For nearly four decades, Sri Lanka’s banks operated under the 1988 Banking Act, which was last amended in 2006. Despite facing a global financial crisis and several domestic challenges, it wasn’t until 2024 that Sri Lanka introduced significant changes to its banking code.
The regulator, the Central Bank of Sri Lanka, announced the implementation of the Banking (Amendment) Act No. 24 of 2024 in June as an alignment with current economic conditions, market developments, international standards, and best practices that introduced stricter governance standards, capital and liquidity requirements, and financial reporting and auditing obligations. According to the Central Bank, with the banking sector comprising 61.5% of the total assets of the financial sector, these reforms aim to ensure the safety and soundness of banks, protect depositors, facilitate access to foreign funding and support global expansion, the regulator noted.
Bingumal Thewarathanthri, Chief Executive of Standard Chartered Sri Lanka and the Chairman of the Sri Lanka Banks Association, joined Ruvini Fernando, Head of Strategy, Risk and Transactions of Deloitte Sri Lanka and the Maldives, and Malinda Boyagoda, Partner, Audit and Assurance and Industry Leader for Financial Services of Deloitte Sri Lanka and the Maldives to dissect the new banking code and discuss the implications for the banking sector, investors, borrowers and the economy.
How does the new Act change the landscape for bank shareholders and owners?
Malinda: Shareholding and ownership are key areas where there are changes in the new Act. What comes into the forefront is the definition of ‘material interest’. Previously, the Act had reservations about ownership in quantitative measures where a person or a party could only have a shareholding that represents a 10% voting right in a bank. The new Act broadens the definition of material interest. In addition to the quantitative definition of 10% voting rights, if a person or a party has the right or ability to nominate, or appoint a Chief Executive or directors of a bank or have the ability to control the operating policies, then such parties are also termed as having material interest. You cannot acquire a material interest unless approved by the central bank.
As a banking Chief Executive, your focus likely gravitates towards compliance and governance. How will the new Act impact your role and the work you do in the bank?
Bingumal: For nearly 40 years, we have been operating under the 1988 Banking Act, which was quite forward-thinking at the time. There were some amendments in 2006, but since then, we have seen no significant changes, even after the global financial crisis and the introduction of the Basel frameworks. I believe it is high time we updated the banking legislature.
Compliance costs are a significant factor, but they are unavoidable. Banks face substantial compliance expenses due to financial crimes, cybercrimes, and other risks. With the new Act, we are focusing on the framework and monitoring, including related party monitoring (RPM) and oversight of key management personnel. New criteria will require better experience and qualifications, and the Central Bank will ultimately decide on key appointments.
Finding and compensating qualified individuals with the right level of experience will introduce additional costs, similar to more mature markets.
The biggest challenge, however, will be managing costs related to capital, liquidity, and governance, which are central themes of the Act’s large exposure policy. For instance, the single borrower lending (SBL) limit is reduced from 30% of total capital to 25% of Tier I capital. In some cases, this could decrease the SBL limit by 20% to 40% for many banks—a significant change.
Another notable adjustment is the clients contributing to large exposures. Currently, clients with exposure of 15% of the core capital will come down to 10% with the new act. Aggregation of these clients should be within 55% of the total borrowing of a bank. Additionally, the Act addresses subsidiaries, holding company structures, directors, and their involvement. This means that banks will need to reconsider their current capital structures, likely increasing their reliance on Tier II capital and needing to raise more Tier I capital, which comes with its costs. With rising capital costs, particularly due to increasing US interest rates, there is hope that costs will decrease in emerging markets by the end of next year with an easing cycle.
Starting January 2026, compliance monitoring will begin, with full compliance required by the end of 2028. This timeline gives banks some room to bring in new capital and manage their SBLs.
Another critical aspect is attracting foreign capital, which demands a return on tangible equity (ROTE) of 18-20%. Currently, the industry return on equity (ROE) is about 13-14%. Foreign investors entering emerging markets expect a high ROTE. Globally, banks like Standard Chartered aim for a tangible equity return of around 12%, but we have delivered over 14%. The Sri Lankan banking sector should target at least a 15% ROTE, ideally 18%, to attract capital. Achieving this will require being lean and efficient, keeping the cost-to-income ratio low. The path is challenging, but I believe it is the right direction. There will be difficulties, but we will move forward.
