New regulations being discussed for Sri Lanka's non-bank financial institutions

The NBFI segment is a small part of the financial sector overall, representing just 8% of total deposits. However, it has been an area of concern in recent years. The stability of some of these institutions has been brought into question, and considerable thought has been given to how to regulate NBFIs. No final solution has been developed thus far, and the regulation remains a work in progress.

Early Regulation

The Finance Companies Act was first passed in 1988. The act required capital of LKR5m ($36,000) for NBFIs, but it was otherwise a general document that allowed for various restrictions and regulations as the authorities saw fit. The act was amended in 1991, clarifying offences and adding a requirement that finance companies accept a director from the central bank on their boards. In the 1980s and 1990s the country faced some troubles with NBFIs, with a total of 13 collapsing. There have been few failures in recent years, but some have been dramatic and brought into question the quality of supervision. During the fall of Central Investments and Finance, a finance company run as a Ponzi scheme even though it was registered with the Central Bank of Sri Lanka, depositors were left without savings and fears of a wider panic spread.

The central bank does not guarantee the deposits of finance companies. A presidential commission set up after NBFI failures in 2008 called for depositor insurance, though an official report was never published. Efforts have been made to reform the sector, and a new Finance Business Act was passed in 2011. Rather than simply amending the existing law, the government decided to enact an entirely new law. It believed fresh legislation would send a strong signal to the market and ensure that the segment was aware of the changes. More importantly, the new act defined what counted as deposits, which was lacking under the old law. It also clearly made it an offence to take deposits without proper authorisation. The word finance, financing or financial must now be in the company’s name, while other establishments are prohibited from using those words in their names. The new law also gave the government considerable power to deal with errant institutions and individuals.

Critics

The reforms were not popular and have been overtaken by events, as a new Sri Lankan government was elected and policies have been greatly altered as a result. Some critics have questioned the Finance Business Act of 2011, saying it raises serious constitutional issues. For example, speaking in early 2014 at a seminar organised by consultancy firm Consultants21, attorney K Kanang-Isvaran said the act allows the central bank to seize the passports of an NBFI’s manager should there be an investigation into that institution, which he called a violation of due process. The panel at the 2014 seminar also suggested the central bank has done a poor job of managing the NBFI segment, that depositors have trouble getting to their funds following a failure, that fit and proper rules need to be properly applied, and that merging poorly run companies with others is not the answer.

Other Plans

NBFIs were also central to the prior government’s banking sector consolidation plan, which was proposed under former President Mahinda Rajapaksa in 2014. The central bank was especially interested in consolidation of the NBFI subsector. If the plan had been carried out, the number of these institutions would have been greatly reduced. The goal was to have a total of 20 institutions, down from the 56, three of which were to be focused on microfinance. An estimated 90% of the segment’s assets are held by 20 companies, according to the central bank. Each institution would have been required to have more than LKR20bn ($144m) in assets.

The goal was not only to have fewer NBFIs, but also to have institutions that are compliant with central bank regulations. Smaller NBFIs were to merge with larger NBFIs or with banks, with the central bank offering support if capital was needed to absorb the smaller institution. The authorities also said they wanted to see an increasing role for foreign banks in the economy. The consolidation programme also called for an increase in minimum capital to LKR1bn ($7.2m) by January 2016 and then to LKR1.5bn ($10.8m) by January 2018. Specialised leasing companies were to increase their capital to LKR300m ($2.2m) by 2016. However, the consolidation master plan has been called off under the administration of President Maithripala Sirisena in favour of a more organic, gradual change via market forces.

Niche Operation

Finance companies fall under a particular niche in Sri Lankan financial services, serving the unbanked population through a higher interest rate regime. “NBFIs do largely gut-based lending, making assessments without proper documentation and incurring much more risk,” DP Kumarage, CEO of People’s Leasing and Finance, told OBG. “But in this sense, they are more hands on, often visiting people’s workshops and houses.” This requires a number of different strategies in assessing the ability of clients to pay. Roshan Egodage, CEO of Commercial Credit, told OBG, “Dealing with higher-risk clients comes down to the superior models you use to identify that risk. Branch managers must be empowered and well-qualified, and systems must be in place that quickly identify when things go wrong.”

Another major issue has been the competition created by more banks entering the leasing field. At a February 2014 seminar Ranjith Fernando, former CEO of NDB Bank, said a number of licensed commercial banks entered that segment as a way to maintain their margins, but as a result finance firm have had to compete for deposits to keep their cost of funds low. This has led to increasing instability. Fernando added that the regulators need to start to take a closer look at finance companies and begin to apply risk-based supervision. “Banks are fighting to increase profit, so commercial banks are now moving into leasing and our car business is now moving to the banks,” Nalin Wijekoon, CEO of Softlogic Finance, told OBG. “They have more attractive rates because their cost of funds is lower. So in the last few years, non-performing loans have increased. Profit is increasing, but the risk is higher. Finance companies are moving to different businesses – microcredit, gold loans and working capital loans.”

Microfinance is also a growing business for many NBFIs, though it remains unregulated by the central bank. Attempts have been made to put regulation in place since 2006, introducing a supervising authority for the 20,000 microfinance institutions nationwide. As it stands, there is sometimes a disparity in how different companies operate, and, without a credit reference system for the micro-, small- and medium-sized enterprises sector, consumers can take out multiple loans from different institutions and quickly become overburdened. The industry is looking to develop a credit information database for their clientele.

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The Report: Sri Lanka 2016

Banking chapter from The Report: Sri Lanka 2016