SRI LANKA: An Introduction to Banking & Finance

Introduction  

Sri Lanka's banking and finance sector, amidst a backdrop of significant economic, legal, and political shifts, presents a landscape rich in both challenges and opportunities. The sector's journey through the economic crisis, subsequent economic reforms, and evolving legal frameworks offers a unique insight into the current state of banking and finance in Sri Lanka.

In April 2022, Sri Lanka experienced a historic economic downturn prompting the Government of Sri Lanka (“GOSL”) to engage with the International Monetary Fund (“IMF”) for a 48-month External Fund Facility of USD 2.9 billion. Critical policy decisions, including tax increases and exchange rate management, were implemented to stabilise the economy, thereby contributing to decreased inflation, increase of foreign reserves, and gradual currency stabilisation.

Current Economic Conditions 

The response of the Central Bank of Sri Lanka (“CBSL”) to these economic conditions has been notable. High policy rates were initially implemented to control inflation, which impacted the sector's credit growth. Thereafter, CBSL lowered the Standing Lending Facility Rate to 10% and the Standing Deposit Facility Rate to 9% by November 2023 to boost economic recovery, maintaining this through January 2024.

The fiscal policy adjustments by GOSL, particularly in the 2024 budget, demonstrate a commitment to economic recovery and stability. The allocation of significant funds for foreign debt restructuring, the proposal to divest state-owned bank investments, and the increase in borrowing limits reflect a strategy to strengthen the banking sector. These fiscal measures are supplemented by monetary policy adjustments aimed at balancing inflation control with economic recovery.

The relief measures granted during the COVID-19 pandemic, including payment moratoriums and other concessions, were intended to alleviate the financial strain on businesses, particularly for small and medium-sized enterprises. According to CBSL, initial concerns over the sufficiency of these measures in supporting vulnerable subprime borrowers, and the potential for non-performing loans to weigh on banks’ asset quality, have been ameliorated to a significant extent.

GOSL has also embarked on an ambitious plan to restructure and divest several key state-owned enterprises, in a move to optimise government expenditure. This initiative targets entities such as the Ceylon Electricity Board, Sri Lankan Airlines, Ceylon Petroleum Corporation, Sri Lanka Telecom, and Sri Lanka Insurance Corporation. These reforms are pivotal in enhancing operational efficiency, financial stability, and overall service quality, by not only reducing the fiscal burden on the government but also improving the competitiveness and sustainability of these vital sectors.

Sri Lanka's hike in personal and corporate income taxes in 2023, part of the broader fiscal consolidation efforts, is aimed at strengthening state revenues on the path to economic recovery. In January 2024, Sri Lanka witnessed an increase in its Value Added Tax (“VAT”) rate, rising from 15% to 18%, along with a reduction in the VAT threshold to Rs. 60 million and the removal of VAT exemptions from a large number of goods. Such revenue measures have, however, drawn criticism about its impact on domestic spending and the investment climate.

Banking Sector Regulatory Framework 

CBSL regulates various financial entities in the country, including Licensed Commercial Banks, Licensed Specialised Banks, Licensed Finance Companies, Registered Finance Leasing Establishments, Authorised Primary Dealers, and Authorized Money Broking Companies.

The regulatory and supervisory framework for these entities is primarily outlined in the Central Bank of Sri Lanka Act (“CBSL Act”), the Banking Act, the Finance Business Act, and the Finance Leasing Act. Currently, Sri Lanka has 24 Licensed Commercial Banks (inclusive of 11 foreign banks), 6 Licensed Specialised Banks, and 34 Licensed Finance Companies.

Licensed Commercial Banks are permitted to operate all regular banking services such as acceptance of demand deposits and maintenance of current accounts. Licensed Specialised Banks focus on specific sectors and are tailored to meet the demands of specific industries. Both Licensed Commercial Banks and Licensed Specialised Banks are permitted to engage in foreign exchange transactions.

 In addition to accepting deposits and providing loans, Licensed Finance Companies provide specialised financial services. Registered Financing Leasing Establishments provide a variety of leasing options to individuals and businesses for the purchase of assets.

Banking Sector Reform 

The new CBSL Act, which repeals the Monetary Law Act, marks a significant shift in the banking sector's regulatory environment. This change includes more stringent requirements for the appointment of directors and senior management in banks, increased supervisory powers for CBSL, and restrictions on monetary financing of the government (subject to exceptional circumstances), with overall enhanced measures for risk management and financial stability.

