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Financial System Stability
About the Financial System

Financial System Stability
Financial system stability means a safe and secure financial system which is able to withstand external and internal shocks. A stable financial system creates a favourable environment for depositors and investors, encourages financial institutions and markets to function effectively and efficiently, and hence, promotes investment and economic growth. Financial system stability requires a stable financial and economic environment within an effective regulatory framework and a safe and robust payment and settlement system. The maintenance of financial system stability entails identifying and addressing potential vulnerabilities and risks to the financial system.
creating a trust-worthy and enabling environment favourable to savers and investors
helping the transmission of monetary policy, thereby assisting the attainment of price
encouraging efficient financial intermediation, which eventually promotes investment
  and growth, and
encouraging effective and efficient operation of markets and improving distribution of
  resources in the economy

  Financial System Stability - Pamphlet Series No.2 >>
  Financial Stability Review 2013 | 2012 |2011 | 2010 | 2009 | 2008 |

Structure of the Financial System
Financial system, i.e. financial intermediaries and financial markets, channel funds from those who have savings to those who have more productive uses for them. The financial system in Sri Lanka comprises the major financial institutions, namely the Central Bank of Sri Lanka (CBSL), Licensed Commercial Banks (LCBs), Licensed Specialised Banks (LSBs), Licensed Finance Companies (LFCs), Specialised Leasing Companies (SLCs), Primary Dealers (PDs), Pension and Provident Funds, Insurance Companies, Rural Banks, Stock Brokers, Securities Market Intermediaries, Unit Trusts and Thrift and Credit Co-operative Societies; the major financial markets, such as the Foreign Exchange Market, Money Market, Capital Market and the informal financial market; and the financial infrastructure which is the legal framework related to the financial system and the payment and settlement.

The table I below provides data on the assets and liabilities of the main institutions in the financial system at the end of 2014.

Table I
Total Assets and Deposit Liabilities of the Main Institutions in the Financial System
as at end December 2014 (a)
Assets Deposits
Financial Institution Rs. bn. % Share Rs. bn. % Share
Central Bank of Sri Lanka 1,464.3 12.2 n.a n.a
Institutions Regulated by the Central Bank 8,016.4 66.6 5,100.3 98.2
  Deposit Taking Institutions 7,751.7 64.4 5,100.3 98.2
            Licensed Commercial Banks 5,884.6 48.9 3,976.8 76.6
            Licensed Specialized Banks 1087.5 9.0 709.6 13.7
            Licensed Finance Companies 779.6 6.5 413.9 8.0
  Other Financial Institutions 264.7 2.2 n.a. n.a.
            Primary Dealers 191.1 1.6 n.a. n.a.
            Specialized Leasing companies 73.6 0.6 n.a. n.a.
Institutions not Regulated by the Central Bank 2,560.7 21.3 94.5 1.8
  Deposit Taking Institutions 112.4 0.9 94.5 1.8
            Rural Banks (b) 103.5 0.9 89.6 1.7
            Thrift and Credit Co-operative Societies (b) 8.9 0.1 4.9 0.1
  Contractual Savings Institutions 2,272.9 18.9 n.a n.a
            Employees' Provident Fund 1,486.9 12.3 n.a. n.a.
            Employees' Trust Fund 199.1 1.7 n.a n.a
            Approved Private Provident Funds (c) 134.2 1.1 n.a n.a
            Public Service Provident Fund 41.0 0.3 n.a n.a
            Insurance Companies (d) 411.7 3.4 n.a n.a
  Other Financial Institutions 175.5 1.5 n.a n.a
            Stock Broking Companies (e) 11.3 0.1 n.a n.a
            Unit Trusts/ Unit Trust Management Comapnies (e) 128.6 1.1 n.a n.a
            Market Intermediaries* (e)(f) 29.6 0.2 n.a n.a
            Credit Rating Agencies (e) 0.3 0.0 n.a n.a
            Venture Capital Companies 6.2 0.1 n.a n.a
Total Assets 12,041.4 100.0 5,194.8 100.0
Source: Central Bank of Sri Lanka

(a) Provisional
(b) Registered with the Department of Co-operative Development
(c) Registered with the Department of Labour
(d) Regulated by the Insurance Board of Sri Lanka
(e) Regulated by the Securities and Exchange Commission of Sri Lanka
(f) Market Intermediaries include Underwriters, Margin Providers and Investment Managers.

