Sri Lanka - Financial Sector Reforms

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 17236-CE SRI LANKA FINANCIAL SECTOR REFORMS July 31, 1998 Finance and PSD Sector Unit South Asia Region FILE COPY This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY AND EQUIVALENT UNITS Currency Unit = Sri Lankani Rupees (Rs) US$1.00 = Rs 60.00 WEIGHTS AND MEASURES Metric System ABBREVIATIONS ADB Asian Development Bank BOC Bank of Ceylon CBSL Central Bank of Sri Lanka CDS Central Depository System CSE Colombo Stock Exchange DFCC Development Finance Corporation of Ceylon DFI Development Finance Institution EPF Employees' Provident Fund ESOP Employee Stock Option Plan ETF Employees' Trust Fund FC Finance Company GDP Gross Domestic Product GOSL Government of Sri Lanka ICICI Industrial Credit and Investment Corporation of India IDA International Development Association IMF International Monetary Fund MCB Monetary Control Board MOF Ministry of Finance NBFI Non-Bank Financial Institution NDB National Development Bank NIC National Insurance Corporation NPL Non-Performing Loan NSB National Savings Bank PB People's Bank PCB Private Commercial Bank PERC Public Enterprise Reform Commission RDB Regional Development Bank RRDB Regional Rural Development Bank SCB State Commercial Bank SEC Securities and Exchange Commission of Sri Lanka SIERA Share Investment External Rupee Accounit SLIC Sri Lanka Insurance Corporation SMIB State Mortgage Bank SOE State-Owned Enterprises SRO Self-Regulating Organizations USAID United States Agency for interniationial Development GOVERNMENT OF SRI LANKA - FISCAL YEAR January I - December 31 Vice President: Ms. Mieko Nishimizu Country Director: Mr. Roberto Bentjerodtl Sector Manager: Ms. Marilou Uy Principal Financial Specialist: Mr. Joseph Pernia J  SRI LANKA FINANCIAL SECTOR REFORMS CONTENTS Page No. I. BACKGROUND .....................................................1 Table 1. 1: M2X/GDP Ratio in South Asian Countries . ...................................... 1 Table I.2: Relative Size of Financial Sector Components .................. ............... 2 Table I.3: Market Capitalization to GDP Ratio in Selected Countries .............. 3 II. PROPOSED REFORM AGENDA .....................................................3 Figure II. 1: Inflation and Average Commercial Bank Lending Rate ................ 5 ANNEXES I. THE BANKING SYSTEM .................................................... 13 A. The Central Bank .................................................... 13 B. Commercial Banks .................................................... 17 Table AI. 1: Comparative Financial Performance ............................................. 19 C. Other Banking Institutions .................................................... 23 D. Banking System Infrastructure .................................................... 27 II. CAPITAL MARKETS .................................................... 34 A. Legal and Regulatory Framework .................................................... 35 B. Institutions .................................................... 38 Table AII. 1: Stock Offerings on the CSE .................................................... 40 Table AII.2: Secondary Market Activity: Key CSE Statistics .......................... 41 C. Money and Bond Markets .................................................... 42 D. The Fund Management Industry .................................................... 43 E. Foreign Portfolio Investment and Participation ................................................ 44 F. Recommendations .................................................... 45 This report is based on the findings of a mission which visited Sri Lanka in March 1997. The mission consisted of Messrs. Joseph Pernia (mission leader), Nirnaljit Paul, Rakesh Nangia (SASFP), and Ms. Sriyani Hulugalle (SACCO). Assisting the Bank team were Messrs. Terry Chuppe, Carlo Punsalan and Stanley Silverberg (Consultants).  Page No. III. DEVELOPMENT FINANCE AND CONTRACTUAL SAVINGS INSTITUTIONS .............................. 48 A. Development Finance Institutions ............ ................................ 48 Table AIII. 1: Key Performance Indicators - DFCC .......................................... 49 Table AIII.2: Key Performance Indicators - NDB ............................................ 50 B. Provident and Pension Funds ............................................ 52 Table AIII.3: Coverage of the Employees' Provident Fund ............................. 53 C. Insurance Companies ............................................ 56 ATTACHMENTS Attachment 1.1 Loan Classification and Provisioning .61 Attachment 1.2 Bank Failure Resolution .63 Attachment 1.3 Bank Branch Sales .66 Attachment 1.4 Bank of Ceylon and People's Bank .68 Attachment 1.5 Commercial Banking and Financial Sector Assets .70 Attachment 1.6 Commercial Banks Summary Statistics .71 Attachment 1.7 Private Commercial Banks Financial Statistics 1997 .73 Attachment 1.8 Finance Companies Selected Financial Statistics .75 Attachment 2.1 Money and Bond Markets .76 Attachment 2.2 The Fund Management Industry and Foreign Portfolio Investment .80 Attachment 2.3 Comparative Capital Markets Data .86 Attachment 3.1 Development Finance Corporation of Ceylon .92 Attachment 3.2 National Development Bank .95  SRI LANKA FINANCIAL SECTOR REFORMS I. BACKGROUND 1. In the period from 1989 to 1997, Sri Lanka's financial sector grew annually at 5.9 percent in real terms, reaching 125.4 percent of GDP, while inflation averaged 12.2 percent. National savings, as a percentage of GDP, increased from 14.6 to 21.4 percent. Broad money grew annually at 18 percent, reaching 33 percent of GDP, while nominal GDP grew at 17.1 percent. Thus, the financial sector deepened only slightly. Compared with other countries in the region, Sri Lanka's broad money to GDP ratio was the lowest. (Table I. 1). Table 1.1: M2X/GDP Ratio in South Asian Countries (1996) Pakistan Bangladesh India Nepal SriLanka M2X" (in billions of 976 488 6,233 94 253 National Currency) GDP (in billions of 2,171 1,302 12,770 250 769 National Currency) M2X % of GDP 44 37 49 38 33 M2 plus foreign currency deposits 2. The financial sector comprises diverse institutions. The banking system consists of 2 large state-owned commercial banks, 6 small domestic private banks and 18 foreign commercial bank branches; a National Savings Bank (NSB); 17 regional rural development banks (RRDBs); and a state mortgage bank (SMIB). There are two Development Finance Institutions (DFI) that specialize in term lending. Twenty-four finance companies (FC) provide lease financing and installment credit. There are also 5 leasing companies, 10 merchant banks and 7 venture capital companies. Contractual savings are accounted for mainly by the two government- sponsored provident funds for private sector employees, the Employees' Provident Fund (EPF) and the Employees' Trust Fund (ETF), and six insurance companies. (The government employee pension fund is completely unfunded, and benefits are financed by the general budget.) These institutions mobilize large pools of long-term resources but invest these funds principally in short-term government securities.  -2 - Table 1.2: Relative Size of Financial Sector Components (1997) Financial Sector Total Assets Share Ratio to GDP Components (Rs Billion) (%) (%) Central Bank 183.9 16.5 20.7 Commercial Banks 464.1 41.6 52.1 State-Owned Banks 267.4 24.0 30.0 Private Dom. Banks 138.9 12.4 15.6 Foreign Banks 57.8 5.2 6.5 National Savings Bank 83.8 7.5 9.4 DFIs (DFCC/NDB) 44.4 4.0 5.0 State Mortgage Bank 5.8 0.5 0.7 Finance Companies 22.3 2.0 2.5 EPF/ETF 159.7 14.3 17.9 Insurance Companies 22.8 2.0 2.6 Stock Market 129.4 11.6 14.5 Capitalizationl/ TOTAL1/ 1116.2 100.0 125.4 " There is some double counting due to investments by domestic institutions in the stock market. See Attachment 1.5 for more details. 4. Securities markets have grown rapidly in recent years, but equity markets are still shallow, and currently are in doldrums due to larger economic and political problems. Primary debt markets are at an infant stage, and are dominated by short-term government securities. There is little activity in secondary debt markets due to the captive nature of the main holders of government securities. In the last few years, the government has taken several steps to invigorate the capital markets by modernizing the stock exchange facilities, promoting foreign participation, developing the investment fund industry, enforcing higher disclosure standards, providing tax incentives and promoting investor awareness. During 1997 and early 1998, primary issues of corporate debentures, especially by commercial banks, increased, supplying to the market new instruments for capital mobilization. Despite these actions, the size of Sri Lanka's capital market in relation to GDP remains small (Table I.3).  - 3 - Table 1.3: Market Capitalization to GDP Ratio in Selected Countries: 1990 - 1996 1990 1996 SriLanka 11.4 15.1 India 12.7 36.1 Indonesia 7.6 12.8 Philippines 12.9 37.4 Pakistan 7.0 16.9 Thailand 29.7 12.7 5. Following the findings and recommendations of the Presidential Commission on Finance and Banking in 1991/92, significant reforms in the financial sector have been implemented. These include improved financial disclosure through the adoption of international accounting and auditing standards in banking and capital markets. The ability of banks to recover loans has been strengthened byparate execution powers, which allow banks to recover loan collaterals without resorting to the courts. The government also completed the recapitalization of the two state-owned commercial banks in 1993 and 1996, respectively, but this was done without adequate reform in governance, perhaps missing an opportunity for true structural change. Measures to improve the regulatory, supervisory and institutional infrastructure have helped to establish a world-class stock market in Colombo. The finance company crisis that started in the late 1980s has been stemmed, although the resolution of five failed FCs remains pending. Central bank refinancing of directed credits has been virtually stopped. II. PROPOSED REFORM AGENDA 6. Rationale for Further Reforms. Despite progress to date, the financial system is shallow, with the asset side concentrated in immobilized government securities (38 percent), and the liabilities side in bank deposits (33 percent). Government borrowing dominates the financial markets (Rs. 286 billion), while savers invest mainly in bank deposits (Rs. 248 billion). 7. There are large pockets of inefficiency, as evidenced by high intermediation costs, especially in the state-owned sector. Although declining, the level of non- performing assets is still high, especially in the state-owned sector (10 percent for private banks vs. 19 percent for state-owned banks). These inefficiencies have been at the expense of both depositors and borrowers. The private sector has taken advantage of the protection afforded by the inefficiency of the state-owned sector, and has preferred to enjoy high intermediation spreads rather than compete for market share.  -4 - 8. Dominance by the state sector has also stymied effective competition. Although the share of private institutions in gross financial sector assets has risen from 22 percent in 1989 to 44 percent in 1997, the sector is still dominated by larger and less efficient state-owned institutions. The two state commercial banks (SCBs), Bank of Ceylon (BOC) and People's Bank (PB), account for 57 percent of banking sector assets. The state also dominates the market in life insurance (45 percent), general insurance (60 percent) and pension funds (over 90 percent). 9. Reform Objectives. In view of the above, the goal of financial sector reform should be to achieve a sector that is large enough to mobilize needed capital, both domestic and foreign, and allocate it safely and efficiently to its most productive uses in a predominantly private economy. The government cannot continue to dominate the market if the private sector is to be the principal agent of economic growth. Savers must have a choice of instruments and institutions that can meet their varying risk-reward objectives. Intermediaries must be disciplined through strong corporate governance, market competition, and effective regulation and supervision. Credit discipline among borrowers must be instilled and engendered by appropriate market incentives and effective legal and judicial processes. 10. More specifically, a reform program for Sri Lanka's financial sector should aim to: (a) reduce the crowding out of the private sector through fiscal stabilization and further liberalization of the government debt market; (b) improve the efficiency and health of state-owned financial institutions by reforming governance, preferably through privatization; (c) promote market competition by reducing the dominance of state- owned financial institutions, and encouraging faster growth by private financial institutions and foreign participation; (d) encourage savings by diversifying savings instruments beyond bank deposits to cater to varying savings needs; and (e) achieve more effectively the savings and insurance objectives of the pension system while minimizing labor market distortions and moral hazard.  -5 - 11. Macroeconomic Foundation of Financial Sector Reform. Success in Fig. l-1 Inflation and Average Conmercial financial sector reforms is conditioned on Bank Lending Rate (1EB7) achieving macroeconomic stability. The 3 stability of the financial sector is dependent . on macroeconomic stability. High and T volatile inflation increases the risk for both ' lenders and borrowers and complicates the pricing of financial instruments (Figure o!i ; 11.1). High inflation erodes the return of a C ,,, C LO 0 ,,c fixed income financial instruments, including bank loans, putting pressure on j e WP the profitability of banks and other debt issuers. High and volatile inflation rates cause large swings in relative prices and price uncertainty further distorts the perception of risks. Since uncertainty increases over time, borrowers and lenders shorten their time horizons and prefer short maturity instruments, hindering capital formation. 12. In Sri Lanka, a sustained fiscal disinflation must be the foundation of financial sector reform and development. Persistently large fiscal deficits have also crowded out the private sector. Large pools of savings in the National Saving Bank, the two provident funds, the insurance companies and, the commercial banks and other financial institutions are captured through investment restrictions or high reserve requirements to finance the deficit. Moreover, to control debt service, there is always the pressure to repress interest rates on government debt. Since the cost of repression is borne principally by the financial intermediaries they have passed this on to the private sector both through lower deposit rates and higher lending rates. 13. Real Sector Linkage of Financial Sector Reforms. Enterprise reform, especially of that of state-owned enterprises (SOE), must accompany, if not precede, financial sector reforms to ensure more lasting reforms. Financial institutions merely mirror the conditions of the enterprise sector and the quality of their portfolios depends on the quality of enterprises to which they lend and in which they invest. It is, therefore, essential that a financial sector reform program be accompanied by reforms in the enterprise sector. In Sri Lanka, enterprise reform must focus on the privatization and restructuring program for SOEs. Exit of unviable firms needs to be facilitated by improving the legal and judicial processes for reorganizations and liquidations. Labor market distortions need to be addressed to promote labor mobility. There is also need to review and rationalize the investment incentives structure and pursue liberalization of the trade regime to promote greater efficiency of the private enterprise sector. 14. Improving the Efficiency and Health of the State-Owned Commercial Banks. The main problems relate to the weaker performance and continued dominance of the sector by the two SCBs. The SCBs lack the type of internal governance and self discipline that stockholders, boards of directors and management provide in private  - 6 - institutions. External governance and discipline from the market competition is also weak owing to the SCBs' effective duopoly. 15. The government has tried but largely failed to improve the health and efficiency of the SCBs by recapitalizing them, and setting targets and monitoring their performance more closely. The government believes that the ultimate solution lies in privatization, but that this solution is not feasible in the near-term due to current political constraints. So long as privatization is not yet politically feasible, structural measures would have to be put in place to approximate the corporate governance of private institutions. 16. In essence, these structural measures should include the following: (i) separating the commercial business of state-owned financial institutions from non- commercial activities; (ii) permitting them to undertake the non-commercial operations as "off-balance sheet" activities on the account of the government; (iii) emphasizing efficiency over growth; and (iv) downsizing, or at least, limiting growth to increase the market share of private financial institutions and facilitate eventual privatization. 17. Segregating commercial and non-commercial activities would instill financial discipline as commercial and non-commercial objectives and results are clearly defined ex ante and evaluated ex post, respectively. Failure in one would not be covered by the other. Taking out non-commercial programs from the balance sheet increases transparency since their costs are clearly identified as fiscal costs rather than hidden as quasi-fiscal deficits which eventually will have to be recognized. It promotes also greater accountability and efficiency. In fact, to reduce the fiscal cost of such programs and achieve maximum results it would make sense for the government to competitively bid out management of these programs to both state-owned and private financial institutions. 18. One transparent way of achieving this condition would be through management or governance contracts, preferably the former. Under this approach, the government, as owner, would enter into an agreement that would assure autonomy and authority for the board of directors and management, clarify their mandate and objectives, including clear quantitative goals, and spell out the rewards and penalties for success and failure, respectively. The government is in the process of signing a Memorandum of Understanding (MOU) with the two SCBs to grant more autonomy to their current management. However, it is unlikely that the MOUs would bring about the desired improvement in the performance of the two banks because of the weakness of the present management. 