In an effort to enhance the financial sector’s safety nets, as highlighted by the IMF and World Bank, GOSL recently introduced the Banking (Special Provisions) Act. This aims to strengthen the bank resolution framework under the Crisis Management Framework of Financial Institutions Regulated by CBSL. Whilst supplementing the CBSL Act, the Banking (Special Provisions) Act introduces provisions for the resolution of Licensed Commercial Banks, deposit insurance, and winding up/liquidation of such banks.

GOSL has also approved the new Banking Amendment Bill which proposes to regulate the issuance of licenses, ownership, corporate governance, supervision, capital requirements, liquidity framework, permitted credit facilities, and other related matters.

The proposed Secured Transactions Act is designed to establish a more efficient and reliable framework for secured financial transactions, enhancing legal certainty for both lenders and borrowers. This Act will likely facilitate improved access to credit, particularly for small and medium-sized enterprises. On the other hand, the proposed Microfinance Act aims to regulate and streamline the microfinance sector, ensuring better protection for consumers and promoting responsible lending practices.

In the main, these amendments aim to modernize CBSL's operations, providing it with greater autonomy and accountability, and strengthening its role in ensuring resilience and integrity of the financial system.

Other Related Reforms 

GOSL intends to introduce several new laws to manage public debt, finances and assets. This includes proposed legislation such as the Public Debt Management Act, Public Financial Management Act, Public Asset Management Act and the Public Enterprise Reform Law.

Initiatives are also underway by the Colombo Stock Exchange to integrate environmental, social, and governance (ESG) factors into financial services and products. This includes the development of green bonds and sustainable financing instruments, which aim to support environmentally friendly projects and promote responsible investment practices.

GOSL is prioritizing digital transformation and international compliance by advancing overdue cybersecurity legislation. This initiative will complement existing laws on data protection and financial crime, enhancing the integrity of the financial system.

Sri Lanka's insolvency laws, overseen by the Companies Act for companies and the Insolvency Ordinance for individuals and partnerships, face criticism for their shortcomings. Reform proposals, like the Rescue Rehabilitation and Insolvency Bill, aim to modernize the framework, emphasizing restructuring for viable companies and offering relief to struggling entrepreneurs and small businesses.

In the attempt to streamline revenue administration, amendments are underway to the Inland Revenue Act, VAT Act, Finance Acts, Social Security Contribution Levy Act, Telecommunication Levy Act, and Tax Appeals Commission Act. In similar vein, to enhance efficiency in tax collection and broaden the tax base, efforts are being taken towards mandatory tax registration of persons over 18, and introduction of digital solutions to streamline the tax collection process, making it more transparent, accessible, and less prone to corruption.

Potential Hurdles and Solutions 

Sri Lanka's rank in the Doing Business Index and its performance in enforcing contracts highlight challenges in attracting foreign direct investment. Stricter fiscal policies by GOSL, aimed at reducing debt burdens, might pose challenges for investors. However, the Colombo Port City, established as a special economic zone, offers a solution by facilitating business setup and offering tax incentives for strategic businesses. The Colombo Port City Commission recently announced that three licensed commercial banks have obtained the relevant license to operate within the special economic zone.

GOSL has confirmed the introduction of new legislation aimed at attracting both domestic and foreign investment. The proposed Investment Law is set to create a conducive, transparent environment for investors by streamlining processes and offering clearer guidelines. Concurrently, the Public Private Partnership Law is being proposed to foster public-private collaborations in developing and maintaining public infrastructure and services, providing a structured approach to private investment in public projects.

Additionally, GOSL is allocating LKR 100 billion towards automating services in government agencies dealing with investors, aiming to expedite approval processes, reduce bureaucratic hurdles, and enhance transparency, thus promoting a more investor-friendly environment.

Conclusion 

The banking and finance sector in Sri Lanka is currently undergoing a transformative phase, poised to overcome economic challenges and embrace positive changes through legislative measures like the CBSL Act, the Banking (Special Provisions) Act, and the proposed banking act. The sector's resilience and adaptability, coupled with proactive government initiatives and legal reforms, are expected to play a crucial role in steering it towards a promising and sustainable future.