Severe challenges to the financial sector in 2023: Central Bank

Sri Lanka’s financial sector, which experienced an unprecedented array of challenges in the aftermath of the economic crisis, continued to operate under challenging conditions in 2023, the Central Bank said on Friday.

Releasing its Financial Stability Review (FSR) of 2023, it said the overall economic contraction during the nine months ending September 2023 coupled with tax hikes aimed at supporting fiscal consolidation; and elevated price levels and interest rates resulted in strained balance sheets of economic agents.

Accordingly, financial intermediation1 witnessed a considerable decline reflecting the subdued demand and supply conditions for credit amidst a considerable deterioration in credit quality.

Here are excerpts from the report:

Financial sector exposure to the Government continued to increase amidst the fall in overall credit growth, highlighting imbalances that pose challenges to the financial sector. While the approval of International Monetary Fund’s Extended Fund Facility in March 2023 brought in confidence, ensuing developments such as uncertainties about the sovereign debt restructuring process and the results of the bank diagnostics exercise raised some concerns on the sector.

With these developments, financial markets which witnessed extreme turbulence in 2022 demonstrated signs of stabilisation. Financial market’s stress as indicated by the Financial Stress Index remained broadly at low levels in the first ten months of 2023 as overall market conditions significantly eased compared to 2022.

The banking sector, which was adversely affected by the spillover effects of the recent economic crisis, continued to operate amidst challenging conditions while some signs of improvement were observed during the year ending Q3 of 2023.

Credit concentration risks persisted within the banking sector with some high credit concentration on certain sectors, namely, construction and agriculture, posing higher vulnerabilities due to economic and climate related issues. In addition, the high exposure of the banking sector to the sovereign posed concerns for the sector, which necessitated the exclusion of banking sector investments in Treasury bonds from the restructuring perimeter.

Several banks including two Domestic Systemically Important Banks (D-SIBs) reported a decline in profits during the period. The loans and advances portfolio of the Licensed Finance Companies (LFCs) sector contracted significantly during the year ending Q3 of 2023, particularly due to the restrictions on vehicle imports which affected leasing and hire purchase activities. Amidst the decline in the core business, the LFCs sector diversified its activities particularly towards pawning/gold loan facilities which heightened the sector’s risk to fluctuations in global gold prices.

The strained balance sheets of the household and the corporate sectors in the backdrop of the severe economic crisis which resulted in an erosion of real income levels amidst elevated price levels, hindered the debt repayment capacities of households and corporates. Household and the corporate sectors, which account for a significant share of financial consumers within the economy, witnessed a deterioration in credit quality during the period under review, highlighting concerns for the financial sector.