19. Since the state-owned commercial banks are to be privatized eventually, the management or governance contracts should underscore the caretaker nature of management until these institutions are privatized. Management should be mandated to focus on conserving assets, reducing cost, downsizing staff and branches, increasing loan recovery, and limiting lending to high quality loans, such as to the government, the interbank market and blue chip companies. Thus, aside from improving efficiency,  -7 - structural reforms could facilitate privatization, by removing the political and social costs of operating the SCBs, thereby assuring a more transparent privatization process. However, all these measures are a second best solution to the problem of governance. Only genuine privatization will provide the final solution. 20. Promoting Market Competition. Market discipline through competition is weak in Sri Lanka's financial sector due to dominance by state-owned financial institutions in banking, pension funds and insurance. This has been heightened by the Government's regular recapitalization of the SCBs. While the share of the private sector in financial assets has increased from 22 percent in 1989 to 45 percent in 1997, dominance is achieved by the size of the state-owned financial institutions. In banking, the two large state-owned commercial banks are by far bigger than the largest private commercial bank, and together, account for 57 percent of the market. On the other hand, the state-owned financial institutions are less efficient and carry more problem assets than private financial institutions. This is mainly due to government guaranteed loans provided to clients with political clout. Downsizing or, at least, limiting the grow-th of state-owned financial institutions by stressing profitability over growth, and consolidation over expansion would not only engender greater competition and market discipline but also facilitate the privatization of state-owned financial institutions. Smaller but more profitable state-owned financial institutions would be easier to sell, considering the limited capacity of domestic capital markets and foreign investor interest. 21. Another way of promoting the private sector would be to privatize the flow of savings. In banking, through established market presence and wide branch networks, and perhaps the perception of security (explicit deposit insurance in the case of the National Savings Bank), the state-owned banks continue to dominate deposit taking. Thus, without privatization, it will take years before their dominance in the market will decline. The share of the private sector can be expanded by encouraging the private sector to borrow from state-owned banks and lend out these funds. The whole system would benefit as private banks have a better track-record at making good loans, while state-owned banks have the infrastructure to collect deposits. 22. A third approach would be to explicitly downsize the state-owned banks by selling off branches to the private sector. This has to be done in an orderly manner and should be based on a medium-term plan, which is linked to the plan to eventually privatize the banks themselves (Attachment 1.3). 23. Market Integration. Markets provide discipline when integrated and competitive. Liberalization will also improve resource allocation, promote financial intermediation, help reduce the fiscal deficit by containing interest subsidies, and promote transparency and market discipline especially for government borrowing. The main causes of market segmentation have been repression on the rates on government securities, the high reserve requirement for banks to provide a captive market for low- yielding government securities, the captive markets for government debt in the National Savings Bank, the provident funds and insurance companies, the administered deposit  -8 - rates of the National Savings Bank, and interest subsidies for the government credit programs. The key elements needed to achieve greater market integration are the liberalization of the government debt market, and the budgetization of non-commercial government programs. 24. The main financial market instrunent is the Treasury bill (with maturities of 3, 6, and 12 months) auctioned weekly to securities dealers, including the NSB. Liquid asset requirements for banks, finance companies and specialized banks provide a captive market for Treasury bills. Moreover, almost two-thirds of government debt is sold directly to captive investors, principally the NSB, pension funds, and government-owned specialized banks. These are mostly fixed rate, non-marketable, intermediate-term instruments, called "rupee loans". These practices simplify debt management and keep GOSL's borrowing cost artificially low but are highly distortionary and crowd out the private sector. It is recommended that CB SL and GOSL gradually move to more reliance on market-priced government securities and less on captive investors and "rupee loans". The latter should be converted into medium and long-term government securities, with rates tied to those on marketable government securities to reduce market segmentation. 25. The CBSL faces two major constraints to establishing market-deternined interest rates: (i) GOSL securities account for a large share of the domestic debt market, and crowd out private financing; and (ii) significant distortions in financial markets are created because large state-owned financial institutions play a major role in financial markets. The investment policies of NSB and EPF and other state-owned lenders are significantly influenced by GOSL. Similarly, the actions of state-owned banks are influenced by GOSL. 26. Due largely to captive sources of GOSL funds, govermment securities continue to be priced on non-market terms. State-owned financial institutions create market anomalies by setting interest rates based in part on non-commercial criteria. Also, there is little long-term funding available to finance investments. GOSL should encourage the development of long-term debt markets. It could start by improving its financial management through the issuance of long-term bonds instead of merely rolling over short-term securities to finance its development expenditures. If the rates on these bonds are market determined, they could also provide a benchmark for private sector securities. 27. Recently, CBSL commenced the sale of longer-term government securities by auction. This will deepen the government securities market and may also provide a benchmark for pricing private bond issues. While establishing longer-term benchmarks would help, more fundamental changes will be needed to develop a significant private bond market in Sri Lanka. These would include greater price and exchange rate stability, more confidence in stable government policy, more consistent economic growth, and less concern about military conflict. It is difficult to establish market-clearing rates that appeal to both large business borrowers, and investors who demand adequate  -9- compensation for bearing significant risks (interest rate risk, foreign exchange risk, and risks associated with business environment and government policy uncertainties). 28. Reducing Tax and Regulatory Arbitrage. In a world of perfect financial markets, financing decisions would be indifferent to the mode of financing, i.e., firms would be indifferent among alternatives of obtaining loan finance, drawing down on reserves, or issuing new shares or debt securities. Similarly, in the selection of investment instruments, investors would only be driven by risk-return considerations. In the real world where issuers and investors prefer one financial instrument over another, the key question to raise is what market imperfections make issuers and investors choose one financial instrument over another. The most important market interventions have to do with varying tax and regulatory treatment. 29. In Sri Lanka, the current system of taxation of financial assets and transactions discriminates among instruments, issuers, investors and uses with no clear justification. This is the result of ad hoc tax measures that, over time, have made the taxation of the financial sector very complex. Recently the rates were reduced but not yet made consistent. This has resulted in market segmentation and tax and regulatory arbitrage between market segments, e.g., differing cash reserve requirements between banks and finance companies have prompted banks to create finance company subsidiaries to avoid this tax (para 1.08). Simplification and rationalization of the tax regime are required to increase market integration, enhance the flow and allocation of resources for capital accumulation, and promote efficient use of existing resources. 30. External Governance and Prudential Supervision. There is need to review the regulatory framework to avoid overlaps and underlaps among the banking regulator, the capital market regulator, the insurance regulator and the proposed regulator for pension fumds. There are obvious overlaps and underlaps today. These could increase as the distinction among these traditional financial sector segments is blurred through financial innovation. Enforcement powers should be calibrated to be effectively used. Enforcement itself has to be strengthened. 31. Although banking regulations have been substantially strengthened over the last few years through several legislative actions, supervision and enforcement remain weak, mainly due to inadequate operating procedures and lack of qualified and experienced staff. Examiner training remains inadequate. Growth in staff size and experience lags behind the growth in the number, size and complexity of institutions to be supervised. The Bank Supervision Department in central bank has yet to finalize a computer-based off-site monitoring system to complement on-site examinations. Bank supervision should monitor efforts by banks to go after big defaulters. The Central Bank needs to define the main risks facing the banking system today, and focus its limited resources to those areas that pose the greatest risks. 32. Reinforcing the Credit Culture. The extra-judicial powers of financial institutions in recovering loan collateral have helped to strengthen credit discipline (para  - 10- 33). However, indiscriminate loan forgiveness programs, such as the large scale writing- off of agricultural loans in 1994, or the debt reprieve programs of the Rural Regional Development Banks, send the opposite signal and undermine the credit culture. The Government should refrain from announcing and undertaking such programs, especially before elections. Individual financial institutions should be left to themselves to deal with loan default on a case by case basis and on pure business grounds. 33. Legal and Judicial Recourse. Efficient and effective enforcement of financial contracts under the law and, if necessary, by the courts is another important source of discipline. Recent legislation has improved the ability of lenders to enforce financial contracts, particularly through the so-called parate powers, which allow lenders to foreclose on loan collaterals without the intervention of the courts. However, for default cases that are filed in the courts, the judicial process still takes too long. In addition, the current law allows defaulters to obtain restraining orders from the courts against banks, thereby dragging the cases even longer. There is a need to find ways of reducing the time to resolve court cases, and increase the capacity of the courts. IDA's proposed legal reform project could serve as a vehicle for the design and implementation of reform measures in this regard. 34. Reforming the Provident Funds. The provident funds are defined contribution schemes and are fully funded. Moreover, they are not complicated by inter- generational or intra-group income re-distribution, and are purely savings instruments for old-age. However, because of the high rate of contribution combined with underperforming investments, they are seen more as a tax for the present rather than savings for the-future, resulting in widespread evasion. Moreover, since contributions are mandatorily deducted from payroll in the formal sector, they constitute a labor market distortion, as evidenced also by widespread evasion. 35. There are several reform measures that can help make the provident funds an effective instrument for savings for old-age while minimizing labor market distortions. First, improved investment performance of the EPF/ETF would help market these funds as an attractive savings instrument for old age. Implementation of the recent lifting of the investment restriction in goverunent securities should be accelerated. Fund management should be professionalized, preferably by contracting it out to private fund managers on a competitive basis. Permitting some overseas investments could further increase portfolio diversification and performance. IDA and Japanese grant funds are available to assist the authorities in these areas. Work has already been initiated in this area. 36. Second, as fund investments are liberalized and fund management privatized, the regulatory and supervisory framework has to be strengthened. Provident and pension funds are vulnerable not only to moral hazard (excessive risk-taking) but also to fraud. Thus prudential standards and effective regulation and supervision are critical elements of the system. In Sri Lanka there is not yet an effective regulator and supervisor of public or private funds nor adequate prudential guidelines. In some cases private funds are established under the Trustee Act (and managed under trusteeship arrangement) while  - 11 - in others they are not, and provident or pension fund assets are not separated from a company's assets. As a first step, the GOSL should establish an office for a regulator of provident and pension funds. 37. Third, the industry should be expanded outside of the EPF/ETF and into private provident/pension schemes to give savers choices, and promote competition in the industry. Experience in other countries shows that risks, costs and rates of return are strongly influenced by whether a pension system is centrally managed by the public sector or decentralized in the private sector. Public sector managers of centralized provident funds are subject to political interference and have little incentive to operate efficiently or earn reasonable returns. The first step would be for GOSL to reassess the recent ban on the entry of private pension funds. The policy of allowing private funds to be established was in effect until last year. However, a law which prohibits the creation of new funds that was passed more than 20 years ago, was recently gazetted and became effective in 1996. However, as this step was found to be regressive, it was subsequently reversed. 38. Fourth, the mandatory nature of EPF/ETF should be re-examined. It is not evident that mandatory savings schemes increase overall savings. Mandatory savings for old age might merely re-allocate savings in other instruments. Instead, the tax incentives to save through provident/pension funds should be enhanced to encourage people to save for old age over and above other savings objectives. On the other hand, there is clear evidence that payroll taxation distorts labor markets, promoting suboptimal employment in activities that are not captured by the payroll tax. 39. There is also a governance issue. It is probably safe to say that funds centrally collected through a payroll tax by a government machinery would be misallocated. The current captive nature of the EPF/ETF in holding government securities, and the resulting negative returns to savers argues against a centralized mandatory contribution scheme. The current widespread evasion, and the inability of the government machinery to enforce compliance, are another argument. 40. The problems of myopia (people don't save for the future) and moral hazard (those who do not save believe that they will be cared for anyway by the state) can be addressed by a minimum social assistance scheme that provides a minimum (not a desirable) safety net against abject poverty. There is no reason for discriminating against the poor today in favor of the poor tomorrow. This safety net should be financed through the general budget rather than through a payroll tax to minimize labor market distortions. 41. Contingency Planning and Crisis Management. Efficient and sound financial systems take years to achieve, but only weeks or days to lose. This is so because they are anchored on confidence as much as, if not more than, on economic fundamentals, especially in the short term. Moreover, with greater integration of international financial markets, the sources of crises could be external. The recent financial crises in other countries provide lessons for vigilance. It would be wise for Sri Lanka to develop contingency planning and crisis management capability, while working  - 12 - on more fundamental structural reforns. Already work has been initiated to obtain consultancy services for this purpose.  - 13 - ANNEX I SRI LANKA FINANCIAL SECTOR REFORMS THE BANKING SYSTEM A. The Central Bank Background 1.01 The Central Bank of Sri Lanka (CBSL) is governed by a three-person Monetary Control Board (MCB) consisting of the Governor of CBSL, a representative of the Ministry of Finance (MOF) and a non-government appointee. The Minister of Finance provides direct input into CBSL decisions through the MCB and, under certain conditions, can overrule MCB decisions. However, it should be acknowledged that CBSL does operate with a considerable degree of independence in most areas and has a significant role in influencing government policy and managing the financial system. Nevertheless, it would be preferable if CBSL were to function as a more autonomous central bank. 1.02 The CBSL performs a broad range of traditional central bank activities which include conducting monetary policy, advising the Treasury on public debt management, regulating commercial banks, finance companies and specialized banks, regulating the exchange rate, and maintaining international reserves. Because CBSL has a sizable professional staff and considerable expertise in several financial areas, GOSL has given it the responsibility to carry out financial activities not traditionally associated with central banks. These include managing the GOSL-sponsored provident plans, and providing financing to selected sectors (agriculture, exports, and troubled finance companies), a function that has been phased down in recent years. It would be preferable if CBSL's responsibilities were confined to traditional central bank activities so that it can concentrate its efforts on improving its performance in these areas. This would not preclude the Governor of the Central Bank from serving in an advisory capacity in connection with other government financial activities. 