This article was originally published by Asian Development Blog and is republished with permission.
The building blocks of any aspiring modern banking system have to be based on strong foundations. Sri Lanka’s banking industry has continued to manage its risks prudently while maintaining a comfortable level of liquidity and capital, and ensuring credit quality. The country also has strong foundations led by a strong regulator in the Central Bank of Sri Lanka, one of the premier central banks in South Asia and beyond.
But contrasting bank share of domestic credit to private sector relative to gross domestic product, reveals that banks can have a greater role in the economy and showi greater appetite for going into more underserved markets.
At the end of 2017, the banking system in Sri Lanka consisted of 32 licensed banks: 25 licensed commercial banks (including 12 branches of foreign banks) and 7 licensed specialized banks. The asset base expanded during 2017 at an annual growth rate of 12.3% – mainly attributable to an increase in lending to manufacturing (21.9%), trading (19.8%), and construction (19.5%), the total of which accounts for 43% of the total credit exposure of the banking sector.
The increase in lending was mainly funded by a 17.5% growth in deposits. In 2017 alone, 111 new banking outlets were opened.
Despite this business growth, the banking industry continued to manage its risks prudently. The gross nonperforming loan ratio slightly declined from 2.6% to 2.5% during 2017, and is less than half of the 5.6% seen in 2013. Profitability has been stable, with a return on assets between 1.3% and 1.4%, and an interest margin of 3.5%–3.6% between 2013 and 2017.
However, one area were Sri Lanka’s banks perform substantially below their regional peers is in lending to small and medium-sized enterprises (SMEs).
Investing in SMEs is key to supporting financial inclusion and growth in the economy and, consequently, a driver of employment generation. With their high-quality loan portfolios but low profitability, banks in Sri Lanka should be able to gradually take more risk in the underserved SME segments without undermining financial stability.
Recognizing this, ADB has been investing in SME lending both from an operational perspective―working with Sri Lanka’s banking system to address some shortcomings―and from the development perspective to support productivity, enhanced growth, and poverty alleviation.
Our team spent significant time analyzing why SME lending is below par in Sri Lanka. The answer points toward credit lines aligning with properly built incentives. With low margins, banks did not want to incur in additional transaction costs such as monitoring and reporting the status of subloans.
Despite our team’s initial attempts at greater innovation―including leapfrogging to a credit auction mechanism to allocate credit to onlending to SMEs―we settled on a more modest but effective model of incentives or behavior-based SME lending.
It was critically important for the government financial schemes to be designed to include incentives and penalties―and at all times operating under a competitive credit allocation process―in order to change banks’ past behavior.
ADB allocated funds to banks semi-annually on a pro-rata basis based on each bank’s requested amount. For a bank to qualify for a next round of fund allocation, it had to meet various development and disbursement targets within 5 months from the allocation.
Among these conditions, 20% of the number of subloans had to be to first-time borrowers, 20% of the number of subloans must be women-led SMEs, and 70% of the amount of subloans must be lent cumulatively to targeted SMEs. Moreover, 80% of the amount of a bank’s allocation must be onlent. Banks had to bear the borrowing interest cost for the unutilized amount.
Under this scheme, participating banks were pressured to meet the disbursement and development targets and search for underserved SMEs who wanted to borrow. This is because banks wanted to avoid the interest costs for the unutilized portion and continue to qualify for a next fund allocation. The results so far have been positive.
Another area where Sri Lanka’s banking system lags countries of comparable income per capita is in banking sector penetration – with the banking footprint of project financing and securitization being relatively small. These areas are crucial if banks are to take up a greater role in developing infrastructure financing in Sri Lanka.
Sri Lanka has been investing in infrastructure development largely through the budget, including from international financial institutions at semi-concessional rates such as the ADB and the World Bank, and across nonsovereign financing at more commercial rates.
Skilled labor and improvements to human capital, together with building world class infrastructure―including connectivity from farm to market and from ports to rail to airports―will be critical. Looking forward, despite some success, public finances cannot continue to drive this build up in capital formation.
Banks and capital markets should provide the critical link, and eventually know how to successfully drive this transition to a more homegrown and commercially-based sustainable infrastructure financing model.
Elsewhere in Asia, banks finance infrastructure development during the construction phase working closely with other sponsors and developers. Pricing of loans during the riskier construction phase of the project should reflect risks, and these assets in turn sold-off by banks post construction. Special purpose vehicles could be promoted tocontinue providing funding through local currency bond markets.
While the returns post-construction would suggest for banks to keep these performing assets on their balance sheets given the decline in risk, this could potentially undermine banks’ asset liability management given the long-term financing associated to infrastructure projects. Indeed, once a deal flow of such infrastructure projects is generated in an economy―including through public–private partnerships―banks can comfortably sell their loans from their portfolio, and more effectively recycle capital for new greenfield projects.
In Sri Lanka, the trade-off between innovation and the largely fail-safe banking practices could be rebalanced by promoting greater innovation in such areas as core development banking. The government is planning to relaunch the idea of infrastructure development banks or even nonbank financial institutions, and hopefully these will make good progress in the coming year.