How do you think banks will strategically approach these new regulations? Will they need a fundamental shift in business models to adapt to these changes?
Ruvini: This brings us to a pivotal moment for most banks, as these changes significantly alter their operational landscape. Traditionally, banks have relied on key customers to whom they have consistently lent and with whom they have cultivated stable relationships. However, the new regulatory norms will restrict this approach. Banks must diversify their customer base and increase their capital, which presents new challenges.
This shift means stepping out of their comfort zones and exploring new business areas. Additionally, banks must offer alternative, fee-based services such as advisory roles in raising capital. Building a new customer base will also involve targeting the underbanked, and those segments of the population with lower creditworthiness. This will require innovative solutions and will inevitably incur additional costs due to the need to process a higher volume of transactions of lower value which are more dispersed.
Leveraging technology to manage internal operations and monitor customer performance more effectively can help reduce overall operating costs, allowing banks to adapt to these new demands more efficiently.
How will lending decisions at banks be affected, particularly regarding large corporates? What are the implications for the corporates that have been long-time borrowers from these banks, and how will banks redefine these existing relationships?
Bingumal: We will have to work with limited capital, which means making some tough decisions. Banks may shift from focusing on portfolio-led returns to prioritizing client-led or even transactional-level returns. When engaging in transactions, particularly term transactions, a significant amount of capital is required. If these transactions are not secured, the risk becomes even greater. Therefore, assessing the return on each transaction is something we must incorporate into our lending decisions. Currently, we evaluate relationship returns—if the relationship is profitable, we consider it satisfactory.
However, the challenge arises when a client shifts short-term loans, cash management and FX transactions to another institution. If we have not priced our long-term loans correctly, we could yield low returns from a major client. This is particularly important when dealing with large clients because, with limited capital, what we offer and at what price will be a crucial discussion. This concept is known as RORWA—Return on Risk-Weighted Assets. We evaluate the risk weight of every transaction, and while this is already in the system and considered by all banks, there will now be much stricter controls. Credit committees will also closely scrutinize these factors.
Unfortunately, some large corporations may need to diversify their banking relationships and work with four or five different banks, as there will be a lending cap that banks cannot exceed. Another critical factor is that these corporations must access the capital markets to meet their funding needs.
As a Partner in charge of Audit and Assurance at Deloitte, what new challenges or expectations does the new Banking Act introduce for your role and your team?
Malinda: On the financial reporting side, the new regulations impact not only the auditors but also the banks as the preparers of financial statements. Under the new requirement, banks must complete their financial statements and have them audited within two months. While this is not necessarily an issue for most large banks that already meet this timeline, it could pose challenges to some multinational banks where portions of the audit work depend on the work done at the parent company level. These banks might need to work upfront to comply with these new requirements.
Furthermore, there are new requirements for auditor rotation, something not previously seen in the banking sector. While listed companies have had regulations on partner rotation, we have not seen mandates for audit firm rotation in this country until now. The Banking Act introduces this change with an aggressive timeline: audit firms must rotate every six years, and audit partners must rotate every three years. In comparison, EU or UK regulations require a tender every ten years and mandatory firm rotation every 20 years. So, the six-year rotation for audit firms and three-year rotation for partners outlined in the new Act represent much shorter timelines.
In addition to auditor rotation and reporting timelines, the Act imposes specific reporting obligations on auditors. If auditors identify any issues during an audit that could affect the stability of the bank or impact the interests of the deposit holders, they are now explicitly required by law to report these findings to the central bank. This new requirement underscores the increased responsibility placed on auditors to safeguard financial system stability.
Do you anticipate this Act will have broader implications? If so, in what ways might it impact the broader financial industry?