1.03 CBSL's functions related to macro-economic management include responsibility for managing the government debt; controlling inflation; managing international reserves; and assuring reasonable stability in financial markets. The twin deficits -- fiscal and trade -- have made CBSL' task extremely challenging. However, performance has been facilitated by forced savings mobilized by GOSL through captive sources of funds, and by financial assistance from external donors and creditors. In recent years, despite the government deficit, inflation has generally remained within a  - 14 - ANNEX I tolerable range, real interest rates have generally been positive, and international reserves have remained stable. Main Issues and Recommendations 1.04 Government Debt Management. The main financial market instrument is the Treasury bill (with maturities of 3, 6, and 12 months) auctioned weekly to securities dealers, including the NSB. Currently, almost two-thirds of the Government debt is sold directly to captive investors, principally the NSB, the provident funds, and government- owned' specialized banks. These are mostly fixed rate, non-marketable, intermediate-term instruments. Liquid asset requirements for banks, finance companies and specialized banks provide a captive market for Treasury bills. Current practice simplifies debt management and keeps GOSL's borrowing cost artificially low. In the 1997 budget, GO SL reduced the borrowing ceiling to Rs. 115 billion and retired public debt substantially by using privatization proceeds. It is recommended that CBSL and GOSL gradually move to more reliance on market-priced government securities and less on captive investors and non-marketable instruments. Even if the latter are not phased out, their rates should be tied to those on marketable government securities to reduce market segmentation. 1.05 The CBSL faces two major constraints to establishing market-determined interest rates: (i) GOSL securities account for a large share of the domestic debt market, and crowd out private financing; and (ii) significant distortions in financial markets are created because large state-owned financial institutions play a major role in financial markets. The investment policies of NSB and EPF and other state-owned lenders are significantly influenced by GOSL. Similarly, the actions of state-owned banks are influenced by GOSL. 1.06 Recently, CBSL commenced the sale of longer-term government securities by auction. This will deepen the government securities market and may also provide a benchmark for pricing private bond issues. While establishing longer-term benchmarks would help, more fundamental changes will be needed to develop a significant private bond market in Sri Lanka. These would include greater price and exchange rate stability, more confidence in stable government policy, more consistent economic growth, and less concern about military conflict. It is difficult to establish market-clearing rates that appeal to both large business borrowers, and investors who demand adequate compensation for bearing significant risks (interest rate risk, foreign exchange risk, and risks associated with business environment and government policy uncertainties). 1.07 Monetary Policy Management. Banks are required to hold liquid assets (Treasury bills, cash and deposits) of 20 percent of their liabilities. Such requirements do not provide a liquidity source unless they are based on averaging over an extended time period. Indeed, the CBSL should give careful consideration to long term averaging of the  - 15 - ANNEX I liquidity requirement as it will help provide greater market depth and encourage bank arbitrage activity that would help smooth out swings in market liquidity and call money rates. The liquid asset requirement does provide a larger captive market for Government securities. However, as a prudential tool it probably has little value. Because of the zero weight given to liquid assets in the risk-weighted capital guideline applicable in Sri Lanka, eliminating this requirement would not necessarily increase bank lending, unless a bank's capital base were in any case large enough to allow increased lending. 1.08 A greater burden for commercial banks, however, is the cash reserve requirements of 12 percent of liabilities. These reserve requirements must be met by a non-earning deposit with the central bank or by vault cash up to a certain limit. The effect is to raise funding costs, put upward pressure on lending rates, reduce earnings, and place commercial banks at a competitive disadvantage vis-a-vis competitors that are not subject to this requirement, e.g., finance companies. 1.09 If required cash reserves were to be reduced, their negative impact on bank profits would be reduced. CBSL has expressed its intention of reducing the reserve requirements further. However, a reduction in required reserves would enable banks to increase lending, and the impact of the resulting expansion in credit would be inflationary. One approach would be to wait until market conditions make it appropriate to reduce reserve requirements and/or attempt to offset the impact of such a reduction through open rnarket operations -- the approach apparently pursued by CBSL when cash reserve requirements were reduced from 15 percent to 12 percent. An alternative approach would be to substitute for the cash reserve requirement a higher liquidity requirement. Under this approach, the negative impact on bank spreads and earnings would be diminished, and bank capital would be strengthened. However, the overall liquidity reserve requirement should be reduced when market conditions permit. 1.10 Call money markets in Sri Lanka are thin and overnight money interest rates have exhibited substantial volatility. On some occasions, rates have been as high as 100 percent per annum. This has been caused by a combination of factors. First, cash management by GOSL has been erratic, and communication between the Treasury and CBSL on GOSL cash needs often has been inadequate. Second, the call market has been dominated by state-owned banks who have often been reluctant to lend to competing institutions. Finally, CBSL has often failed to act in a timely manner to prevent short- term shortages of funds in the market. While CBSL accepts the use of open market operations as the principal tool for financial market intervention and management, it has yet to fully integrate the use of this tool in its financial market activities. IDA, the International Monetary Fund (IMF) and USAID have been working with CBSL during the past few years to help improve open market operations. 1.11 CB SL recently introduced reverse repurchase agreements with commercial banks to provide short term liquidity. However, due to the pre-specified limits on the  - 16 - ANNEX I advances that can be extended using this instrument, short-term funding shortages often have not been prevented. The CBSL should gear policy on open market operations towards controlling liquidity over longer periods, without constraining liquidity in the short term. 1.12 Bank Regulation and Supervision. Bank regulation in Sri Lanka reflects a combination of legislative provisions and additional authority granted to the Monetary Board. For example, banking legislation specifies minimum capital standards for banks, but empowers the Monetary Board to specify additional capital requirements as they relate to individual bank conditions. Compared to bank regulation in most developing countries, the scope of CBSL authority is substantial. 1.13 The bank regulatory and supervisory environment in Sri Lanka has improved substantially since 1988. The Banking Act of 1988 empowered the Monetary Board with authority to require more extensive bank disclosure and reporting (including submission of annual audited statements), raise capital requirements, and subject banks to more rigorous supervision. In the ensuing years, additional regulatory requirements were introduced including suspension of interest on non-performing loans and more stringent provisioning requirements. Many of these changes followed the recommendations of the Presidential Commission on Finance and Banking.' The Banking Act of 1995 further strengthened commercial bank supervision and regulation, established minimum capital standards for Specialized Banks (including the NSB, RDBs, SMIB, NDB and DFCC) and extended CBSL supervision to these institutions. CBSL is exploring the possibility of bringing merchant and investment banks also under an appropriate regulatory body such as the SEC. 1.14 Despite strengthened regulation, bank supervision remains weak, mainly due to inadequate operating procedures, lack of qualified and experienced staff and lack of focus by senior management While the reports submitted by banks provide adequate material for examination, off-site monitoring is inadequate. The bank supervision department in CBSL is in the process of developing a computer-based off-site monitoring system (para 1.66 - 1.68). Examiner training is inadequate. Growth in staff size and experience lags the growth in the number, size and complexity of institutions to be supervised. Considering that it will take time to increase supervision capacity, it would make sense for the central bank to define the main risks being faced by the banking system and direct its current limited supervision capacity toward those areas that pose the greatest risks. The bank supervision department could also save scarce resources by working more closely with external auditors in identifying and addressing key problems Ninth Interim Report of the Presidential Commission on Finance and Banking of the Central Bank of Sri Lanka, Printed at the Department of Government Printing, Sri Lanka, 28th December, 1992.  - 17- ANNEX I in individual banks. B. Commercial Banks Background 1.15 There are 26 commercial banks of which 2 are state-owned, 6 are domestic private conmmercial banks (PCBs), and the remaining 18 are foreign banks. Yet despite the number of banks, the sector continues to be duopolistic. The two state commercial banks (SCBs), Bank of Ceylon (BOC) and People's Bank (PB), account for 57 percent of banking sector assets (BOC 32 percent, PB 25 percent). The largest PCB is a little more than a third the size of the smaller SCB. 1.16 In the period 1989-97, the commercial banking sector grew at about 20 percent per annum, with total banking sector assets and deposits amounting to Rs. 464 billion (US$7.0 billion) and Rs. 330 billion (US$5.0 billion) respectively by end-1997. The PCBs grew fastest, with the increase in the total number of bank branches from 663 in 1989 to 926 in 1997 largely accounted for by the increase in PCB branches from 61 to 267. On the other hand, the market share of foreign banks declined as three banks closed and only one bank opened (Attachment 1.6). 1.17 During the 1990s, important banking reforms were implemented. International accounting and auditing standards were adopted. Disclosure standards have been improved and are close to international standards. Prudential regulations have been strengthened. The loan recovery by banks has been enhanced through parate execution powers which allows banks to take over mortgaged assets in the event of borrower default without resorting to the courts. Moreover, commercial courts have been instituted, although with limited operations so far. Central Bank refinancing of directed credits has been virtually stopped. The government will shortly be signing a performance contract with the two SCBs stipulating specific targets to improve performance. However, it is unlikely that this will bring the desired results since the current management is weak. 1.18 The GOSL completed the agreed recapitalization of BOC and PB in 1993 and 1996 respectively, which enabled the SCBs to meet international capital adequacy standards. In the context of these recapitalizations, BOC and PB agreed with the GOSL to implement operational improvements and achieve performance targets, of which the key ones were the following: (i) appointment of international auditors; (ii) compliance with intemational standards specifically on accounting, auditing, loan loss provisioning and capital adequacy; (iii) a freeze on staff recruitrnent and branch expansion; (iv) requirement to obtain GOSL guarantee for loans to state-owned enterprises (SOEs); (v) direct budget funding of GOSL's subsidies and not at the expense of the SCBs; and (vi) assurance that the returns on assets and capital, and personnel costs are in line with those of the private commercial banks. Loans to SOEs are now guaranteed by GOSL, and  - 18 - ANNEX I subsidies provided by the SCBs are directly supported by the budget. However, settlement of guarantees and reimbursement of subsidies are delayed and only partially offset SCB costs. 1.19 The banking sector as a whole continues to be liquid and profitable, and the public's confidence on it steady. There does not appear to be a short-term problem that could cause a crisis. But there are major structural weaknesses. In view of the East Asian financial crisis, the role of bank supervision has become even more important The main issues relate to the weaker performance of the SCBs, and the inefficiency of the sector due to the dominance by the SCBs which has prevented effective competition and protected interest spreads for the whole sector at the expense of savers and borrowers. Performance 1.20 Foreign Banks.2 The foreign banking sector has continued to decline in importance. At the end of 1997, only 18 foreign banks were operating in Sri Lanka. Foreign banks have been less aggressive than domestic banks and have not posed any real competition to them. As a result, they have lost market share in terms of both assets and deposits (see Table AI.1). This was partly due to the higher earnings of foreign banks from off- balance sheet activities. Some foreign banks have portfolio problems, which will require corrective measures and close monitoring and supervision by the central bank. 1.21 Private Commercial Banks.3 Since 1989, PCBs' interest margins have increased although their return on assets has decreased. This is partly due to higher, more adequate rates of loan loss provisioning. In 1997, accumulated provisions of the PCBs were 2.1 percent of total advances compared to only 1 percent in 1989. As a group, the PCBs continued to gain market share, largely due to more aggressive deposit mobilization via branch expansions (Attachment 1.7). 2 These foreign banks are: Citibank, American Express, Grindlays Bank, Chartered Bank, Hongkong Bank, Banque de Societe Generale, Deutsche Bank, Algamene Bank, Amsterdam-Rotterdam Bank, Overseas Trust, Bank of Oman, Habib Bank A.G., Middle East Bank, Indian Overseas Bank, Indian Bank, State Bank of India, Habib Bank. The PCBs are: Hatton National Bank (HNB), Commercial Bank of Ceylon Limited (CBC), Seylan Bank Limited, (SLB), Sampath Bank (SPB), Union Bank of Colombo, Limited (UBC), and Pan Asia Bank Limited (PAB).  - 19- ANNEX I Table AI.1: Comparative Financial Performance (1989, 1993-1997) 1989 1993 1995 1996 1997 Interest Margin Bank of Ceylon 5.4% 6.9% 9.9% 6.6% 7.0% People's Bank 8.3% 8.9% 8.1% 6.6% 6.5% Private commercial 6.7% 9.6% 10.0% 5.6% 5.8% banks Foreign banks 5.7% n.a. 10.4% 5.8% 6.4% Return on Assets Bank of Ceylon 0.3% 2.1% 2.4% 2.4% 2.3% People's Bank 0.6% 0.8% 0.1% 0.6% 1.4% Private commercial 2.1% 1.5% 1.5% 1.2% 1.2% banks Foreign banks 1.7% n.a. 1.8% 2.9% 1.3% Return on Capital Bank of Ceylon 12.2% 31.6% 30.2% 24.9% 22.1% People's Bank 28.4% 17.8% 4.3% 13.5% 34.6% Private commercial 23.7% 22.5% 19.6% 10.0% 19.7% banks Foreign banks 19.8% n.a. 15.3% 16.8% 16.4% Employee Expense/Total Assets Bank of Ceylon 2.0% 2.2% 2.0% 2.2% 2.4% People's Bank 2.9% 3.1% 2.8% 2.5% 2.9% Private commercial 1.4% 1.7% 1.7% 1.9% 1.9% banks Foreign banks 1.2% n.a. 1.7% 1.7% 1.8% 1.22 State Commercial Banks. Since the recapitalization in 1993, Bank of Ceylon's performance has improved. BOC appears to have met some of the profitability measures agreed with GOSL. Its returns on assets and capital, in fact, exceeded those of the PCBs. However, this picture is deceiving since the high return in 1995 included large interest income from non-performing loans (Rs 1.88 billion or 15.5 percent of total interest income or 66 percent of net income after taxes). Interest on these loans, which has not been received, has been accrued since repayment of these loans is guaranteed by GOSL. If interest income from these loans were excluded, BOC would not have met the profitability criteria agreed with GOSL.  -20 - ANNEX I 1.23 BOC's performance has also improved in terms of overhead and personnel costs although not to the level of the average PCB, as agreed with GOSL under the terms of the recapitalization plan. As a percent of total assets, employee expense increased from 2.0 percent in 1989, to 2.2 percent in 1993 and 2.4 percent in 1997, compared to only 2.0 percent for the PCBs and foreign banks. Total overhead costs (net of provisions for doubtful loans) also improved but were higher than those of the PCBs, although slightly lower than those of the foreign banks. 