* Excluding the assets of Licensed Banks, Licensed Finance Companies and Specialised Leasing Companies which are registered as Market Intermediaries
n.a. - Not applicable

The banking sector in Sri Lanka, which comprises LCBs and LSBs, dominates the financial system and accounted for 58 per cent of the total assets of the financial system as at the end of 2014. Banks play a critical role within the Sri Lankan financial system, as they are engaged in provision of liquidity to the entire economy, while transforming the risk characteristics of assets. Banks are also engaged in providing payment services, thereby facilitating all entities to carry out their financial transactions. On the other hand, banks can create vulnerabilities of systemic nature, partly due to a mismatch in maturity of assets and liabilities and their interconnectedness. Therefore, the soundness of banks is important, as it contributes towards maintaining confidence in the financial system, and any failure may have the potential to impact on activities of all other financial and non-financial entities, and finally the economy.

In terms of the asset base and the magnitude of services provided, the LCBs are the single most important category of financial institutions within the banking sector. At the end of 2014, the LCBs dominated the financial system with a market share of 49 per cent of the entire financial system's assets and 84 per cent of the banking sector's assets. Therefore, the health of Sri Lankan financial system depends to a large extent on the soundness of the LCBs.

At the end of 2014, the banking sector comprised 25 LCBs and 9 LSBs. Even though a large number of licensed banks exist in the country, the stability of the financial system is primarily dependent on the performance and financial strength of the six largest LCBs, consisting of the two state banks and the four largest domestic private commercial banks. These six banks, which are generally, referred to as the Systemically Important Banks (SIBs), represented 75 per cent of the LCB sector assets, 63 per cent of the banking sector assets, and 36 per cent of the entire financial system’s assets.

The LSB sector represented 9 per cent and 16 per cent of the entire financial system's assets and banking sector's assets, respectively at the end of 2014. The systemic importance of the LSB sector is relatively low in comparison to the LCBs, both in terms of size and their impact on the financial system, as it does not play a major intermediary role in the payment cycle.

The table II below provides data on certain macro-prudential indicators relating to LCBs and LSBs. The Central Bank as the regulator of the LCBs and LSBs, compiles aggregate macro-prudential indicators on the banking system, as part of its framework to assess financial system stability.

Table II
Financial Soundness Indicators
2007 2008 2009 2010 2011 2012 2013 2014

Licensed Commercial Banks

1. Capital Adequacy Ratio - Tier I Capital Ratio (%)

11.9 11.1 12.9 13.0 13.4 12.2 14.3 12.6

2. Capital Adequacy Ratio - Total Capital Ratio (%)

13.6 13.8 15.4 15.2 15.5 15.8 17.5 15.6

3. Gross NPA as a % of Total Loans & Advances

5.0 6.0 8.2 5.1 3.5 3.4 5.2 3.6

4. Net NPA as a % of Capital Funds

11.9 16.7 25.3 14.6 9.9 10.9 24.4 13.1

5. Sectoral Credit Distribution (%)

          Agriculture & Fishing

5.2 5.4 11.6 13.9 13.3 13.1 12.2 10.5


16.9 17.9 15.7 13.6 12.6 11.2 11.8 11.9


2.2 2.6 2.9 2.3 2.3 2.5 2.9 3.5


2.3 2.2 1.7 1.7 2.2 1.8 2.9 2.8


16.4 14.6 14.6 14.1 11.8 11.4 12.4 13.1


13.6 13.8 14.9 15.2 12.0 16.3 16.9 17.3

          New Economy

1.1 1.1 1.3 1.0 1.0 1.2 1.2 1.5

          Financial & Business Services

5.5 4.9 3.3 4.5 5.4 4.6 4.0 5.0


0.9 1.0 1.0 1.1 1.1 5.3 6.5 7.9
          Other Services 4.9 6.0 5.2 6.9 7.8 3.2 3.1 3.7
          Other Customers 30.9 30.6 27.7 25.8 30.7 29.5 26.2 22.9