Ruvini: As the banking sector’s ability to meet the economic needs of its bigger corporate clients via large exposures becomes more restricted, we can expect an overflow of demand for capital into other areas, such as the capital markets. For a long time, our capital markets have not reached their full potential. For example, our stock market represents only a small fraction of the GDP, and our debt markets are largely inactive, with little to no trading in the secondary debt market. However, we are now approaching a stage where we will likely see increased activity in the capital markets, both in debt and equity as the larger corporates will mobilize more capital through alternate sources.
Additionally, other forms of funding via collective investment schemes like private equity funds, and venture capital funds, are relevant to businesses at various stages of their lifecycles. In Sri Lanka, these instruments and investment vehicles have developed over time. However, with the increasing need for diverse financial solutions, there will likely be a greater demand for these options. Fortunately, we already have a reasonably solid regulatory framework in place to support the operation of most of these investment vehicles, although their attractiveness to investors must be closely evaluated.
How do the recent changes in Sri Lanka’s Banking Act compare to best practices in more developed markets? Do you believe these changes are appropriate for a country at Sri Lanka’s current stage of development?
Bingumal: This topic is certainly open to debate. The reality is that large exposure policies are quite common in many markets. There are only one or two markets within our Asian footprint that do not have such policies. I believe we are a bit late in implementing these measures. The question now is whether the timing is appropriate. As we are emerging from a crisis, there has been adequate time provided—we have three more years to adjust. This period allows us to develop the capital market further and to seek additional capital, both for banks and for corporations.
Regarding related party transactions (RPTs), particularly concerning independent common directors of companies and their exposures, the real challenge in Sri Lanka is its small scale. All exposures, including those of companies, will need to undergo a separate review, and there will be collateral requirements as specified by regulators. This represents a new challenge for us, although it’s common in many markets, especially in developed economies.
The main issue we face is the limited pool of resources for bank and corporate boards in Sri Lanka, and everything is interconnected. Corporates own banks, banks have exposure to these corporates, and there are downstream and upstream operations, with buying and selling occurring under subsidiary structures. This interconnectedness will challenge compliance with related party policies, influencing lending practices, and managing conflicts of interest.
What are the practical implications likely to be? Will banks remove some directors because it’s more prudent than requiring those companies to provide new collateral? How do you think this situation will unfold?
Malinda: That’s the interesting part. The challenges facing the banking sector and corporates due to these new regulations are palpable. In addition to related parties, the Act addresses borrowing by a group of connected parties. Previously, the focus was primarily on single borrower limits (SBLs) for specific individuals or corporations, as well as their related parties.
Now, the definition has been expanded to include connected parties. If you’re a group of companies, all subsidiaries, associates, sister companies as well as individuals and close relations having material interests in such companies are considered together when determining single exposure limits. Also, the concept, known as economic interdependence, wasn’t previously addressed. For example, if 90% of a company’s sales are to a particular entity, then that company is economically dependent on that other entity. Under the new rules, these two companies could be considered together when assessing large exposures.
The Act addresses issues based on substance rather than being confined to a specific formula or rule, and this approach allows the central bank to assess situations in multiple ways. If they determine that parties are connected—whether legally or substantively—they have the authority to combine those borrowings and classify it as a large exposure. This will create additional challenges and affect the groups and parties to whom banks can lend.
To the best of your knowledge, how do regulators in other markets enforce the concept of economic interdependence? Are there specific strategies or frameworks they use to manage and monitor these relationships effectively?
Bingumal: They will examine the board of directors and their exposures, including the exposures of existing investors, the entities they are exposed to, and their related parties, including holding companies. While there may be caps on these exposures, this level of scrutiny is quite common in many mature markets.
However, the extent to which this will be monitored, whether they will identify a company that exceeds these limits and then allow time for remediation, remains to be seen. We also need to recognize that the regulator is assuming a significant amount of authority under this Act.
You mentioned the timeframe thresholds for compliance. Do these also apply to the regulations around economic interdependence, or is that still uncertain at this point?
Bingumal: There is still much uncertainty regarding what these changes will mean for the banking sector. This specifically relates to the large exposure policy, which limits 25% of Tier I capital. How the 25% and 10% thresholds are applied, especially concerning related parties, economic interdependence, and interconnectivity, is something we’ll need to wait and see how regulators approach.