1.24 Largely due to aggressive deposit mobilization by the PCBs, the market share of People's Bank decreased in the period 1989-97. But PB continued to focus on growth which has apparently led to reduced efficiency. In 1997, net income after taxes was Rs. 1,694 million, up from Rs. 853 million in 1994 and Rs. 540 million in 1989 (initial reports for 1996 indicate that PB showed net losses). Returns on assets and capital were low due to a combination of factors including lower interest spreads and higher overhead and employee costs. PB's performance did not measure up to benchmarks agreed with GOSL. The low profitability led to a low capital adequacy ratio of 5.5 percent at the end of 1997. This ratio would be even lower if the interest on non- performing but government guaranteed loans were not accrued. PB's weak financial position is compounded by the high level of non-performing loans (equivalent to 20 percent of total advances) in relation to the level of accumulated provisions (equal to only 8 percent of total advances or 32 percent of non-performing loans) (Attachment 1.4). Issues and Recommendations 1.25 Provisions and Capital. Loan loss provisions for both SCBs seem inadequate in view of uncertain portfolio quality. In 1995, total non-performing loans amounted to 15 percent and 20 percent of total advances for BOC and PB, respectively. Accumulated provisions were only 10 percent and 8 percent of total advances, respectively, although loans classified as "loss" were already about 78 percent of non performing loans for both banks. The SCBs should undertake a more thorough loan portfolio review, or be required to increase provisions. CBSL already has initiated a portfolio audit of the SCBs. 1.26 Moreover, income from non-performing loans guaranteed by the government inflates the banks' reported income. Despite government guarantee, interest income from non-performing loans should not be recognized until payments are actually received and accounts are regularized. Even if there is assurance that the government would honor its obligations, it is questionable whether they will be honored in a way that would fully compensate for foregone interest income. This accounting practice should be changed to improve disclosure of SCB performance, and subject them to greater market discipline.  -21 - ANNEX I 1.27 The treatment of interest income from such loans also impacts on the banks' capital adequacy ratio (reported in 1995 as 13 percent and 6.3 percent for BOC and PB, respectively). This ratio assumes zero risk on government guaranteed loans and thus no capital requirement. The result is to inflate the capital ratio in two ways: (i) the capital base is inflated by the income recognized although not received; and (ii) risk assets are reduced by the zero risk-weighting on government guaranteed but non-performing loans. Adjusting for these effects, BOC's capital adequacy ratio could be 25 percent lower than reported. With similar adjustments, PB would be substantially undercapitalized. 1.28 Accounting and Auditing. The SCBs have been substantially complying with international accounting and auditing standards, except of the income accrual practice described above. However, external auditors are appointed for only one fiscal year and re-appointment in succeeding years is usually not allowed. In line with international practice, the SCBs should be allowed to retain the same external auditors for at least three years at a time. This would assure continuity of audit treatment and enable the auditors to deepen their understanding and coverage of the banks' control systems. This practice could also result in improved service and more consistent accounting treatment and standards. 1.29 Pre-Privatization Reforms. In private institutions, stockholders, boards of directors and management provide internal governance and self discipline. While the privatization of the two SCBs is not yet on the political agenda, structural measures would have to be put in place to approximate this condition in these banks. 1.30 In essence, these structural measures would include the following: (i) separating the commercial business of the SCBs from non-commercial activities; (ii) permitting them to undertake the non-commercial operations as "off-balance sheet" activities on the account of the government; (iii) emphasizing efficiency over growth; and (iv) downsizing, or at least, limiting growth to increase the market share of private financial institutions and facilitate eventual privatization. 1.31 Segregating commercial and non-commercial activities would instill financial discipline as commercial and non-commercial objectives and results are clearly defined ex ante and evaluated ex post, respectively. Failure in one would not be covered by the other. Taking out non-commercial programs from the balance sheet increases transparency since their costs are clearly identified as fiscal costs rather than hidden as quasi-fiscal deficits which eventually will have to be recognized. It promotes also greater accountability and efficiency. In fact, to reduce the fiscal cost of such programs and achieve maximum results it would make sense for the government to bid out management of these programs to both state-owned and private financial institutions. 1.32 One transparent way of achieving this condition would be through management or governance contracts, preferably the former. Under this approach, the  - 22 - ANNEX I government, as owner, would enter into an agreement that would assure autonomy and authority for the board of directors and management, clarify their mandate and objectives, including clear quantitative goals, and spell out the rewards and penalties for success and failure, respectively. 1.33 Since the SCBs are to be privatized eventually, the management or governance contracts should underscore the caretaker nature of management until these banks are privatized. Management should be mandated to focus on conserving assets, reducing cost, downsizing staff and branches, increasing loan recovery, and limiting lending to high quality loans, such as to the government, the interbank market and blue chip companies. 1.34 Competition. Market discipline through competition is weak in Sri Lanka's banking sector due to dominance by the SCBs. The SCBs are by far bigger than the largest private commercial bank, and together, account for 57 percent of the market. Downsizing or, at least, limiting the growth of SCBs by stressing profitability over growth, and consolidation over expansion would not only engender greater competition and market discipline but also facilitate the privatization of state-owned financial institutions. Smaller but more profitable state-owned financial institutions would be easier to sell, considering the limited capacity of domestic capital markets and foreign investor interest. 1.35 Another way of promoting the private sector would be to privatize the flow of savings. Through established market presence and wide branch networks, and perhaps the perception of security (explicit deposit insurance in the case of the National Savings Bank), the state-owned banks continue to dominate deposit taking. Thus, without privatization, it will take years before their dominance in the market will decline. The share of the private sector can be expanded by encouraging the private sector to borrow from state-owned banks and lend out these funds. The whole system would benefit as private banks have a better track-record at making good loans, while state-owned banks have the infrastructure to collect deposits. 1.36 A third approach would be to explicitly downsize the state-owned banks by selling off branches to the private sector. This has to be done in an orderly manner and should be based on a medium-term plan, which is linked to the plan to eventually privatize the banks themselves. Attachment 1.3 provides more details on bank branch sales.  - 23 - ANNEX I C. Other Banking Institutions National Savings Bank 1.37 Background. The NSB is state-owned, raises funds from the public via time and savings deposits, and places them largely in various Government securities. NSB has the authority to lend and invest up to 40 percent of its assets in non-Government instruments. However, at year-end 1996 claims on the GOSL and Government-related institutions exceeded 80 percent of NSB's assets. Thus, NSB acts principally as an intermediary for mobilizing funds for the GOSL. 1.38 Until 1991, interest on NSB deposits received favorable tax treatment, making their tax-equivalent cost to the Government substantially higher than direct borrowing from financial institutions and the public. However, since 1997 NSB has not received an interest subsidy and the interest rates it offers are more comparable with those of the other commercial banks. 1.39 Issues and Recommendations. NSB is a price leader in the market for time and savings deposits. It also participates in Treasury Bill auctions and functions as a dealer in Treasury bills. Because NSB is owned and managed by GOSL, its pricing policies are largely determined by the GOSL. Thus, in essence, it is the GOSL that acts as a price leader on deposits and exerts significant influence in market pricing of Treasury bills. This has created pricing distortions in the financial markets. However, since 1997 NSB has had more autonomy in rate setting. 1.40 Although NSB has a role in mobilizing deposits, this role can be performed by other financial institutions as well. Both People's Bank and Bank of Ceylon have more branches than NSB, including branches in most rural areas where NSB branches are present. Moreover, the number of RRDB branches exceeds the total number of NSB branches. Also, NSB's overall cost of raising deposits in rural branches is very high. Most NSB deposits come from relatively large term deposits in urban locations. Clearly, such depositors have alternative savings outlets, and their savings are unlikely to be reduced if NSB were to be closed or acquired by other institutions. 1.41 NSB also has a role in mobilizing small savings through the postal savings system. However, the postal system in general is inefficient and its savings windows in particular are largely inactive, owing to poor management and inadequate staff incentives. GOSL would need to revamp the postal system first before it can expand effectively beyond mail delivery and into financial services. An IDA project is being prepared to assist in revamping the postal system. 1.42 Reorganizing NSB. There appears to be no rationale for continuing the operations of NSB at the current scale, and these should therefore be scaled down. Those  -24 - ANNEX I activities where NSB has an indispensable role in mobilizing savings should be retained. For example, the postal savings function could be retained by a smaller Government- owned savings bank. The investments of this institution would be confined to cash and obligations of the Government. The management of this institution could be contracted to a private vendor utilizing some form of incentive-based compensation. Alternatively, if the postal system were substantially improved, it could arguably contract its services for the collection of small savings and the performance of small payment transfers to banks on a competitive basis. Banks would find it attractive to use the services of an efficient postal system to extend their reach to the rural areas. 1.43 The bulk of NSB branches should be sold by auction, principally to private commercial and foreign banks. The state-owned banks should not be permitted to bid for branches, except, possibly in rural areas where there are no other interested parties. This process could materially increase the relative size of the privately-owned banks, enabling them to compete more effectively with Bank of Ceylon. It would also materially increase the role of the private sector in the financial system and its role in allocating resources to the most productive business activity. 1.44 Because NSB's branches are largely self-contained as deposit takers, dividing up NSB is not likely to be difficult, and because NSB's staff size is modest compared to the state-owned banks, dealing with unions and staffing issues should not present an overwhelming problem. Some combination of early retirements, buyouts, and commitments by acquirers to retain some share of existing staff should be possible. 1.45 If NSB is permitted to continue operations in its present form, it should price its deposits and other activities as though it were a profit maximizing private institution. NSB should seek to earn a market-based return on its equity capital taking into account full corporate tax liability. This required rate of return should be factored into decisions related to deposit pricing and growth. Regional Rural Development Banks and Regional Development Banks 1.46 Regional Rural Development Banks. Regional Rural Development Banks (RRDBs) were established through legislation enacted in 1985 to develop a sound rural credit structure, and provide credit to rural individuals and businesses who had limited access to the formal credit system. By 1993, 17 RRDBs were established, and in 1996 these institutions had more than 170 branch offices. The CBSL provided the capital (Rs. 25 million for each institution) and hence owns all RRDBs. However, each RRDB is independent with its own board and management. RRDBs compete more with informal money lenders than with commercial banks. 1.47 The principal operating advantage of RRDBs was supposed to be their low cost per employee compared with state-owned banks. Nevertheless, most of these banks  - 25 - ANNEX I were unable to generate the volume of deposits and loans to make effective use of staff. At end-1996, total assets of all RRDBs were only about Rs. 4 billion, an average of only about Rs. 20 million per office, and total deposits were less than Rs. 2.5 billion. The training and experience level of staff generally was low, and the chairman of most RRDBs was a local political appointee with little or no banking experience. 1.48 RRDBs received several forms of GOSL subsidy including income from zero cost capital invested in Government securities, a 1 0-year income tax holiday and reduced reserve requirements. They also received staff assistance from CBSL and state- owned banks, and had access to CBSL refinance facilities and borrowings from donors. However, the financial performance of RRDBs has generally been weak. The lending rates charged generally were not high enough to compensate for high operating costs and low loan recovery rates. The fact that RRDB lending is viewed as a government subsidized program may have discouraged loan repayments, compared with the repayment experience of informal money lenders. A special government amnesty program that forgave delinquent loans for borrowers willing to pay 25 percent of their loan balances may also have contributed to collection problems. 1.49 Regional Development Banks. In December 1996, legislation was enacted to enable the Monetary Board to establish Regional Development Banks (RDBs) for supporting economic development in specific regions in agriculture, industry, trade, commerce and other sub-sectors. All existing RRDBs would be acquired by the RDBs. These new banks would have stronger capital position and governance structure than the RRDBs. 1.50 Initially, the RDBs would receive capital from CBSL, Bank of Ceylon, Peoples Bank, NSB and the Employee Provident Fund (EPF). Subsequently, shares could also be sold to other parties, including private banks. The authorized capital for each RDB would be Rs. 500 million, although the initial capitalization would probably be Rs. 60 million for each bank. The board of each bank would elect a chairman, and select a person with extensive experience in banking and finance as the general manager of the bank. 1.51 The RDBs would operate as specialized banks with powers specified in the Banking (Amendment) Act, No 33 of 1995. They would be subject to the supervisory requirements and oversight prescribed by the Monetary Board and Bank Supervision Department of the central bank. These banks would not have the authority to accept demand deposits ( even though some RRDBs had modest amounts of demand deposits). They would be subject to an annual audit and disclosure requirements. During their first two years of operation they would not be subject to income tax. 1.52 Issues and Recommendations. The RDBs were expected to begin operations in 1997. These larger institutions with broader ownership, professional  - 26 - ANNEX I management and stronger oversight might be more successful than the RRDBs. However, they are likely to have many of the operating difficulties faced by the RRDBs because they would also be operating in less affluent economic areas, with government ownership and incentives that reflect a mixture of economic and social goals. 1.53 To assure profitability and soundness of the RDBs, the CBSL should require that the RDBs price loans and deposits adequately to obtain a market-based rate of return on their equity capital. Although write-offs of some assets may be unavoidable, to the extent possible RDBs should avoid loan forgiveness programs and other actions that give the impression that collections would not be pursued. Indiscriminate loan forgiveness programs, such as that for agricultural loans in 1994, encourage a default culture. Credit loss guarantee schemes, such as those proposed in the 1998 budget, contribute to this culture. Finance Companies 1.54 Background. To arrest serious deterioration in finance company (FC) performance that occurred in the late 1980s and to restore confidence in the FCs, GOSL instituted several actions. These included increasing CBSL supervision of FCs and raising capital requirements. Due to FC failures and the mergers of FCs that followed, only 45 of 72 FCs operating in 1987 remained in operation by 1989. Furthermore, due to CBSL's stricter annual registration requirements, only 20 of the 45 FCs in operation were re-registered, and the remaining 25 were no longer allowed to renew their registration or take new deposits. By the end of 1997, there were 24 registered FCs, which included the FCs that were taken over or rehabilitated by other finance companies individually or in partnership with commercial or investment banks. Five FCs are still under CBSL receivership with an outstanding refinancing of Rs 2.4 billion (equal to 15 percent of the total assets of FCs). One company accounted for Rs 1.4 billion or 58 percent of the total CBSL refinancing. 1.55 While FCs are now diversifying their portfolios, other financial institutions are moving into the FCs' traditional areas of business such as 'hire-purchase' finance and leasing. This, coupled with the fact that they do not have recourse to low cost funds such as demand and savings deposits, has increasingly placed greater pressure on the FCs' operations. The FCs are also disadvantaged by their relatively small size compared to banks. Their total advances are equivalent to only 4 percent of the total deposits in the banking sector. Partly due to these factors, the largest FC (which is also listed in the stock exchange) is positioning itself for conversion into a commercial bank. 1.56 CBSL has supervisory jurisdiction over the FCs. Under the Finance Companies Act, as amended in 1991, adequate prudential regulations are in place. These include minimum capital requirements (currently Rs. 25 million), mandatory  - 27 - ANNEX I provisioning, single borrower limits, liquidity requirements, disclosure and auditing standards, and interest suspension requirements. 