SL’s financial system poised for recovery with asset quality gains, stronger capital buffers

• CBSL asserts the financial sector needs to continuously strive towards assuring financial stability in the medium to long term
• Notes demand for financial services is set to grow, driven by stable prices and enhanced financial intermediation
• Stresses that as credit expands into the private sector, financial institutions will need to manage pressures on credit quality and capital adequacy

Sri Lanka’s financial system is poised for improvement, with asset quality expected to rise and capital buffers to strengthen, while risks are prudently managed, the Central Bank of Sri Lanka (CBSL) said in its Financial Stability Review 2024. 

The report comes as the economy stabilises despite ongoing challenges. The crisis caused deep macrofinancial imbalances, but these are gradually being corrected through policy measures, reforms, and behavioural responses, supporting financial system stability.

“While the progress of the financial sector thus far while managing the spillovers from the economic crisis has been commendable, the sector needs to continuously strive towards assuring financial stability in the medium to long term,” the CBSL said.

With the economy improving, demand for financial services is set to grow, driven by stable prices and enhanced financial intermediation. However, as credit expands into the private sector, financial institutions will need to manage pressures on credit quality and capital adequacy, especially given high non-performing loan (NPL) ratios and caps on large exposures, CBSL cautioned.

Attracting deposits amid low rates remains a challenge, while falling lending rates could squeeze net interest income and profitability. Sovereign exposure, particularly in government securities, which generated significant returns recently, may also decline, the bank warned.

The CBSL added that adjustments in the external and fiscal sectors, including suppressed import demand and delays in meeting sovereign debt obligations, must be handled carefully to ensure financial stability.

Nevertheless, the completion of external debt restructuring will open the door to further external financial resources, albeit prudently.

“Challenges will persist as the benefits experienced through the recovery in macrofinancial conditions, supported by the favourable base effect, diminish,” the CBSL noted, adding that the outlook depends on sustained fiscal consolidation, balanced external demand, and stable prices to foster economic expansion.

With higher risk-taking expected during the credit cycle’s expansion, vulnerabilities may build, underscoring the need for proactive risk management, CBSL said.

As the macroprudential authority, the CBSL, along with the Financial System Oversight Committee, will continue to monitor systemic risks and recommend policy measures to ensure financial stability. It called on all stakeholders to remain committed to timely, well-sequenced reforms for sustained stability.