6. Return on Assets (%)

1.9 2.0 1.7 2.5 2.4 2.5 2.0 2.1

7. Return on Equity (%)

15.0 14.8 11.0 20.8 20.3 21.7 17.4 16.8

8. Liquidity Ratio, % (DBU)

24.8 25.7 33.0 29.4 26.2 26.2 30.8 33.2

Licensed Specialised Banks

1. Capital Adequacy Ratio - Tier I Capital Ratio (%)

21.2 21.0 23.6 25.0 21.1 20.3 20.6 17.3

2. Capital Adequacy Ratio - Total Capital Ratio (%)

20.6 25.6 22.0 24.4 20.0 20.5 18.6 15.7

3. Gross NPA as a % of Total Loans & Advances

6.7 8.9 10.4 7.9 6.8 6.4 9.3 9.5

4. Net NPA as a % of Capital Funds

23.0 26.7 30.4 17.8 19.0 20.8 37.6 45.9

5. Return on Assets (%)

1.7 1.4 2.4 3.8 2.5 1.8 1.0 1.7

6. Return on Equity (%)

10.0 6.9 15.3 27.1 17.4 13.6 8.6 15.1

7. Liquidity Ratio (%)

61.0 61.9 71.1 74.3 65.4 61.4 80.3 77.7
Source: Central Bank of Sri Lanka

Components of the Financial System

The financial system consists of the Central Bank, as the apex financial institution, other regulatory authorities, financial institutions, markets, instruments, a payment and settlement system, a legal framework and regulations. The financial system carries out the vital financial intermediation function of borrowing from surplus units and lending to deficit units. The legal framework and regulators are needed to monitor and regulate the financial system. The payment and settlement system is the mechanism through which transactions in the financial system are cleared and settled.

Regulatory Authorities >>
Financial Institutions >>
Financial Markets >>
Financial Instruments >>
Payment and Settlement Infrastructure >>

Regulatory Authorities Central Bank of Sri Lanka
The regulation and supervision of banking institutions is mainly governed by the
  Monetary Law Act No.58 of 1949 , the Banking Act No.30 of 1988 and the Exchange Control Act No. 24 of 1953.
The regulation and supervision of finance companies is undertaken in terms of the
  Finance Business Act, No 42 of 2011 .
The regulation and monitoring of finance leasing establishments is conducted under the
  Finance Leasing Act No.56 of 2000.
The regulation of supervision of primary dealers in government securities is carried out
  in terms of the Local Treasury Bills Ordinance No.8 of 1923 and the Registered Stocks and Securities Ordinance No.7 of 1937.

The institutions being supervised are the systemically important institutions for financial stability. However, competition in the financial sector sometimes could make some financial institutions unviable, if they do not adapt themselves to the rapidly changing financial environment. Such institutions are either restructured or liquidated, based on the extent to which they have deteriorated.

Securities and Exchange Commission
The Securities and Exchange Commission (SEC) is responsible for licensing and regulating stock exchanges, stock-brokers, stock dealers and unit trust companies, in terms of the Securities and Exchange Commission of Sri Lanka Act No. 36 of 1987. The SEC also registers underwriters, margin providers, credit rating agencies, investment managers and securities clearing houses. In order to co-ordinate financial stability issues, the Central Bank is a member of the Board of Directors of the SEC and the Deputy Governor in charge of Financial System Stability represents the Central Bank on the SEC Board.

Insurance Board of Sri Lanka
The Insurance Board of Sri Lanka (IBSL) regulates and supervises the insurance industry -insurance companies and their agents and insurance brokers, under the Regulation of Insurance Industry Act No.43 of 2000 to safeguard the interests of policy-holders. The Central Bank is a member of the IBSL and is represented on it by the Deputy Governor in charge of Financial System Stability.

Financial Institutions
Institutions Regulated by the Central Bank of Sri Lanka
Licensed Commercial Banks >>
Licensed Specialised Banks >>
Licensed Finance Companies >>
Registered Finance Leasing Establishments >>
Authorised Primary Dealers >>

A law to regulate and supervise Micro-Finance Institutions is also being formulated. Action is being taken to establish an independent authority for monitoring micro- finance institutions.

Institutions Not Regulated by the Central Bank of Sri Lanka
Certain financial institutions are not regulated by the Central Bank. These include Stock Broking / Dealing Companies, Unit Trust Companies and Investment Management Companies, which come under the purview of the SEC, Insurance Companies and Insurance Brokers which are regulated by the IBSL, and Venture Capital Companies, Pension and Provident Funds and Micro-Finance Institutions.