1.57 While in terms of growth, the FCs kept pace with the banking sector, registering 23 percent average growth in assets and 26 percent in deposits, they produced higher returns than banks on total assets (2.6 percent ) as well as on equity (18 percent) (Attachment 1.8). The three largest FCs account for 69 percent of the total assets and 72 percent of total deposits. Despite intense competition from other financial institutions, the FCs continued to raise deposits by offering higher deposit rates, and managed to remain profitable by generating higher interest margins. 1.58 Issues and Recommendations. CBSL's supervisory capacity, particularly in respect of non-bank financial institutions, is currently overstretched. CBSL staff spend an inordinate amount of time attending to the five FCs under CBSL's receivership, and are able to devote little time to on-going monitoring and supervision of the other 24 registered FCs. In the past, CBSL disposed of some FCs through sale to existing successful FCs. CBSL should vigorously pursue disposal of the remaining FCs under its receivership so it can return to steady-state FC supervision activities. 1.59 Due to high profit potential in the FC business, and availability of lower cost funds in the banking sector, competition in traditional FC market niches from other banking institutions is intensifying. Although FCs will continue to play a role in the financial sector, this role would diminish. As a strategic step, therefore, CB SL should perhaps encourage mergers and/or consolidation among FCs to enhance their financial and competitive strength. CBSL should also tighten the requirements with regard to the approval and re-registration of deposit-taking FCs. This would result not only in stricter enforcement and more uniform standards, but also strongly capitalized institutions. D. Banking System Infrastructure 1.60 Capital Requirements. In October 1993, Sri Lanka adopted the Basle Accord capital guideline of 8 percent of risk-adjusted assets as the minimum capital requirement for banks. However, only domestic banking assets are risk weighted. CBSL should require that FCBU assets also be included. The 1995 banking law amendments raised the minimum level of capital for existing commercial banks (and licensed specialized banks) to Rs. 50 million, and for new banks to Rs. 100 million. However, from a risk management standpoint, capital requirements are not meaningful unless provisioning standards are satisfactorily enforced. If a bank is under-provisioned, its capital is overstated. The state-owned banks seemed to be materially under-provisioned due to a generous treatment of non-performing loans that are government-guaranteed (para 1.28). The problem is particularly acute in the case of People's Bank, which does not meet the risk-based capital requirements, despite under-provisioning.  - 28 - ANNEX I 1.61 Interest Accrual on Non-performing Loans. When a loan is delinquent for three months, a bank is required to cease accruing interest, and to reverse any previously accrued interest on that loan. Rules on interest accrual in Sri Lanka compare favorably with those in most developing countries. However, the treatment of delinquent loans in Sri Lanka is complicated by the substantial volume of overdrafts in bank loan portfolios. Determining when such loans become delinquent is not always precise. Moreover, interest income on non-performing government-guaranteed loans continue to be accrued. CBSL should disallow this practice, and require the same income treatment for all'non-performing loans. 1.62 Asset Classification and Loan Loss Provisions. Loan classification in Sri Lanka is principally based on the time a loan is delinquent, although judgments about the potential for loan default are also made. Provisioning requirements are based on a combination of loan classification and the value placed on loan collateral, where it is present. CBSL loan classification standards appear to be insufficiently rigorous. In practice, examiners seem to rely either on a straight time-based approach or the provisioning level determined by the bank in question. No judgments about the potential risk of default seem to be made. Moreover, loans that are in arrears for three months should already be classified as substandard, instead of the current definition of six months. (Attachment 1.1 contains a more detailed discussion of loan classification and provisions.) 1.63 Expected net exposure depends on the value assigned to collateral. Bank Supervision has issued "Guidelines on the Valuation of Security for Provisioning Purposes." These valuations generally appear to be reasonable in the case of private sector collateral, although it is unclear whether valuations assigned to assets adequately factor in the time value of money and legal and other expenses likely to be incurred by a bank in pursuing the collateral. 1.64 Government guarantees are given full value despite the fact that in the past the government has not always honored its guarantee commitments in a timely manner. Even if there is assurance that the government will honor its obligations, it is questionable that those obligations will be honored so as to fully compensate for foregone interest. Consideration should be given to valuing government guarantees at less than 100 percent (perhaps factoring in the cost of foregone interest) so that non-performing government guaranteed loans are subject to some provisioning requirement. 1.65 Bank Ownership Limits. No individual or company is permitted to own more than 10 percent of the shares of a bank, although there are two private banks where substantially more than 10 percent of the shares are owned by single shareholders. Because capital markets are thin in Sri Lanka it is difficult for any organizing group to raise the substantial amount of capital needed to start a new bank without violating the  - 29 - ANNEX I ownership limits. Also, if individual banks get into difficulty, ownership limitations will make it difficult for them to recapitalize or otherwise gain assistance. CBSL is aware of ownership concentrations and should be in a position to monitor potential abuses. Ad hoc exceptions might be made by CBSL as necessary and if the potential for abuse is absent. However, it is not clear that there are significant benefits associated with this ownership limitation. Moreover, the greatest potential abuse from concentrated bank ownership in Sri Lanka rests with government ownership. The limit on the maximum ownership share of banks should be raised. Privately-owned banks should also be permitted to have a minority of inside directors. 1.66 Reporting and Disclosure. Over the past few years, disclosure standards for banking have substantially improved and appear to be consistent with international standards. Required reporting includes monthly statements of assets, liabilities and liquidity ratios; quarterly statements on non-performing advances of Rs. 500,000 and over, income and expense items, risk-based capital calculations; year-end reports of sources and uses of funds, and a balance sheet and income statement providing detailed notes on accounting procedures, commitments, transfers to reserves, depreciation on physical assets, investment values, taxes, and data related to cash reserves. 1.67 The banks are currently required to submit ample data for evaluating their operating performance and financial condition. A computer-based monitoring system would greatly improve the CBSL's ability to effectively analyze this data. Standard ratio analysis could be on a personal computer using standard spreadsheet packages. A data base could also be developed for statistical comparisons and ratio analyses. This could have several potential benefits: (i) it would improve the ability of Bank Supervision and senior management within CBSL to evaluate the condition of banks; (ii) it would help allocate scarce staff resources more efficiently as more problematic banks are given more attention than others; (iii) it would help enhance staff understanding of factors affecting bank performance; (iv) it could serve as a useful training device; (v) selected data could be made available to banks to better evaluate their own performance; and (vi) it would help improve the accuracy of data submitted by banks, as the comparative analyses would help to spot errors. 1.68 Several domestic private banks are listed companies and their annual reports provide a reasonable degree of disclosure, including information on provisioning expense and accumulated provisions. The state-owned banks publish annual reports with somewhat less information, and foreign bank branches operating in Sri Lanka provide very little public disclosure on their Sri Lanka branch operations. It would be desirable if some of the detailed data collected by CBSL, including data on income and provisioning were disclosed for individual banks on a regular basis as suggested above. 1.69 Bank Examinations. The current requirement that banks be examined every two years may be a reasonable arrangement for stronger banks, but insufficient for  - 30 - ANNEX I banks facing problems. It is important that limited examination resources be allocated effectively. On-site and off-site activity should complement each other. The former (along with external audits) is essential if bank reports are to be relied upon, and the latter should help determine the focus and frequency of examinations. Both need to be strengthened in Sri Lanka. On-site examinations also provide Bank Supervision with an opportunity to evaluate a bank's credit culture, internal controls, conformity with certain prudential standards, and overall management quality. Consideration should be given to more frequent on-site examinations for weaker banks when sufficient resources are available. These additional examinations could focus on specific areas and, possibly, be triggered by off-site findings. 1.70 An examination manual was prepared with the assistance of IDA but written directives, focusing on rules for income accrual, provisioning, valuing collateral, etc., are limited and do not provide sufficient detail. There apparently is no formal training program for examiners, although some participate in a regional Southeast Asian examination school. Examiners are not sufficiently knowledgeable about banking and pursue relatively clerical activities. Examiner training should be strengthened through a combination of classroom and on-the-job training. 1.71 The 1995 banking law amendments specify that specialized banks will be subject to CBSL supervision. It is unclear how frequently on-site examinations of these institutions will be conducted. All deposit-taking institutions, including finance companies should be required to meet common standards, including capital ratios, rules on income accrual, provisioning requirements, etc. While the frequency of examinations and required reports might be varied for different institutions, common prudential standards should apply to all institutions. All supervisory staff should report to the same senior officer in CBSL. Supervisory standards should be made uniform for all deposit- taking financial institutions. 1.72 Bank Supervision should attempt to work closely with auditors through a regular dialogue so that potential differences in standards can be resolved and external audits can serve a more useful role for supervision. 1.73 CBSL Personnel Policies. There appears to exist a serious shortage of qualified staff within the Bank Supervision Department. Overall staff size within the department is only 79, of whom 63 are professionals. According to the Director of Supervision, at least 30 to 40 additional staff are needed. Bank supervision staff turnover is high. GOSL should implement the recornmendations of the Presidential Commission on Finance and Banking that CBSL's supervisory department be strengthened and an improved remuneration package be introduced in Bank Supervision with a view to attracting high quality staff. They could engage experienced private sector auditors to address this issue in the short term and also to help build in-house supervision capacity.  -31 - ANNEX I 1.74 The growing demand for skilled personnel within the financial sector makes it difficult for Bank Supervision to recruit the best and the brightest. The cost to CBSL and the economy of inadequate bank supervision staff can prove to be very high. GOSL should consider assessing banks an examination fee, and using the resulting revenues to support a larger and more qualified Department of Supervision. 1.75 Enforcement. The CBSL should strengthen the enforcement of punitive actions to be taken if a bank does not meet capital requirements or other supervisory requirements. Several actions are possible. It could place limits on the expansion of a delinquent bank or restrict certain forms of new lending. The bank could also be asked to sell assets or pursue policies that raise operating margins at the expense of growth, for example by paying lower rates for some categories of deposit. 1.76 Bank Accounting and Auditing. The 1988 Banking Act amendments require that commercial banks submit annual audited financial statements with certain specified inclusions. The 1995 Banking Act amendments specify that the Monetary Board issue auditing guidelines, and that banks must select from a list of qualified auditors compiled by the Director of Bank Supervision, to meet their auditing requirements. The Director of Bank Supervision may enlarge the scope of the audit, and the auditor would have to carry out the additional examinations and other audit work required by him. 1.77 Bank audits are carried on annually, whereas bank examinations occur every other year. Bank Supervision has had difficulty recruiting and maintaining a large, qualified staff. There appear to be opportunities for Bank Supervision and bank auditors to work more closely in Sri Lanka. Given labor market conditions and Government staffing problems, this may be a desirable approach. It should be noted that in Canada, Germany and some other industrialized countries, heavy reliance on private auditing firms has served the supervisory process reasonably well. 1.78 The Sri Lanka Accounting and Auditing Standards Act, enacted in August 1995, requires that the Institute of Chartered Accountants of Sri Lanka (ICASL) adopt accounting and auditing standards for a specified group of companies, and to revise these standards from time to time, when appropriate. The companies specified include banks, financial institutions, stock brokers, those operating unit trusts, all listed companies, unlisted companies meeting specific size-related criteria, and certain public corporations. An Accounting Standards Committee and an Auditing Standards Committee, comprised of Government officials, members of the Institute, and certain private individuals, have been established to consult with, advise and assist the Institute in its activities. A Sri Lanka Accounting and Auditing Standards Board, comprised of Government officials and appointed private individuals with accounting, business and legal credentials, has also been established to monitor compliance with the accounting and auditing standards. The Board has its own staff and have enforcement powers that can lead to legal action and  - 32 - ANNEX I serious penalties. ICASL standards will be enforced when they are gazetted in October 1998. A compliance monitoring unit is also to be set up by the Standards Board. 1.79 These are serious attempts on the part of GOSL to upgrade the quality of financial reporting in Sri Lanka, although it is difficult to pre-judge their efficacy. In the U.S., where reporting standards are already high, monitoring depends heavily on private oversight by shareholders, analysts, lenders, and investment firms. The SEC imposes reporting standards on public companies, but generally is unable to review submitted reports in detail, until problems arise. It tends to impose after-the-fact penalties. Financial markets discipline poor quality disclosure through adverse pricing and reduced access to financing. There is also private legal action to penalize false reporting. All of these elements contribute to the quality of disclosure. In Sri Lanka, the task of reviewing financial reports and audits will be substantial. A Board, acting as a Government agency, and potentially subject to political interference, may face difficulties in effecting improvements. Only four listed commercial banks, DFIs and a few listed finance companies publish their quarterly unaudited accounts. The disclosure policies should apply to all deposit taking institutions to promote market discipline. 1.80 Bank Failure Resolution. While Sri Lanka's only commercial bank failure involved a BCCI branch when that bank failed, a number of finance companies have failed during the last 10 years, and both state-owned commercial banks and NSB might have failed in the absence of Government assistance. The current laws related to private bank failures in Sri Lanka are unsatisfactory. Two options exist. One involves liquidation and establishes a system of creditor seniority that places the claims of small holders of time and savings deposits ahead of other depositors and unsecured financial creditors. However, the level of that priority position is too small (Rs. 5,000 or less than US$100) and should be raised to at least Rs. 50,000 to have any significance. In all failing depository institutions, those holding time and savings deposits of up to Rs. 50,000 should be given a priority position compared with larger depositors and other unsecured financial creditors. 