The Sri Lankan banking sector faces a critical juncture as the country moves toward completing its debt restructuring. A healthy banking industry needs a stable sovereign, and why the new government must pursue reforms because the government debt-to-GDP ratio will remain high, declining only gradually to 103% by 2028 from 116% in 2022, even with successful debt restructuring.
According to a November 2024 statement by Fitch Ratings, banking exposure to government securities and loans to state-owned enterprises (SOEs)—33.4% of assets in local currency and 3.4% in foreign currency—leaves it vulnerable to fluctuations in sovereign financial health.
Larger banks, particularly the state-owned Domestically Systemically Important Banks (D-SIBs), hold substantial amounts of government and SOE debt, amplifying their risk. Adhering to fiscal reforms would help mitigate these risks by bolstering state creditworthiness and enabling the banking sector to perform its critical economic functions effectively.
Banks act as intermediaries that channel savings into productive investments, provide credit to businesses, and facilitate trade and consumption. Their ability to operate efficiently depends on the financial health of the government. Without fiscal stability, banks face higher non-performing loans (NPLs), reduced access to foreign funding, and increased systemic risks. The fiscal consolidation measures, structural reforms, and debt restructuring framework under the IMF programme aim to restore macroeconomic stability, providing the banking sector with the foundation to bolster economic recovery and growth.
The September 2024 agreement between Sri Lanka and international bondholders, which aligns with the IMF programme, represents a significant step toward restoring investor confidence. Fitch notes that the new government is committed to these agreements, mitigating risks of policy reversals or delays in debt restructuring. Consultations between the Ministry of Finance, the IMF, and the Official Creditor Committee in October 2024 confirmed adherence to principles of equitable treatment for creditors, a move Fitch views as critical to completing the restructuring process. A successful outcome for Sri Lanka could lift the Long-Term Foreign-Currency Issuer Default Rating (IDR) from its current RD (Restricted Default) status, improving access to international capital markets.
Economic recovery, supported by the IMF programme, has already begun to ease pressures on banks. Real GDP grew by 5% in the first half of 2024, compared to a 7.3% contraction during the same period in 2023. Revenue-raising measures implemented since 2022 increased government revenue collection by 43% year-on-year during the first seven months of 2024. This fiscal improvement has strengthened borrower repayment capacity, reducing NPL pressures on banks. According to the Central Bank of Sri Lanka, the NPL ratio declined to 12.8% in the second quarter of 2024, down from 13.5% a year earlier. Provisioning improved, with the coverage ratio rising to 51.1% from 44.8%, enabling banks to absorb potential losses more effectively.
The ability of banks to fund businesses and households depends on a stable economic environment. The debt restructuring framework addresses local and foreign currency obligations, reducing systemic risks for banks while improving their liquidity and credit quality. Fitch projects that enhanced sovereign creditworthiness would enable banks to regain access to foreign-currency wholesale funding hitherto constrained during the crisis. This access is essential for maintaining adequate capital to meet the credit demands of businesses and individuals, which fuels economic activity and job creation.
Challenges, however, persist. The gross general government debt-to-GDP ratio will remain high, declining only gradually to 103% by 2028 from 116% in 2022, even with successful debt restructuring.
Political uncertainty further complicates the recovery with uncertainty around the new administration and its capacity and inclination to implement reforms. While the IMF programme offers flexibility in fiscal adjustments, economists in Sri Lanka caution that maintaining adherence to its structural reform agenda is essential for stabilizing the economy.
The banking sector’s role as a financial intermediary makes its stability vital for sustaining economic growth. As the economy progresses in its recovery, the Central Bank Financial Stability Review 2024 noted that enhanced provisioning, strategic credit allocation, and prudent risk management will be essential to fortify the banking industry against prevailing and emerging challenges while balancing financial stability with the need to foster economic resilience.
The Financial Stability Review 2024 provided a detailed analysis of the banking sector and its challenges as of the second quarter. The Banking Soundness Index (BSI) reflected improving liquidity, profitability, capital adequacy, asset quality, and resilience to market risks. However, the BSI remained below 100, highlighting the lingering difficulties faced by the sector. Efficiency, a key sub-index, deteriorated due to rising operating expenses, the Central Bank noted.
The easing of inflation expectations and macroeconomic stabilization spurred a 4.8% expansion in credit during the first half of 2024 to Rs508.8 billion. Rupee-denominated credit drove this growth, accounting for 97.1% of the increase, while foreign currency-denominated credit grew marginally, primarily due to lending to overseas entities. Domestically Systemically Important Banks (DSIBs) are responsible for 76.7% of the total credit expansion. Other domestic and foreign banks also reported increases due to declining market interest rates and rising loan demand.