Financial Markets
The Financial Market, which is the market for credit and capital, can be divided into the Money Market and the Capital Market. The Money Market is the market for short-term interest- bearing assets with maturities of less than one year, such as Treasury bills, commercial paper, and certificates of deposits. The major task of the Money Market is to facilitate the liquidity management in the economy. The main issuers in the Money Market are the Government, banks and private companies, while the main investors are banks, insurance companies and pension and provident funds. The Capital Market is the market for trading in assets for maturities of greater than one year, such as Treasury bonds, private debt securities (bonds and debentures) and equities (shares). The main purpose of the Capital Market is to facilitate the raising of long-term funds. The main issuers in the Capital Market are the Government, banks and private companies, while the main investors are pension and provident funds and insurance companies.

The Financial Market can be also be classified according to instruments, such as the debt market and the equity market. The debt market is also known as the Fixed Income Securities Market and its segments are the Government Securities Market (Treasury bills and bonds) and the Private Debt Securities Market (commercial paper, private bonds and debentures). Another distinction can also be drawn between primary and secondary markets. The Primary Market is the market for new issues of shares and debt securities, while the Secondary Market is the market in which existing securities are traded.

The Central Bank through its conduct of monetary policy influences the different segments of the Financial Market in varying degrees. The Central Bank's policy interest rates have the greatest impact on a segment of the Money Market called the inter-bank call money market and a segment of the Fixed Income Securities Market, i.e. the Government Securities Market. The Central Bank may also intervene in the inter-bank Foreign Exchange Market, which is closely connected to the Money Market.

Financial Instruments
Deposits are sums of money placed with a financial institution, for credit to a customer's account. There are three types of deposits - demand deposits, savings deposits and fixed or time deposits. Demand deposits are mainly used for transaction purposes and for the safekeeping of funds. Funds can be withdrawn on demand. Demand deposits do not earn interest, but banks provide a number of services to demand deposit- holders like cheque facilities, standing orders, Automated Teller Machine (ATM) cards and debit cards to facilitate withdrawals and payments. Savings deposits earn interest, which may be calculated on a daily, weekly, monthly or annual basis. Funds may be withdrawn from savings accounts at any time. However, if the number of withdrawals exceeds four in any month, interest will not be paid for that particular month. Financial institutions issue pass-books or statements detailing transactions to savings deposit holders and also provide services such as ATM and debit cards. Fixed or time deposits are funds placed at financial institutions for a specified period or term. Fixed / time deposits earn a higher rate of interest than savings deposits. Fixed / time deposits can be for short, medium or long term. Funds can only be withdrawn before the maturity date with prior notice and a penalty may be imposed. A fixed / time deposit holder has a facility to borrow funds from the financial institution using the deposit as collateral.

A loan is a specified sum of money provided by a lender, usually a financial institution, to a borrower on condition that it is repaid, either in instalments or all at once, on agreed dates and at an agreed rate of interest. In most cases, financial institutions require some form of security for loans.

Treasury Bills and Bonds
Treasury bills are government securities that have a maturity period of up to one year. Treasury bills are issued by the Public Debt Department of the Central Bank, on behalf of the Government of Sri Lanka, under the provisions of the Local Treasury Bills Ordinance. Treasury bills are issued in maturities of 91 days, 182 days and 364 days. Treasury bills are zero coupon securities and are sold at a discount to face value, which is paid at maturity. The difference between the purchase price and the face value is the interest income to the owner. Treasury bills are considered liquid assets as they can be easily sold in the secondary market and converted to cash. Treasury bonds are medium and long-term government securities and are issued in maturities ranging from 2 years to 20 years. Treasury bonds are issued by the Public Debt Department of the Central Bank, on behalf of the Government of Sri Lanka, under the provisions of the Registered Stocks and Securities Ordinance. Treasury bonds are interest-bearing securities, with interest paid bi-annually. Treasury bills and bonds are guaranteed by the Government and are the safest of all investments, as they are default risk free. Treasury bills and bonds are tradable securities which are sold by auction to Primary Dealers, who in turn market the securities to the public. The yields on Treasury bills and bonds are market determined and the market is both active and liquid. From 2004, Treasury bills and bonds are issued in scrip-less (paperless) form and transactions are recorded electronically in the "LankaSecure" system of the Central Bank.

