calculating capital charge for operational risk under Pillar 1 Adopt Basel III Capital Standards Increase in quality and quantity of capital of bank; Introduction of a capital conservation buffer with the intention of creating capital buffers in good times that can be used to absorb shocks in periods of stress; and Introduction of a counter-cyclical buffer to reduce pro-cyclicality to prevent excessive credit growth

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The Risk Management Framework of banks will also be improved further

Key Policy Measure Target Date During 1st Quarter 2014 In 2014: Supervisory Observation period In November 2014: Issue Direction to maintain minimum LCR effective from 1st January 2015 During 1st Quarter 2014

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Issue guidelines on the Stress Testing Framework Implement the new Liquidity Risk Management
Framework by the introduction of the Basel III Liquidity Coverage Ratio (LCR)

Introduce a Regulatory Framework for Valuation of

immovable Property of Licensed Banks

Introduce prudential requirements to regulate the

exposure of the banking system to asset markets and other potential economic shocks and concentrations During 2014

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Several new Regulatory measures will be implemented in the banking sector

Key Policy Measure
Incorporate appropriate changes to existing regulatory framework in line with new accounting standards Introduction of the new off-site surveillance reporting system Amendments to existing Directions and other regulations Establish minimum standards for core banking systems and other IT based platforms used by banks Develop a comprehensive supervisory framework for consolidated supervision of banking groups

Target Date

From 2nd Quarter 2014

During 2nd Quarter 2014 During 2014

The new regulatory framework will continue to be in line with international best practices
Adopt Standardised Approach for calculating capital charge for operational risk under Pillar 1 in compliance with Basel II Capital Adequacy Requirement Issue guidelines to strengthen
The Stress Testing Framework of the Banking Sector Minimum Requirements in Core Banking System of Banks

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Develop new Regulations on

Liquidity Risk Management Framework for Valuation of Immovable Property of Licensed Banks

Require banks to further strengthen

The quantity and quality of capital to improve their loss absorbency capabilities The systems and processes to migrate to advanced approaches on the Basel II capital framework The management of banking risks in an integrated manner, and The governance, fitness and propriety of directors and senior management to establish operational accountability

Amend the Banking Act to take into account the new developments in domestic and international financial markets
Supervision of bank dominated financial groups to be strengthened Provisions to facilitate mergers and acquisition of banks to be introduced Bank resolution measures to be strengthened

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At the same time, the Central Bank will significantly enhance the level of regulatory action in the NBFI sector, as well
Introduce a system of lower leverage ratios to NBFIs which are only partiallycompliant with the Directions of the Central Bank Publish the maximum deposit levels for each NBFI on a quarterly basis, beginning 2Q, 2014 Introduce a liquidity support fund for NBFIs which require short term liquidity support, by 2H, 2014 Closely monitor the implementation of the proposed merger/absorption plan Strengthen the risk focused regulatory and supervisory system Use an online early warning system to identify emerging risks in an NBFI Impose penalties on, and/or disqualify from holding office, key management personnel when there are continued non-compliances of Central Bank Directions Expedite the investigation processes on unauthorised finance businesses

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In this newly emerging scenario, certain marketing practices currently pursued by Banks & NBFIs will be discontinued
Lottery schemes will be prohibited New guidelines will be issued on non-interest incentive schemes offered by banks to mobilize deposits Accuracy of disclosures on interest rates, fees and charges, etc. will be closely monitored The implementation of the current Directions on Customer Charter of banks will be enforced More focused attention will be given to customers complaints and consumer protection, so as to address grievances in an efficient and timely manner

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In the meantime plans are also underway to strengthen other areas of the financial sector, and these too, will be supported
A deeper secondary market for Government Securities will be developed The e-trading platform will be extended, with two-way quotes made mandatory A Central Counter Party (CCP) System will be established together with SEC, CSE and Lanka Clear, and settlement of all G-sec transactions will be made only through such CCP Major improvements to the Payments & Settlements platform will be carried out in order to be prepared for the future Improvements in the national payment system including CCAPS will be facilitated and the participation of banks and non-bank service providers in developing payment and settlement systems, will be promoted The Securities and Exchange Commissions 10 strategy Capital Market Development Master Plan will be supported, whereever necessary

The resulting outcome from all these initiatives will lead to a new equilibrium in the financial sector in Sri Lanka
Larger aggregate capital base Increased potential to finance large scale transactions Increased investments by foreign investors Improved level of efficiency and corresponding profitability Availability of a full range of financial services at affordable costs More effective supervision

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As a result of the merger/absorption process, all banks and NBFIs will emerge stronger, more resilient, and be better positioned to support the envisaged economic growth of the country

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