There are also questions about the types of security that will be required. Will they require cash security and immovable property, or would a corporate guarantee suffice? Even with corporate guarantees, there’s the question of whether corporate security can effectively provide one. These are all issues that need further discussion and clarification. CBSL has engaged the banks to come up with a framework that will work for the industry.
We’ve discussed the potential changes in lending to large corporates and the impact on Sri Lanka’s capital markets, which haven’t been a strong funding source. What about other sectors, like SMEs and consumer lending? What are the likely implications of the new Banking Act on banks’ relationships with SMEs and their lending practices for mortgages, credit cards, and other consumer loans?
Ruvini: Banks must find new ways to increase lending to SMEs, requiring a shift in how they conduct their business. Currently, banks rely heavily on collateral, but moving into the SME market means that this comfort will no longer be available. They will need to develop more innovative ways to lend to SMEs, whose ability to repay can be unpredictable due to their exposure to greater volatility and market fluctuations.
Banks should consider the ups and downs that SMEs experience and the need to support them in growing to the next level. To do this, banks must make a concerted effort to understand their new customer base, especially SMEs, as their ability to grow will depend on successfully serving this segment. Only if the SME sector grows can banks potentially increase their lending to larger corporations in parallel.
For retail customers, banks must offer more innovative financial products that provide better access to faster services. It’s not just about physical access anymore; digital access is also crucial, which will require investment. Banks must ensure their service levels and monitoring mechanisms are up to date because, without collateral, they need to understand how retail customers and SME businesses will generate cash flow and how their performance can be monitored to ensure loan recovery. This shift presents numerous management challenges and requires new investments, and mindset changes on how banks sell products, service their clients and ensure recovery.
If banks need to rebalance their portfolios by increasing their exposure to SMEs and consumer lending, what will be the implications for their capital requirements?
Bingumal: The real challenge for banks will be operating with limited capital. We will be compelled to focus more on SMEs and personal financing. Currently, we operate with a large brick-and-mortar structure, with branches where SME clients are treated almost like mini-corporates. However, this approach is becoming less feasible because the transaction sizes for SMEs are relatively small, and even with a 3-4% margin, the profit isn’t substantial.
To address this, leveraging platforms will be crucial. The way we approach SMEs needs to change. For example, we could partner with a platform like Daraz and offer to finance all their suppliers. Similarly, we could approach other multinational or local corporations and offer to finance their suppliers and buyers. This approach would allow us to use data to create a lending model. If a supplier has been in a programme for three years with no defaults, has a good product, and shows low returns, we could quickly approve loans up to around Rs50 million.
This type of data-driven lending needs to become more prevalent. I also agree that decisions should be driven by data, utilizing fewer human resources to make the process more efficient and scalable.
Beyond the cost of implementing new systems and processes, is there also the challenge of higher risk weights for SME lending compared to lending to an AA-rated corporation? If banks shift their portfolios towards SMEs, will they still need additional capital to support this type of lending?
Bingumal: When it comes to personal financing and SMEs, especially with programme lending, the risk weight is generally low. However, the key question is: where will the capital and funding come from? Banks must divest and reinvest to find the necessary resources—there’s no other option. For example, you might sell off 10 of your buildings and use the proceeds to invest in a digital platform. This would enable you to onboard 10,000 clients and grow your asset base to Rs100 billion. This strategic shift is essential because you won’t be able to create space within your existing cost and capital structures.
From a returns standpoint, programme lending can be quite favourable, with relatively low capital consumption for retail lending.
So, beyond being a strategic shift, is this also a mindset change that requires looking beyond brick-and-mortar collateral and reassessing the physical assets in your books, such as buildings? How should boards and strategic management teams adjust their approach to banking in light of this change?
Ruvini: Absolutely, because banking as we know it, is changing. I agree with Bingu on the importance of platform-led lending; this approach will require significant investment in technology and data. You won’t be able to spend much time evaluating a 20–30-million-rupee application. Instead, you’ll need to implement a parameterized standard evaluation process that provides quick answers, as customers increasingly expect faster turnaround times.