Repurchase Agreements
Repurchase agreements (Repo) are arrangements which involve the sale, for cash, of securities (usually government securities) at a specified price with a commitment to repurchase the same or similar securities at a fixed price on a specified future date. The difference between the sale price and the repurchase price is the interest income. The agreement is called reverse repo when viewed from the perspective of the securities buyer. A repo is similar to a loan that is collateralised by the securities underlying the agreement. Most repos are very short-term money market instruments.

Commercial Paper
Commercial papers (CPs) are short-term, non-collateralised (unsecured) debt securities issued by private sector companies to raise funds for their own use, by banks and other financial intermediaries. CPs are generally issued by creditworthy (high-rated) institutions in large denominations and have additional bank guarantees of payment. CPs are usually sold at a discount, although some are interest bearing.

Corporate Bonds and Debentures
Corporate bonds are medium or long-term securities of private sector companies which obligate the issuer to pay interest and redeem the principal at maturity. Corporate bonds that are not backed by a specific asset are called debentures.

Debentures are unsecured, medium or long term, interest-bearing bonds issued by private sector companies, banks and other financial institutions that are backed only by the general credit of the issuer. Debentures are usually issued by large, well-established institutions. The holders of debentures are considered creditors and are entitled to payment before shareholders in the event of the liquidation of the issuing company.

Asset-backed Securities
Asset-backed securities (ABS) are bonds collateralised (secured) by mortgages, loans, or other receivables. Typically, the issuing institution sells mortgages, loans, instalment credit, credit card or other receivables to a trust or a special purpose vehicle (SPV) that in turn sells ABSs to the public. ABSs are interest- bearing instruments and are often enhanced through the use of guarantees or insurance.

Financial Leases
Financial leases are accommodations provided to finance the purchase of capital or durable equipment in which the legal owner (lessor) lends the equipment to the lessee for payments that cover the full principal and interest cost. The lessee receives all benefits from the use of the asset and incurs the costs associated with its ownership, such as maintenance, insurance and taxes.Legal ownership of the equipment passes to the lessee when the loan principal and interest payments are settled in full.

Shares are securities representing a portion of the ownership of a company that are a claim on the company's earnings and assets. Shareholders are paid dividends which are a percentage of the profits of the company.

Financial Derivatives
A financial derivative is a financial instrument that is linked to another specific financial instrument, indicator or commodity and through which specific financial risks (such as interest rate risk, foreign exchange risk, equity and commodity price risk) can in their own right, be traded in financial markets. The value of a financial derivative comes from the price of an underlying item such as an asset or index. Financial derivatives can be used for risk management, hedging (protecting) against financial losses on commercial transactions and financial instruments and arbitrage between markets and speculation. There are two distinct classes of financial derivatives - forwards and related instruments, and options. The most common forward instruments are forward contracts, futures contracts, forward rate agreements (FRAs) and interest rate swaps (IRS). Financial derivatives are traded over- the- counter, in which case they are customised and can be purchased from financial institutions or are standardised products which are traded on organized exchanges. Although, financial derivatives are still not widely used in Sri Lanka, the market for forward contracts, FRAs and IRS is starting to develop.

Payment and Settlement Infrastructure
One of the most important functions of the financial system is to ensure safety and efficiency in payments and securities transactions. Financial infrastructure refers to the different systems that provide for the execution of both large-value and small-value payments. Payment and settlement systems enable the transfer of money in the accounts of financial institutions to settle financial obligations between individuals and institutions.

The main payment, clearing and settlement systems in Sri Lanka are
Cheque Imaging and Truncation System (CIT), the inter-bank cheque clearing system
  operated by Lanka Clear Ltd.
Sri Lanka Inter-Bank Payment System (SLIPS) operated by Lanka Clear Ltd.
Lanka Settle, comprising the Real Time Gross Settlement System (RTGS) and the
  Scripless Securities Settlement Systems (LankaSecure) operated by the Central Bank of Sri Lanka.

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Financial System Stability
About the Financial System
Financial System Stability
  Structure of the Financial System
  Components of the Financial System
Regulation and Supervision
Regulation and Supervision of Banks
  Regulation and Supervision of Finance Companies
  Regulation and Monitoring of Finance Leasing Establishments
  Regulation and Supervision of Primary Dealers
Monitoring and Surveillance
Maintaining Stability in Money and Foreign Exchange Markets
  Overseeing the Payment and Settlement System
  Surveillance of Financial Conglomerates
  Lender of Last Resort
Financial System Stability Committee
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