Banking non-performing loans (NPLs) saw modest improvement, with the NPL ratio decreasing to 12.8% in the second quarter of 2024, down from 13.5% a year earlier. This reduction, coupled with a contraction in overall NPLs by 2.2%, reflects a stabilization in asset quality. However, the NPL ratio remains elevated compared to global benchmarks. DSIBs and foreign banks reported reductions in NPL ratios, while other domestic banks saw an increase.
Banks reinforced business revival units to address the credit risk, following Central Bank guidelines to assist viable but financially distressed borrowers. Provisions for NPLs also improved, with the provision coverage ratio rising to 51.1% in the second quarter, up from 44.8% a year earlier, indicating solid buffers against potential losses.
The report also highlighted the strengthening capital base of banks. Common Equity Tier-1 (CET-1) capital grew by 13.1%, while net NPLs contracted by 13.7%, reducing the Net NPLs to CET-1 capital ratio to 50.8% from 66.5% a year ago. This improvement enhances the ability of banks to absorb credit losses and reinforces its financial stability, the Central Bank said.
Credit concentration shifted over the period, driven by significant structural changes. The transfer of debt related to a state-owned enterprise (SOE) to the Ministry of Finance reduced credit exposure to infrastructure projects. Meanwhile, credit to consumption, trade, manufacturing, and agriculture increased. Consumption loans, the largest credit segment, grew by 10.7%, led by a sharp rise in pawning activities, which expanded by 48.3% following the imposition of a maximum lending rate on such facilities. NPLs in consumption loans declined by 2.8%, lowering the default risk for this segment.
Despite these improvements, challenges remain. Sectors such as tourism, construction, and agriculture reported high NPL ratios. Tourism, though recovering, recorded a significant 40% NPL ratio, indicating continued vulnerabilities. The construction sector, representing 14.1% of total credit, experienced an 8.2% contraction, driven by residential construction, which faced economic headwinds. Nevertheless, declining costs of construction materials and improved economic activity will support recovery in this sector. Similarly, the agriculture sector, comprising 8.4% of total credit, faces risks from climate-related disruptions despite a decline in its NPL ratio.
The banking exposure to sovereign risk grew significantly during this period. Investments in rupee-denominated government securities increased by Rs1.2 trillion, raising sovereign exposure to 45.7% of total assets. The restructuring of SOE balance sheets and the absorption of debt by the Ministry of Finance played a pivotal role in this increase. The sector also completed divestments in Sri Lanka Development Bonds under the Domestic Debt Optimization (DDO) programme, reducing sovereign exposure by Rs225.1 billion. Significant exposures, primarily concentrated among DSIBs, represented 198.9% of the Tier-1 capital, pointing to the systemic risks tied to sovereign and corporate debt.
Private sector credit recovered moderately, accounting for 45.2% of the total.
Non-financial corporations (NFCs) and small and medium enterprises (SMEs) continued to face high NPL ratios of 16.9% and 21.9%, respectively, reflecting ongoing difficulties in critical economic sectors. In contrast, individual borrowers, representing 34.1% of total credit, exhibited a much lower NPL ratio of 7.6%.
The Central Bank emphasized the need for continued vigilance in risk management. It cautioned against moral hazards if the government suspends parate executions, which could incentivize defaults. Parate execution allows banks to recover outstanding loans by directly seizing and selling collateral without requiring a court order. Furthermore, the report urged banks to address concentration risks associated with significant exposures and systemic vulnerabilities tied to sovereign debt.
The new government faces a choice with far-reaching implications. It wants to increase the income tax threshold and reduce rates. However, it will have to raise non-direct taxes like VAT or Customs duties or cut expenditure, and restructure state-owned enterprises to stay within the IMF programme parameters and sustain the recovery while laying the groundwork for sustained economic growth. The Central Bank Financial Stability Review 2024 noted that enhanced provisioning, prudent risk management, and strategic credit allocation will be essential to fortify the banking industry against prevailing challenges.
Failure to adhere to the IMF parameters risks derailing the recovery, undermining investor confidence, and compounding systemic vulnerabilities within the banking sector. Conversely, by committing to fiscal discipline, structural reforms, and debt restructuring, the government can enable banks to fulfil their critical role as engines of growth, ensuring the recovery benefits the broader economy.
The economic recovery depends on aligning policy priorities with long-term fiscal and financial stability. Banking sector stability, deeply intertwined with sovereign health, will remain a cornerstone of this recovery. Ensuring that banks can support businesses and households is not just a financial imperative but a broader economic necessity that will shape economic progress.