1.81 In the other approach, the Monetary Board could select another bank to take over a failing bank's operations, assume its assets and liabilities, including all pending legal action against the failing bank on terms set forth by the Monetary Board. The transaction would require an acquiring bank to agree to a deal that is not appropriately spelled out, and one where it may be asked to pay a sizable amount for an insolvent bank and unspecified future exposure. The only banks willing to be an acquirer in such a transaction would probably be Government-owned banks. Thus, this would amount to a set of provisions for a Government-owned bank to take over a troubled or failing private bank. It would be preferable if CBSL considered formulating procedures for some form of purchase and assumption transaction where the central bank would facilitate the acquisition of a failing bank, provide limited protection to depositors and forestall potential financial market disruption. CBSL should restudy procedures for  - 33 - ANNEX I dealing with failing banks and other depository. institutions and develop practical, cost- effective procedures for purchase and assumption transactions and other vehicles for dealing with failures. (Bank failure resolution is discussed in greater detail in Attachment 1.2)  - 34 - ANNEX II SRI LANKA FINANCIAL SECTOR REFORMS CAPITAL MARKETS Background 2.01 The Bank's 1991 financial sector report identified a number of obstacles to capital markets development, including: (i) distortions in the tax system that provided advantages to some issuers, investors and instruments over others without clear rationale; (ii) inadequate institutional investor participation due to investment restrictions to capture funds for government debt financing; (iii) lack of investment funds to channel foreign investments into the local capital market; (iv) channeling of most savings to bank deposits and government securities; (v) information uncertainties due to inadequate disclosure to investors; (vi) lack of a well-designed privatization program that supported capital markets development; and (vii) lack of a broad-based marketing campaign to encourage participation by first time investors. 2.02 Progress has been made in addressing many of these issues. Throughout the 1990s, GOSL efforts have focused on the development of the local stock market infrastructure, resulting in the establishment of a modern stock exchange in Colombo. The infrastructure for trading, clearance, settlement and safekeeping of securities meets international standards. Several tax reformns were instituted, including the removal of the capital gains tax on listed companies, declaration of a tax holiday for venture capital companies and unit trusts, abolition of the stamp duty on listed shares and withholding tax on dividends paid to resident shareholders, elimination of the wealth tax, and reduction in corporate tax rates. Steps have also been taken in recent years to improve in the regulatory framework and enforce higher disclosure standards. Significant progress has been made in developing the investment fund industry. A country wide investor awareness campaign was launched. 2.03 Measures were taken to facilitate foreign participation in the capital markets, including a reduction in exchange controls and the liberalization of policy toward foreign investments in shares of listed companies. Foreign investors have played a major role in the development of the securities and investment fund management industries in Sri Lanka through joint venture operations with local firms. Furthermore, foreign portfolio investors have become a major source of trading activity on the CSE, accounting for more than half of the trading activity in 1996. During 1997, despite the unfavorable conditions in the region due to the financial crisis in East Asia, foreign participation still accounted for 43 percent. Foreign investor presence has provided a strong impetus to the development of the stock market infrastructure and regulatory framework to a fairly advanced level for a  - 35 - ANNEX II relatively small securities market. 2.04 Recently, however, there has been a sharp reduction in the volume of new issues in the primary market and the level of secondary market trading on the stock exchange due to larger macroeconomic and political issues. Overall, compared to other developing Asian countries, the results in developing the Sri Lankan capital markets as an instrument of private savings mobilization have been unimpressive. To illustrate, capitalization of companies listed on the Colombo Stock Exchange (CSE) as a percentage of GDP has increased from about 11.4 percent in 1990 to 15.1 percent in 1996. Over the same period, this ratio increased from 12.7 percent to 36.1 percent in India, from 7.6 percent to 42.8 percent in Indonesia, and from 12.9 percent to 37.4 percent in the Philippines. In 1996, among the emerging Asian markets, only Korea (8.6 percent) and Thailand (12.7 percent) had smaller stock markets relative to GDP than Sri Lanka. 2.05 Efforts to develop the bond markets have also shown little result. The primary market for corporate debt is quite small. Also, secondary market trading of corporate debt listed on the CSE is relatively inactive. In the case of government debt instruments, the primary market is large relative to other emerging securities markets; however, the secondary market is not well developed due largely to the captive nature of major investors which has led to the immobilization of government debt securities in government controlled institutions, including the provident funds and insurance companies. The development of the secondary market in private debt securities has been hindered by a variety of factors (para 2.24-2.27). A. Legal and Regulatory Framework 2.06 Sri Lanka has employed a regulatory model for stock market transactions that allows relatively free markets and practitioner-based self regulation accompanied by strong government oversight. This model has allowed the stock exchange to develop relatively well under the guidance and supervision of the SEC and the Ministry of Finance. In contrast to its role in the equity market, however, the SEC has played only a marginal role in the development of the debt securities market. Regulatory and Supervisory Agencies 2.07 Securities and Exchange Commission. The Securities and Exchange Commission of Sri Lanka (SEC) was created under the Securities Council Act No. 36 of 1987 ("Securities Act") as a statutory body responsible for the regulation of the securities markets, issuers and investors. In 1991, the Securities Act was amended granting authority to the SEC to grant licenses to unit trusts. Under the Securities Act, the SEC has the following specific objectives: (i) the creation and maintenance of a market in which securities can be issued and traded in an orderly and fair manner; (ii) the protection of the  -36 - ANNEX II interests of investors; (iii) the operation of a Compensation Fund to protect investors from financial loss arising from the failure of a licensed Stock Broker or Stock Dealer to meet his or her contractual obligations; and (iv) the regulation of the securities markets, insuring that professional standards are maintained. 2.08 Colombo Stock Exchange. The CSE serves as a self-regulatory organization with strong oversight by the SEC. The Securities Act requires that CSE rules must be approved by the SEC. In Sri Lanka, self-regulation appears to be working effectively. All brokerage firms are registered with the SEC. They are also subject to self-regulation by the CSE. The CSE has responsibility to monitor prudential standards (i.e., the capital rule), review financial reports filed with the exchange by the broker members, and conduct on- sight examinations under the oversight of the SEC. The brokerage firms are licensed annually. The CSE also is responsible for surveillance of markets and trading practices. On a regular basis, the Surveillance Division of the CSE conducts checks of broker and investor activities. In cases where unfair trading practices are detected, punitive sanctions have been administered by the exchange. The screen-based trading system has become operational and it makes it easier for the CSE to perform its market surveillance function. 2.09 Ministry of Finance. The Ministry of Finance (MOF) plays a significant role in the development and regulation of the capital markets. The Chairman of the SEC reports to the Minister of Finance. The MOF is responsible for appointing six members of the SEC and also for nominating four non-broker members of the Board of Directors of the CSE. The MOF plays a leading role with respect to policy formulation for the overall financial sector and with respect to foreign investor participation in the capital markets. In order to invest in Sri Lanka, regional and international funds must first obtain approval from the MOF through a process of registration. 2.10 Central Bank. The CBSL is responsible for the supervision of deposit taking institutions. It is also responsible for the operation and supervision of the market for government securities. As such, it could play a pivotal role in the development of a money and bond market in Sri Lanka that could include private issues as well as government debt instruments. Prudential Standards 2.11 Prudential standards are in place for members of the stock exchange. Also, the standards have recently been amended in light of the policy change which will allow members of the CSE to act in the capacity of broker and dealer. In December 1996, net capital and financial reporting standards for members of the exchange becarne effective. The firms' compliance officers are responsible for ensuring that the rules are strictly complied with. Under CSE Rule 2.1, member firms were also instructed to commence maintaining a separate bank account operated solely for the collection and payment of clients' monies. Also, member firms are obligated to ensure continuous monitoring of the  -37 - ANNEX II firms' net capital position as required by CSE Rule 2.2(d). Under the provisions of the net capital rule, member firms are required to maintain minimum net capital of at least Rs. 2.5 million with the level of required capital increasing in increments of Rs. 500,000 as the level of purchases made by the member firm increases. Net capital of member firms is reviewed by the CSE each quarter, and in the event of a net capital deficiency, a member firm must comply with any required increase in net capital as computed by the CSE within 14 days of notification by the exchange. 2.12 At the SEC, the audit division is responsible for monitoring the prudential and operational performance of members of the stock exchange (i.e., stock brokerage firms) and the management companies of the unit investment trusts. In the case of the brokers, the SEC primarily performs an oversight function since the first line of defense is the CSE regulatory staff. Nevertheless, the SEC does conduct on-site inspections on the brokerage firms to ensure compliance with rules and regulations. With regard to the fund management industry, a self-regulatory organization does not yet exist. Thus, it is the SEC's direct responsibility to supervise and monitor the performance of the fund management industry. In order to ensure financial stability and prevent system failure, the audit division of the SEC is responsible to ensure that brokerage firms and fund managers maintain required capital levels and otherwise comply with applicable rules and regulations including the filing of financial reports. With regard to brokers, for example, there are strict "audit trail" rules which require that specified procedures be followed with respect to the recording of orders, execution priorities and allocations. Under a mandate from the SEC, all brokerage firms are required to appoint a compliance officer. 2.13 One gap in the regulatory framework, however, is that registration and prudential standards have not been established for either investment banks or merchant bankers. In view of the potential risk exposure which is inherent in the underwriting of securities, this is a significant weakness in the regulatory framework. In the context of an emerging securities market, the underwriting of securities is relatively capital intensive and subject to substantial market risk (i.e., stock price volatility). NBFIs which serve in the capacity of underwriter or dealer in equity securities and debt instruments should be properly regulated. They are also important to the process of privatization. Clearly, investment banks performiing underwriting and related capital market functions such as investment advisory services should be registered with and regulated by the SEC. 2.14 Currently, merchant banks are apparently not deemed to be either brokers or dealers in securities under the provisions of the Securities Act. Thus, merchant banks are not required to register with the SEC. Since merchant banks do not take deposits from the public, they are not regulated by the Central Bank. It would appear appropriate for any merchant bank engaged in investment banking activities to be subject to SEC supervision. Ultimately, however, merchant banks should be required to establish a separate affiliate or subsidiary for the purpose of performing underwriting or other capital market activities (i.e., fund management or acting as an investment advisor) that would be subject to SEC  - 38 - ANNEX II regulation. 2.15 It is noteworthy that investment advisors are not covered under the Securities Act and there is also no separate Investment Advisors Act. In keeping with international practices, it would be appropriate to amend the Securities Act to require the registration of investment advisors with the SEC. In this way, investment advisory services offered by broker-dealers, investment banks, merchant banks, or other entities could be brought under the jurisdiction of the SEC. B. Institutions Securities Firms 2.16 At present, the securities industry is comprised of 15 highly specialized brokerage firms with total assets of Rs. 172.2 million. Most of the brokerage firms which vary in size and scope of operations have been in operation for many years; however, four new firms were organized in 1992 with the opening of the securities industry to foreign participation. The SEC has concluded that the entry of internationally reputed firms as partners with local brokers has led to a marked improvement in the quality of services, personnel and professionalism within the industry. 2.17 In addition to stock brokerage many firms also provide research and money management services. Historically, the brokerage firms have been prohibited from performing the functions of broker and dealer. This artificial separation was mandated by a regulatory requirement which is in the process of being rescinded. As a result, brokerage firms were not permitted to evolve into fill services securities firns performing dealer- related functions such as firm commitment underwriting, market making, or taking on securities positions for their own trading or investment account. In March 1997, the CSE with the approval of the SEC announced that member firms would be permitted to trade for there own account in an effort to improve market liquidity. When trading for their account, securities firms will be limited to 2 percent of the issued capital in any security. 2.18 With declining stock prices and the substantial reduction in trading volume over the past years, many brokerage firms have been forced to downsize. Nevertheless, the number of firms has remained steady at 15. When the artificial barrier between broking and dealing is removed, stock brokerage firms could be acquired by investment banking or merchant banking finns. This could lead to stronger full-service securities firns, less reliant on brokerage commissions, such as those found in more advanced markets (i.e., the U.S., Japan, U.K., Canada, Korea, Taiwan, and Thailand). Under the existing regulatory scheme, a merchant or investment bank acquiring a stock brokerage firm would have to comply with SEC regulations as well as self-regulation administered by the CSE. If a  - 39 - ANNEX II separate regulatory framework is developed for investment and merchant banks, the integration of investment banking and stock brokerage would happen more quickly. Equity Markets 2.19 The CSE is licensed by the SEC to operate as a stock exchange and is the only stock exchange in the country. The stock market and the related infrastructure for clearance, settlement, and trading are state-of-the-art. The CSE has an automated trading system that replicates the trading techniques employed in the past through the open outcry system. In keeping with international standards, the clearance and settlement process is fully automated. All share transactions are effected via a book entry as soon as trade details are entered into the Central Depository System (CDS). All trades must be executed on the CSE. The CSE has a Main Board for larger companies with a more active trading market and a Second Board for smaller, less active companies. Although a separate over-the- counter market does not exist in Sri Lanka, less active issues are traded on the CSE's Over- The-Counter Board. The new automated trading system, which has replaced the open outcry system using trading floor boards and floor brokers, is an Electronic Order Matching Screen based trading system, enabling brokers or dealers to trade from there own offices. The new trading system has the facility of an electronic order book which is expected to give brokers and investors greater access to market information. 2.20 Size and Growth of Equity Markets. Over the period 1990-97, stock market capitalization in Sri Lanka increased from US$0.9 billion to US$2.1 billion (Attachment 2.3, Table 2.2), while the number of listings grew from 175 to 239 (Attachment 2.3, Table 2.4). While the Sri Lankan stock market has made good progress in the 1990s, its equity market capitalization grew at about one-half the rate of other South and East Asian countries. From 1990 to 1996, the stock market capitalization of ten South and East Asian developing countries increased from US$340.2 to US$855.2 (Attachment 2.3, Table 2.2), while the number of listed companies grew from 4,379 to 10,449. Moreover, market capitalization in Sri Lanka is still quite small relative to GDP. At year-end 1996, stock market capitalization was only 15.1 percent of GDP (Attachment 2.3, Table 2.3).  - 40 - ANNEX II Table AII.1: Stock Offerings on the CSE Part I - Capital Raised Through Common Stock Offerings Type of Offering 1993 1994 1995 1996 1997 Number of New Listings 12 15 14 9 6 Value of New Listings (Rs Bil) 1.1 3.2 2.4 1.6 0.7 Number of Rights Issues 31 29 15 15 12 Value of Rights Issues (Rs Bil) 4.3 7.8 1.2 5.2 1.06 Total: Number of Primary 43 34 29 24 18.0 Issues Total: Value of Primary Issues 5.4 11.0 3.6 6.8 1.76 Part H - Issuance of Bonus Shares on the CSE Bonus Offering 1993 1994 1995 1996 1997 Number of Bonus Issues 19 34 17 21 22 Value of Bonus issues (Rs. Bil) 6.5 1.4 5.4 1.1 0.5 Source: CSE Fact Sheet (1996 & 1997) 2.21 New Issues. Since 1995, macroeconomic conditions have not been conducive to capital mobilization through the stock market. Consequently, the number of new listings through unseasoned common stock offerings declined from 15 in 1994 to 6 in 1997 while the amount of capital raised fell from a peak of Rs 3.2 billion in 1994 to Rs 0.7 billion in 1997. Rights offerings to existing shareholders also declined over this period. As a result, the amount of equity capital raised through stock offerings declined from a record Rs 11.0 billion in 1994 to Rs 1.8 billion in 1997. With unfavorable stock market conditions, the number (22) and value (Rs 0.5 billion) of bonus issues were relatively small in 1997. In a period of falling stock prices, a large volume of bonus issues could contribute significantly to a further weakening in stock prices. 