Sound and Solid
By in the March quarter bad loans have picked up slightly to 3.9 percent during the latest balance of payments crisis where the rupee fell from 110 to 132 rupees and interest rates picked up by around 500 basis points.
"Our view at this point in time is that the banking system remains very sound and very solid," IMF mission chief John Nelmes told reporters last week.
"It is well capitalized and the liquidity position of banks is also very positive. So it is entirely natural that one would see an increase in non-performing loans particularly when we saw very large in the stock of credit outstanding in the last two years."
"But I would emphasize that today it is a very small increase and overall, the system is very sound."
In 2011 credit grew 31.3 percent. By March barely a month after the rupee was partially floated and interest rates allowed to rise quickly, credit was still growing at 35.5 percent a year, according to Central Bank data.
Core capital adequacy in banks which is mainly equity fell from 14.3 percent in 2010, to 13.5 percent in December 2011.
By end March 2011 core capital adequacy had fallen to 13.3 percent. In the same period total capital adequacy which included subordinated debt had fallen from 16.1 percent to 14.9 percent.
But it is much higher than the required 10 percent. Liquid assets of banks were also 31.3 percent by March the Central Bank said.
Rising bad loans are a normal consequence of a balance of a payments crisis.
A typical balance of payment crisis involves a so-called soft-pegged central attempting to defend a dollar peg by selling forex, but also printing money at the same time to keep rates down in 'sterilized interventions'.
Sterilized sales of foreign currency boosts credit volumes while interest rates also rise.
Sterilized forex sales has an effect similar to a banking engine that is revved by pouring gas through rupee injections, while brakes are applied via every rising interest rates making banking system eventually overheat and proverbially blow a gasket.
At the peak of Sri Lanka's latest sterilized foreign exchange sales episode monthly credit volumes from banks rose to 140 rupees from around 30-50 billion rupees without sterilized forex sales which started in mid August 2011.
Sterilized sales of forex give banks reserves (rupees) far above deposits it can raise from customers allowing them to give fresh loans, as the monetary authority buys Treasury bills into its portfolio with printed money.
The contradictory policy can be ended by allowing the exchange rate to fall to account for the money that has been printed and allowing rates to rise, with some painful consequences including an economic slowdown.
A currency depreciation could be avoided if rates were allowed to rise early in the game when credit started to get out of line with deposits.
Standard & Poor's, a rating agency said this week that Sri Lanka's banks were operating in a high risk environment. The agency however did not say the banks were unsound.
The agency said Sri Lanka's banks were subject to capital requirement that were higher than international standards.
"The key regulations for banks seem sufficient," the rating agency said in a Banking Industry Country Risk Assessment (BICRA) which placed Sri Lanka in a high risk group '8' in a scale where the highest risk is 10.
The banking industry was placed on category '7'. S & P said Sri Lanka's finance companies, which are somewhat similar to small family owned regional banks that are found in the US, were less strongly regulated.
But finance companies in Sri Lanka's typically have capital in excess of 15 percent of risk assets. While 'bank' failures are not common in Sri Lanka finance company collapses are more frequent.
Though the rating agency said bank regulations were sufficient it picked a number of holes in the regulatory framework including conflicts where a central bank managed fund was buying banks stocks and the frequency of on-site supervision.
Its analysis is relative to regulatory regimes in other countries.
Sri Lanka's central bank reacted to the assessment saying the analysis was "factually incorrect" and "contradictory."
Central Bank Governor Nivard Cabraal said on-site supervision was annual but that did not reflect the tight supervision of banks that was actually carried out as there was continuous off-site monitoring which was followed up by physical checks when needed.
"When our officers see something they do spot checks," Cabraal said. "Some data is monitored daily and others monthly."
Even when there were calls for directed lending Cabraal has generally asked banks only to lend to good customers and there has not been a state led drive to lower credit standards as happened in the US.
There however has been some Central Bank supported financing to former war torn areas where credit risk was covered partially.
In the past large tax payer financed bailouts have been associated with state banks. There was a run on one private commercial bank during the 2008/2009 crisis and private savings bank failed shortly after a 1999/2000 crisis.
Some troubled small commercial banks banks were also merged with larger lenders, long before any runs developed.
Following the 2008/2009 crisis the Central Bank also acted quickly to restore confidence in the finance companies, with almost no burden on the tax payer. Some lenders are still to fully emerge from their earlier troubles.
The central bank has also slapped a credit ceiling of 18 percent on banks for 2012, which some analysts say may result in mis-allocated capital. Administrative measures sometimes have unintended consequences unlike market based methods such as interest rates.
"Some people may disagree but it was done in the interest of stability," Cabraal said. "I would also like to have growth but we had to make a call on stability."
The IMF has said Sri Lanka's economy would grow by 6.75 percent this year down from 8.3 percent last year. The central bank is expecting 7.2 percent.
A trade contraction is already underway, the surest sign of an ongoing economic slowdown. Since import duties are a key revenues source it can hurt the budget.
"On the fiscal side, revenue collection has been under pressure because of the slowing economy," Nelmes said.
"At the same time government interest payments have also risen somewhat. But in our discussions with the ministry (of finance) we have sensed their firm commitment to ensure that deficit targets are going to be met."
Ironically, state deficit spending can ultimately crowd out private lending so much that eventually bank capital ratios improve simply due to rising risk-free Treasuries holdings, while the economy tanks.
The March data is also very early in the downturn, since rates were allowed to rise properly only during February 2012, which means, indicators may deteriorate somewhat before getting better.
During the 2009/2009 crisis, the currency was floated after risk free rates reached 20 percent. This time even bond rate are not yet at 15 percent.
Unlike highly leveraged economies like the US which are used to low interest rates where banking systems collapse when policy rates are upped to 5.75 percent, Sri Lanka's banks and firms in the economy are able to take greater punishment.
Sri Lanka's current troubles were partly caused by credit spike to state enterprises which were manipulating energy prices. Energy price manipulation also saps tax revenues.
Manipulating energy prices remains a key threat to banks as well as the economy after the end of a 30-year war.
If rulers continue to deficit spend and finance the cash deficit domestically, higher interest rates may persist, delaying a strengthening of the exchange rate and an eventual fall in interest rates.
The longer high interest rates persist, the greater chances of a banking crisis developing.
But oil international prices have now started to fall. But while retail prices of both petrol and diesel are higher after a February adjustment, though there are some concerns over power.
Some analysts say the Central Bank's defence of the dollar peg, even with sterilization, probably helped arrest the credit boom early by forcing interest rates upwards after it only caused a stock market bubble.
If rates were not raised and a "flexible exchange rate" was allowed to gently depreciate, the credit bubble could have grown unchecked and may have turned into broader asset price bubble involving residential and commercial property.
To avoid large fluctuations analysts say Sri Lanka either has to stop manipulating its key inflation index, have a tighter targets like other Asian pegged nations or simply target the exchange rate allow interest rates to float.