According to a regulator, the goal of introducing the new Banking Act is to enhance the risk landscape for the banking and financial sector. Do you believe this objective has been achieved with the new Act?
Malinda: We’ve already discussed several key elements that the Act introduces. One of the main aspects is the single borrower limit, which is designed to reduce the risk associated with lending too much to a single individual or group. We also discussed shareholding, where having one or a few parties exert significant influence over a bank can pose risks. This regulation aims to mitigate such risks by diluting their influence. Additionally, the Act includes various provisions focused on risk management.
The Act empowers the central bank to implement more customized regulations for individual banks rather than applying a blanket approach to the entire banking sector. Based on a bank’s loan book and business model, the central bank can set different capital ratios for each bank. Similarly, when it comes to liquidity, the central bank has the discretion to establish specific rules for a particular bank based on its unique circumstances, rather than enforcing a one-size-fits-all policy across all banks. These measures demonstrate a step in the right direction towards enhancing risk management within the banking sector.
By extension, does the new Act improve financial system stability? If so, does it achieve this at a significant cost?
Bingumal: There is certainly a cost associated with compliance, but is now the right time for these changes? We all agree that we are just emerging from a financial crisis. However, there are transitional provisions and timelines in place for compliance. So, are we moving in the right direction, enhancing risk management, and ensuring financial system stability? The answer is yes—we are achieving that objective.
Sri Lanka has many banks, and there has been a long-standing conversation about consolidation to lower the cost of intermediation. Does the new law favour consolidation?
Bingumal: Regulators will have considerable power to direct certain actions as needed, and I believe they’ll carefully monitor how the large exposure policy impacts banks before making further decisions. As Malinda mentioned, regulators have the authority to set specific requirements. Even foreign banks have included clauses indicating a preference for subsidiarization, which we still lack clarity on. In many mature markets, there is a push towards subsidiarization for better control, but it comes with added costs. Overall, I think these changes are positive, though the timing could be challenging.
Ruvini: I believe we are heading in the right direction. We are broadening the base by increasing access to SMEs, personal financing, and startups. Large conglomerates will turn to the capital markets, which will help the market mature and attract more players. It’s all positive, but we must carefully consider the timing and approach.
Malinda: The Act has also introduced the possibility for a bank to consolidate with a licensed finance company, which was previously not allowed. Before this change, a bank could only merge with or acquire another bank, but not a finance company. This Act permits banks to merge with or acquire finance companies, aiming for greater consolidation within the financial system.
Considering both the positive and negative impacts of the new Act, there may be some negative effects, at least in the short term. In your view, what is the number one downside that banks need to guard against? Additionally, what do you think is the most immediate benefit this Act brings to the stability of Sri Lanka’s financial system?
Malinda: I think the timing and the associated costs are the main downsides to these changes. However, the key advantage in the long run will be the financial system stability they help to ensure.
Ruvini: The timeframe is a significant challenge. Banks will need to undertake substantial internal alignment to meet these deadlines, and the effort required will depend on how quickly bank boards and management can respond. On the positive side, I advocate broadening our base by focusing more on SMEs and personalized lending. There has also been discussion about establishing a credit guarantee institution, which could encourage lending to smaller customers by mitigating risks. This is a positive step in the right direction, as it could help banks adapt more quickly to these changes.
Bingumal: There’s more upside because these changes will enhance governance. While the timing and process can be debated, another important aspect is that this will encourage capital market behaviour, which we expect to see over the next couple of years. With new Tier I capital, rights issues, and foreign investors entering the market, Sri Lankan banks will gain more recognition, which is a significant positive.
I don’t see a major downside in terms of implementation. My main concern is on connected parties. In the short term, we might have a shortage of qualified independent board members for banks because we have a relatively small pool of professionals in Sri Lanka. You could be an independent director of a corporate board and serve on a bank board. If that corporation is required to provide collateral simply because you’re an independent director at a bank, it becomes a significant issue for that director.
However, as the market evolves and more professionals could serve on boards, this should change. Overall, it’s a good outcome for the long term.