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by Gamini Warushamana

The Central Bank (CB) last week after a prolonged silence accepted that the dominance among Financial Institutions (FIs) of a few large players leads to an imbalance in financial markets and create operational risks in the financial sector in the country. This follows the Commercial Bank shareholding crisis in October last year.

The Central Bank in its 2005 Financial Stability Report (FSR) recognised the issue as the first which is posing an operational risk in the financial sector in the country. When business tycoon Harry Jayawardana's shareholdings in Commercial Bank increased to 40%, banking sector trade unions pointed out the risk faced by the banking system and called upon the CB and the Monetary Board to take urgent action to reduce his shareholdings to 10% to comply with the Banking Act.

The report pointed out that an adverse implication could arise from the concentration of share ownership in the financial sector. Related issues of corporate governance of financial institutions are the priority issues which will be addressed by the regulators but no mention had been made for remedies or corrective measures.

The report said that market risk has been minimised by appropriate measures taken by FIs responding to CB directives and added that market and operational risks exist in two areas. The second area is the small corporate sector in the country and visibility of ownership concentration, including the financial sector.

FSR said that overall, there is no serious threat to financial stability in Sri Lanka. However, the report stressed that unhealthy practices by players in the financial sector needs to be curbed.

Non-performing loans (NPLs) ratio has fallen and provisioning for bad and doubtful loans and further capital enhancement have improved in the recent past. Therefore, despite high growth in credit from the banking sector, there is no credit risk from financial institutions, the report said. The impact of the tsunami on credit risk has also been manageable.

The report, however, warns that current practices adopted by some financial institutions such as rescheduling loans, to avoid exposing a deterioration in the quality of loans is not healthy, as it serves to expose the risk rather than address the problem. If this continues on a large scale, it could pose a threat to financial stability, the report said.

All categories of FIs maintain liquidity ratios above the required minimum and hence the liquidity risk in the financial system is minimum. Limitation in existing legislation, particularly in the context of technological advancement and automation, small size of the corporate sector in the country and related shareholding issues have been recognised by the report as financial infrastructure limitations that have to be addressed.

The report recognised external factors that pose a threat to the financial stability in the country. The impact of high oil prices on foreign reserves, foreign borrowing, debt stocks, inflation and growth is on the top. The report said that this could lead to a decline in profitability in the corporate sector, high cost of production, fall in domestic growth and finally this would affect the repayment capacity of borrowers.

High global inflation as a result of high oil prices, and inflationary pressure is another factor which affects financial stability.

The US current account deficit is another factor which poses a threat on the global financial system. If the source of financing from Asia and Middle East declines, this could lead to a higher US interest rate or greater exchange rate. It could affect US output as well as demand and hence reduce export demand, which could hit Sri Lanka's exports.

The GSP+ facility from the European Union and restriction of Chinese exports in major Sri Lankan markets would ease the challenges on Sri Lanka's exports and therefore the potential risk to financial stability from these sources is somewhat low, the report said.

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