2.22 Secondary Market Trading. While annual turnover declined from a peak of Rs. 34.5 billion in 1994 to Rs. 18.3 billion in 1997, foreign participation in the stock market has increased sharply relative to local investors. From 1993 to 1996, the share of total turnover on the stock exchange accounted for by foreign investors increased each year - from 35 percent in 1993 to 43 percent in 1997. On balance, foreign investors were net buyers of Sri Lankan stocks during the 1993-1997 period while local investors were net  - 41 - ANNEX II sellers. Thus, foreign portfolio investors have been a more stable source of trading volume than local investors during a period of contracting stock prices and substantially reduced secondary market activity. In Sri Lanka, stock prices were down sharply in 1995 and 1996 resulting in negative returns (Attachment 2.3, Table 2.5). This trend has been arrested in 1997. At 11.7, the average price-to-earnings ratio for Sri Lankan stocks was one of the lowest among ten South and East Asian emerging stock markets suggesting that the market could be ready to rebound if the macroeconomic and political situation improves (Attachment 2.3, Table 2.6). Table AHI.2: Secondary Market Activity: Key CSE Statistics: 1990-1997 Key Indicators 1991 1992 1993 1994 1995 1996 1997 Annual Tumover (Rs Bil) 4.3 5.0 22.1 34.5 11.2 7.4 18.3 Domestic (Rs Bil) 2.7 3.1 14.4 20.7 5.8 3.4 10.4 Foreign (Rs Bil) 1.6 1.8 7.7 13.8 5.4 4.0 7.9 Companies Listed 178 190 201 215 226 235 239 Companies Traded 166 135 187 203 215 214 225 Market Capitalization (Rs 82 66 124 144 107 104 129 Bil)__ _ Turnover Ratio 7.2 6.7 19.6 25.9 9.0 7.1 14.15 Stock Price (% Chg. 76.2 -31.0 74.5 -0.3 -31.2 -9.4 NA Yr/Yr)II I CSE Fact book (I996 & 1997) and IFC Fact Book (1996 & 1998) 2.23 Stock Market and Privatization. While Sri Lanka has made good progress in developing the stock market infrastructure and regulatory framework, the stock market is still too small to be an effective vehicle for capitalization. For the stock market to play a larger role in capital mobilization and economic development, there must be a closer link between the program for privatization and the capital market development. The stock market can facilitate privatization while privatization can deepen the stock market. In order to increase public awareness and to enhance the ability of investment bankers and other securities market professionals to participate in the process, a list of privatizations should be published and updated at least twice a year. In the event that announced privatizations are withdrawn or delayed, it would be desirable to disclose the reasons to the market and investors at large. Stocks of state-owned enterprises offered through initial public offerings should be priced in a fair and transparent manner. If investors have a favorable investment experience, future public offerings would be facilitated.  -42 - ANNEX II C. Money and Bond Markets 2.24 In Sri Lanka the money markets consists largely of Treasury Bills and the inter-bank call money market. The primary market for corporate debt is quite small and the secondary market for listed corporate debt securities is relatively inactive. The primary market for government debt instruments is large relative to other emerging securities markets; however, the secondary market is not well developed due largely to the captive nature of state-owned financial institutions, which has led to the immobilization of government debt. 2.25 The primary market for Treasury Bills consists of the re-issue of maturing bills and new issues which are sold through a weekly auction by approved dealers. Since the main function of the inter-bank market is to facilitate short-term liquidity management among banks, the inter-bank call money market is confined primarily to commercial banks. It appears that most Treasury Bills are held by investors to maturity or sold back to the primary dealer with whom the investor has an account. Commercial paper, negotiable certificates of deposit, and other forms of private money market instruments are absent from the market. Several studies have been conducted recommending that steps be taken to improve the operations of the market for government securities. Steps have been taken to improve the weekly auctions of Treasury Bills, including the creation of a network of primary dealers. However, the infrastructure for the market including modem systems for clearance, settlement, and secondary market trading are not yet developed. 2.26 The development of the secondary market in private debt securities has been hindered by a variety of factors. First, there is a lack of a well-developed infrastructure for efficient trading. Second, there is still no credit rating agency although a rating agency is to be set up shortly by an international firm. Third, foreign investors have not been permitted to participate in the market for debt securities while government policy with respect to their participation in the equity market is quite liberal. Fourth, in Sri Lanka there is no market- determined yield curve since the government has preferred to roll-over short-term bills to finance long-term development expenditures. In countries with a well-developed bond market, government debt instruments are priced on the basis of supply and demand in the secondary market. The resulting yield curve provides a benchmark for private issuers of securities and quasi-government institutions in issuing their own debt securities. Fifth, the SEC has jurisdiction only over listed securities. In most countries, however, money and bond market instruments often trade in over-the-counter dealer markets rather than on an organized exchange. (Attachment 2.1 provides more details on Sri Lanka money and bond markets, particularly on the need for creating a credit rating agency and defining a debt security clearly.)  - 43 - ANNEX II 2.27 Finally, the development of a viable bond market also requires sound macroeconomic policies and an institutional investor base that is market oriented. In Sri Lanka, vast amounts of savings are immobilized in government securities held by government owned institutions or regulated entities such as banks, provident funds and insurance companies. It is also critical that non-bank financial institutions be pernitted to invest in capital market instruments (i.e., equities and bonds) with market-determined rates of retum. Steps should therefore be taken to liberalize the regulations applicable to NBFIs, serving in a fiduciary capacity, and to develop appropriate regulatory standards for their investments in capital market instruments. D. The Fund Management Industry 2.28 In 1992, the unit trust industry started with the creation of four unit trusts in quick succession each with a foreign partner (Attachment 2.2 provides more details). By the end of 1997 the number of unit trusts had reached 10. The increase was not only in numbers but also was in diversification. GOSL policy aimed to promote growth in the industry by granting a five-year tax holiday and encouraging foreign equity participation. In 1997, an SEC regulation was liberalized to allow a fund manager to manage more than one unit trust. However, SEC has been cautious in permitting an existing management company to operate another unless it has the required infrastructure and professionals. With the new policy in place, more specialized unit investment trusts are expected to be launched in the future including those that invest in "growth" stocks or a particular industry such as plantations, and "income" funds which would invest in Treasury bills, corporate debentures, commercial paper, or other money market instruments. One innovative product that could be introduced in the market with appropriate government policy support would be a "privatization unit trust" managed by private fund managers but consisting of a basket of privatized companies to be offered to the public in the future. 2.29 The securities regulations have also been modified to allow Sri Lankan fund managers to sponsor more than one open-end investment fund (i.e., mutual fund). Thus, it will be possible for a fund manager to offer investors a wider range of investment funds such as: (i) stock funds; (ii) funds investing exclusively in debt instruments; or (iii) diversified funds investing in stocks, corporate bonds and government securities. A recently established fund management company has taken advantage of this policy change by offering more than one fund. In addition to the open-end funds currently available to Sri Lankan investors, there are also five closed-end investment companies listed on the CSE. 2.30 In 1995, the SEC created a Unit Trust Code which brings into a single code all rules and regulations that were formulated on an ad hoc basis since the inception of the unit trust industry and scattered in several documents. This will result in greater investor protection by making it easier for the SEC's audit division to monitor compliance and bring enforcement actions.  - 44 - ANNEX II 2.31 Unit trusts were taxed in the same way as a listed company with the unitholder treated like a shareholder. This tax treatment, however, was to end in FY97, and only the unitholder would be subject to taxation It is commendable that the recently announced 1998 budget has extended the current tax regime for unit trusts to prevent double taxation and further encourage capital market growth. This decision will continue to place the unit trust industry on a level playing field with other forms of investment, such as bank accounts or the purchase of Treasury Bills. E. Foreign Portfolio Investment and Participation 2.32 In 1997, foreign investors accounted for nearly one-half of the Rs 11.2 billion in trading volume on the CSE compared to only 35 percent six years ago. Without the continued support of the foreign investment community through joint venture stock brokerage and money management firms as well as continued trading support, the CSE would have been a less viable institution. 2.33 GOSL policy on foreign participation has facilitated the development of the stock market infrastructure and the local fund management industry. Few restrictions apply to foreign portfolio investment in listed equity shares. Foreign portfolio investment in the Sri Lankan equity market is permnitted for country funds, regional funds, investment and trust funds, with prior approval from the Ministry of Finance. Companies incorporated outside Sri Lanka and individuals residing outside Sri Lanka are also permitted to invest in the local equity market. Investments made after June 5, 1990 are not subject to exchange control regulations. Moreover, foreign firms are allowed to participate in the local fund management industry, the stock brokerage business, and the investment banking business. However, foreigners are not pernitted to invest in corporate debt securities listed on the stock exchange, or in government debt instruments. Also, foreign investors have not been permritted to own shares or units of unit trusts which are available to local investors only. The exclusion of foreign participation from the private debt market has to a large extent hindered the development of the infrastructure for the market. 2.34 With the exception of commercial banking, insurance companies, and residential housing, foreign investment in listed companies normally is permitted up to 100 percent of the equity in each company. In the case of banks falling within the scope of the Banking Act (No. 30) of 1988, foreign investors are permitted to own up to 49 percent of local Sri Lankan banks. For companies involved in residential housing and mining, foreign investment is limited to 40 percent, while in plantation companies it may go up to 49 percent. 2.35 Under the current tax regime, capital gains derived from the sale of portfolio investments in a listed company are not subject to a capital gains tax. Capital gains on  -45 - ANNEX II unlisted Sri Lankan securities are subject to tax. Dividends are subject to a 15 percent withholding tax. In Sri Lanka, double taxation treaties do not provide for exemption from withholding tax. For the remittance of dividends abroad, tax clearance must be obtained, confirming that applicable withholding tax has been paid, but since Sri Lankan companies deduct the tax at source, this is a fairly routine administrative matter. 2.36 There are two closed-end country funds as well as many regional and global investment funds registered with the MOF for the purpose of investing in Sri Lanka. In 1996, the net asset value of such funds was about US$60 million. The two closed-country funds - the Regent Sri Lanka Fund Limited and the Sri Lanka Growth Fund - were established in 1993 and 1994, respectively. For investment in Sri Lanka, such funds must obtain approval from the Ministry of Finance as well as adhere to certain principles (Attachment 2.2 provides more details). F. Recommendations 2.37 In evaluating the existing Sri Lankan capital market, it is important to keep in mind the important economic functions performed by it: (i) capital mobilization; and (ii) the allocation of capital to its most productive use. With regard to the latter, the secondary market plays an important role in that prices are determined on the basis of supply and demand in a fair and transparent manner. The efficient pricing of capital market instruments sends a signal to the real economy about the opportunity cost of capital. In general, the securities markets regulatory scheme employed in Sri Lanka does allow the market to perform its economic functions. In this regard, the SEC does not interfere in the pricing or selection of new issues. The main weaknesses in the capital market are that: (i) the stock market is too small relative to GDP; and (ii) the debt securities market is at a very early stage of development with a weak infrastructure. Thus, the capital market is not sufficiently developed to play an effective role in the privatization process or in the financing of investment projects. Without a long-term strategy linking privatization with the further maturation of the Sri Lankan capital market, it is unlikely that the capital market will achieve its full potential as shown by the experience of other developing countries in the Asian region. 2.38 Further policy actions by the Sri Lankan Government are needed in the following areas to deepen the capital market and achieve greater liquidity and efficiency: (a) an explicit strategy linking the privatization of state-owned enterprises and capital markets development; (b) further rationalization and simplification of the tax regime to foster the creation of a broad array of financial instruments and provide savers with  -46 - ANNEX II the opportunity to earn the highest return possible compatible with their ability to take on the risk associated with capital market instruments; (c) permission to non-residents to purchase corporate debt securities on the same basis as equity securities; they also should be permitted to purchase shares of unit investment trust and/or investment companies listed on the CSE; and (d) establishment of a regulatory framework for investment banks and merchant banks. 2.39 In addition, it is recommended that the GOSL implement the following institutional and regulatory changes: (a) investment banks and merchant banks should be required to register wNith either the SEC or the Central Bank; in the event registration is with the Central Bank, underwriting and dealer activities in corporate shares and debentures should be conducted through a separate subsidiary or affiliate supervised by the SEC; (b) securities brokers and dealers should be permitted to engage in a full range of financial services including underwriting and dealing in both listed and unlisted securities under the regulatory oversight of the SEC; (c) risk based capital standards should be established for investment banks, merchant banks and securities broker-dealers acting as underwriters or dealers in securities; (d) the definition of security should be broadened to place both listed and unlisted (i.e., over-the-counter) securities under the jurisdiction of the SEC; this would allow for the creation of an over-the-counter trading mechanism for private issuers of debt and equity securities; (e) the infrastructure for the debt securities market should be developed including adequate trading, clearing, settlement and depository systems; (f) a credit rating agency should be established with a regulatory mandate to rate all private debt instruments offered to the public; (g) in view of the complexity of securities regulation, greater transparency in the rule making process is needed; the SEC should be required to obtain formal comment from concerned parties before a rule is adopted or amended;  - 47 - ANNEX II (h) an investment advisors act should be enacted or the Securities Act should be amended to require the registration of investment advisors with the SEC; (i) a regulatory framework should be developed for NBFI capital market activities, including (i) provident finds, (ii) private pension funds, (iii) insurance companies, and (iv) bank trust services, in order to establish proper prudential and fiduciary standards, and to codify the rules under which they are allowed to invest in the securities of private companies, state-owned enterprises and other government entities; and (j) regulations and guidelines should be developed to allow private fund managers to manage a substantial portion of the funds held by EPF, ETF and NSB to expand institutional investor participation in the capital markets.  - 48 - ANNEX III SRI LANKA FINANCIAL SECTOR REFORMS DEVELOPMENT FINANCE AND CONTRACTUAL SAVINGS INSTITUTIONS A. Development Finance Institutions Background 3.01 Sri Lanka's two Development Finance Institutions (DFI), the Development Finance Corporation of Ceylon (DFCC) and the National Development Bank (NDB), are arnong the few in the world that have performed creditably over the last decade. Both are fundamentally private sector institutions, although 18 percent of DFCC and 22 percent of NDB shares are still owned by the public sector. Both have strong management, and have successfully resisted political interference in their operations.' They play an important role in the provision of term finance in a country that has practically no government or private bond market, providing about two-thirds of investment financing in 1997. Over time they have diversified their operations, and thus moved away from the traditional single-product DFI model. In 1997, together they accounted for 4 percent of financial sector assets. Performance 3.02 Development Finance Corporation of Ceylon. DFCC began operations in 1956 with a capital of Rs. 8 million. Over the last decade its assets grew at an annual rate of 26 percent, and after-tax profits, 33 percent in nominal terms. This was despite the sharp decline in profits during FY96, mainly due to a downturn in the economy characterized by a prolonged drought, power outages, heightened labor unrest and unprecedented volatility in the financial markets. Gross interest income from its core project finance business has continued to show a healthy growth. Financial leasing has also grown rapidly and accounted for 16 percent of gross income in 1996, compared to about 4 percent in 1991. The quality of the portfolio remains strong with a collection ratio of more than 90 percent. The level of cumulative provisions and interest-in- suspense is about 5 percent of total advances, which is adequate given the past record of follow-up and collection on non-performing assets. It is one of the most profitable and largest capitalized company on the Colombo Stock Exchange (CSE). Table AIII.1 shows key performance indicators. Attachment 3.1 provides detailed financial information. DFCC was rated last year by Asiamoney as the best managed company in Sri Lanka.  -49 - ANNEX III 3.03 Over the last decade, DFCC has diversified into other activities. Soon after opening its first branch in 1988, it launched National Asset Management Ltd., a professional fund management company in 1991. Lanka Industrial Estates Ltd., the first and only private industrial park and Lanka Ventures Ltd., a specialized venture capital company, were established in 1992. Table AIII.1: Key Performance Indicators Development Finance Corporation of Ceylon (in percent) Item 1989 1993 1994 1995 1996 1997 Growth in Assets (compared to 17.2 24.7 33.7 21.8 36.0 12.0 preceding year) Profitability Retum on Assets 3.2 5.6 6.9 6.8 4.5 3.6 Return on Equity 22.4 27.7 20.5 21.0 15.6 14.4 Operating Efficiency Net Interest Margin 4.8 7.1 7.7 8.7 8.1 7.3 Net Spread 5.3 4.0 3.0 3.5 4.7 5.0 Fee Income 1.6 2.1 4.0 3.3 1.2 1.0 Administrative Staff Expenses 0.6 0.8 0.9 0.9 0.8 1.0 Other Operating Expenses 0.7 1.2 1.4 1.7 1.9 2.0 Provisions and Write-off 1.1 3.6 4.7 5.6 5.4 4.0 Net Income before Tax 3.9 7.0 8.5 8.8 6.1 4.7 3.04 National Development Bank. NDB was established in 1979 under an act of Parliament with a subscribed capital of Rs. 600 million, of which Rs. 450 million was paid-up in cash and the rest was in the form of promissory notes, which were subsequently canceled in 1992, prior to privatization. The bank was privatized in 1993 when the GOSL divested 61 percent of its shares through a public offering and further divested in 1997 bringing the public sector ownership down to 22 percent. 3.05 NDB's core business remains medium-and long-term finance, leasing, bills discounting, equity investments, guarantees and underwriting. Its financial performance has been satisfactory. During the last decade, its asset base has increased more than 7 times while after-tax profit has grown at a rate of 27 percent per annum. Leasing, as a relatively new line of business, continues to grow, albeit at a slower pace. The lease portfolio increased by 52 percent last year, down from 64 percent in 1995 and more than 130 percent in 1994. Despite the recent drop in the collection ratio to around 85 percent, mainly due to an increase in non-performing loans in the tourism sector, the rest of the portfolio remains sound. NDB has followed a conservative policy on provisions for its  - 50 - ANNEX III non-performing assets, and is also consciously reducing its exposure to certain sectors such as textiles and tourism. Table AIII.2 shows key performance indicators. Attachment 3.2 provides detailed financial information. 3.06 In its endeavor to diversify, NDB has taken several initiatives in the recent past and established several subsidiaries and associate companies. These include Citi- National Investment Bank, Ayojana Fund Management, Capital Development and Investment Company, Environmental Resources Management and NDBS Stock Brokers. While these activities have diversified NDB's income source, they have not detracted from the core business. The bank recently appointed Industrial Credit and Investrnent Corporation of India (ICICI) as consultants to assist in the formulation of a corporate plan to ensure a coherent business strategy over the mediurn-termn. Table AIHI.2: Key Performance Indicators National Development Bank (in percent) Item 1989 1993 1994 1995 1996 1997 Growth in Assets (compared 10.9 24.0 13.4 20.5 19.8 32.0 to preceding year) Profitability Return on Assets 2.6 4.9 5.3 4.2 3.9 3.2 Return on Equity 7.0 22.8 23.1 18.1 17.1 17.8 Operating Efficiency Net Interest Margin 3.2 6.6 6.4 5.1 5.0 4.6 Net Spread -0.1 3.3 3.4 2.8 2.8 5.0 Fee Income 0.5 2.3 2.9 2.7 1.7 1.0 Administrative Staff Expenses 0.5 0.5 0.4 0.3 0.4 1.0 Other Operating Expenses 0.5 0.5 0.4 0.3 0.4 0.0 Provisions and Write-off 0.0 11.3 11.6 11.7 11.5 10.0 Net Income before Tax 2.7 6.5 6.8 5.7 5.1 4.4 Issues and Recommendations 3.07 Ownership. Although both DFIs are private institutions, the government and state banks still owns shares in them, 18 percent in DFCC, and, until recently, 22 percent in NDB. Most of the govermnent shareholding in NDB was recently sold to foreign investors, leaving only 10 percent of NDB shares in the public sector. This was a good signal of govemrnment policy to the market, to which the market responded positively by oversubscribing the issue. The government should maintain this policy of  - 51 - ANNEX III keeping the private sector nature of the DFIs to preserve effective corporate governance. It should eventually divest itself of all remaining DFI shareholdings. 3.08 Sustainability. Until recently, both DFIs have not had the need to independently mobilize resources in a big way. Most of their funding needs have been met mainly through the government with IDA and Asian Development Bank (ADB) credits. However, as these traditional sources are drying up, and as they continue to stress their private sector nature, both DFIs have to increase efforts to mobilize resources independently in the domestic as well as foreign markets. NDB recently raised US$50 million in international markets with a guarantee from the ADB. This is a welcome beginning. In the domestic markets, both the DFIs have been borrowing small sums from the Employees Provident Fund (EPF), the Employees Trust Fund (ETF) and the National Savings Bank (NSB). The DFCC also launched a fixed-deposit scheme to mobilize resources at the retail level. In spite of these initiatives, both the DFIs are dependent for more than 75 percent of their funds from IDAIADB. Such a dependence on the government could undermine their autonomy and private sector nature. 3.09 In the past, it has been difficult to mobilize domestic resources (and on-lend profitably) because of the lack of a benchmark for pricing. GOSL has not borrowed in the long-end of the market, preferring to roll-over short term borrowing even for development expenditures. GOSL can help develop a bond market by improving its debt management and starting to issue long-term bonds. This would help develop a yield curve and provide a benchmark by which private sector bonds can be priced (para 1.35). Similarly, the establishment of a rating agency, which is currently being discussed, will help to promote a bond market. To match their foreign borrowings, the DFIs should also explore the possibility of foreign currency loans to exporters and other borrowers that can prudently hedge against foreign exchange risk. The foreign exchange risk cover currently being provided by GOSL is yet another link to the government that should be phased out. 3.10 Regulatory and Supervisory Framework. Both the DFIs were established under special acts of Parliament, and have thus enjoyed certain privileges. In December 1995, new legislation was passed which classified both DFIs as Licensed Specialized Banks. This has brought the two DFIs under the purview of the central bank. Although the legislation was passed in 1995, the central bank has only recently begun to meet with the DFIs in order to formulate and discuss suitable regulations. The formalization of the regulatory framework for the DFIs should be expedited and the central bank should begin formal supervision of these two institutions as soon as possible. Also, the DFIs have begun to mobilize fixed-deposits at the retail level. The central bank should determine the nature of these deposits and consider whether these institutions should be brought under the Banking Act. In essence, as the DFIs become more independent in resource mobilization and become fully private institutions, they should be brought under a regime that is consistent with that of other financial institutions to ensure a level playing field.  - 52 - ANNEX III 3.11 Tax-Shelter from Leasing. In November 1996, the GOSL proposed to the Parliament to limit the off-set of capital allowances arising from leased assets only against income arising from leasing, reducing the tax break for diversified financial institutions like the DFIs. While this measure will increase the cost of leasing to the business community and reduce the effective profitability of leasing operations for the DFIs, it does level the playing field, and thus should be approved and implemented soon. B. Provident and Pension Funds Background 3.12 Various provident and pension funds have been operating in Sri Lanka for more than five decades. The largest old age security fund is a mandatory savings plan called the Employees' Provident Fund (EPF). Established in 1958 by the GOSL in an effort to provide benefits to all members of the fornal workforce, each employer and employee is required to contribute a minimum amount based on a share of gross emoluments (currently 12 percent and 8 percent respectively) to either the EPF or an approved private provident/pension fund. Additional voluntary contributions are permitted. The contributions are tax deductible. These accumulated benefits, including the returns made on these amounts through investments, are paid as a lump-sum to the beneficiary upon retirement or death. The Employees' Trust Fund (ETF), which is also state-owned, was established in 1981. The Trust requires every employer to contribute 3 percent of each employee's earnings in addition to the contribution to the EPF. The ETF differs from the EPF as it allows for withdrawal upon termination of employment, and also provides limited health insurance. 3.13 Most of the private provident funds are akin to the EPF. Some organizations operate approved pension funds managed on behalf of the beneficiaries by trustees. However, these are few and small in comparison to the EPF and the ETF. Moreover, the creation of similar new private funds has been recently barred due to the recent effectivity of a law that was enacted 20 years ago (para 3.23). However, since 1997 publicly listed companies are permitted to establish pension or provident funds for their employees. Performance 3.14 With total assets of more than Rs 100 billion, the Employees' Provident Fund is by far the largest in the country. As of December 1995, it covered an estimated 106,000 employers and 6.6 million employees (Table AIII.3). During the first half of the 1990s, the average annual growth in the number of employees was about 6 percent while the number of employers grew by about 5 percent. However, the number of inactive2 2 An account is considered inactive if there are no deposits or withdrawals during the year.  - 53 - ANNEX III accounts (66 percent of employers and 76 percent of employees) remains high, suggesting many duplicate accounts, lack of enforcement, lack of employee awareness as well as inadequate follow-up by the EPF. 3.15 The rate of return on the EPF's investments is poor and continues to be slightly negative in real terms. The average return during the period 1991-95 was about 12.4 percent ranging from 11.5 percent to 13.5 percent. During the same period inflation averaged about 12.5 percent. As of December 1996, total investments amounted to about Rs 137 billion, of which 97.7 percent was in short term government securities. The rate of return on its investment portfolio in 1995 was 12.75 percent. Table AII1.3: Coverage of the Employees' Provident Fund (in thousand) Active Dormant Active Dormant Year Employees Employees Total Employers Employers Total 1975 862 1,429 2,291 24 21 46 1980 1,128 1,921 3,050 23 33 57 1985 1,178 2,720 3,898 25 45 71 1990 1,268 3,625 4,893 27 55 83 1991 1,341 3,845 5,186 29 57 87 1992 1,406 4,078 5,485 31 59 91 1993 1,490 4,335 5,825 33 62 95 1994 1,600 4,500 6,100 35 65 100 1995 1,800 4,800 6,600 38 68 106 1996 1,549 5,327 6,876 35 71 106 1997 1,553 4,953 6,506 35 68 103 3.16 Both the EPF and the ETF have had slightly negative real rates of return during most of their existence. One of the principal reasons for this poor performance has been the preempting of these mandatory savings by the GOSL for budget financing, thus making the EPF an involuntary underwriter of government debt. This tantamounts to a non-transparent tax on fund members. As a first step towards improving investment performance, the GOSL has amended the law to permit the EPF to invest in non- government securities. The EPF has begun to gradually diversify its portfolio. It is considering contracting out fund management to improve investment returns. These are steps in the right direction.  - 54- ANNEX III 3.17 The preempting of the long-term savings mobilized by the EPF and ETF results in reverse-term transformation. Yet Sri Lanka needs long-term funds, for productive investments, housing, infrastructure and other long-term investments.3 3.1l 8 Evasion has been widespread. There are only 1.5 million active employee accounts, comprising about 30 percent of the work force, and follow-up for compliance is poor. While the overall administration and investment performance of the much smaller ETF is better than that of the EPF, it is also poor. Several steps can be taken to improve the performance. Automation of accounts, links to the company registry and Inland Revenue, use of a common identifier such as the National Identification Number would help improve fund adiiministration. Moreover, there is considerable duplication of work between the two institutions. Under these circumstances it is hard to imagine the rationale for the separation of the two institutions. As part of the administrative reforms, GOSL should consider merging the administration and management of the two institutions. Issues and Recommendations 3.19 The current provident fund system was developed based on a report prepared 50 years ago, and has seen few changes over the years. The limited number of changes made have been ad-hoc in nature, and were mainly a political response rather than well-thought out solutions to long-term socio-economic problems. A proposal to reform the system was submitted to Parliament about five years ago. The draft bill proposed to modify the provident funds into a hybrid provident and pension scheme. Instead of a lump-sum, beneficiaries could opt for a combination of a lump-sum retirement grant and an annuity. The bill was dropped after there were objections from the trade unions. Although the draft bill had some deficiencies, it pointed in the right direction. 3.20 Although the public service pension system has a funding problem that has fiscal implications, the provident funds, in contrast, are defined contribution schemes and are, therefore, fully funded.4 Moreover, they are not complicated by inter-generational or intra-group income re-distribution, and are purely savings instruments for old-age. However, because of the high rate of contribution combined with underperforming investrnents, they are seen more as a tax for the present rather than savings for the future, resulting in widespread evasion. Moreover, since contributions are mandatorily deducted 3 Chile's pension reform highlights the important role domestic non-bank institutions can play in aggregating small savings, and supporting the development of domestic capital markets. At the end of 1994, the Chilean pension system held 55 percent of the state securities, 59 percent of the corporate bonds, 62 percent of mortgage bonds and 11 percent of corporate equities. 4 The Bank's recent Public Expenditure Review covered the public service pension system.  - 55 - ANNEX III from payroll in the formal sector, they constitute a labor market distortion, as evidenced also by widespread evasion. 3.21 With a rapidly aging population (the percentage of population over 60 years is expected to increase from 7.8 percent in 1990 to 20.6 percent in 2030), the challenge is to reduce evasion and expand coverage beyond formal sector employees while minimizing labor market distortions. There are several reform measures that can help bring these about. First, improved investment performance of the EPF/ETF would help market these funds as an attractive savings instrument for old age. Implementation of the recent lifting of the investment restriction in government securities should be accelerated. Fund management should be professionalized, preferably by contracting it out to private fund managers on a competitive basis. EPF/ETF management itself needs to develop a methodology for the selection and performance monitoring of fund managers. They also need to develop investment guidelines consistent with the risk-return objectives of the fumd, which should be disclosed to its members. They need to build their own portfolio management expertise to enable them to provide oversight to fund managers. At the same time, GOSL should consider allowing these funds to be invested overseas under clear guidelines to further increase portfolio diversification and improve returns. 3.22 Second, as fund investments are liberalized and fund management privatized, the regulatory and supervisory framework has to be strengthened. Provident and pension funds are vulnerable not only to moral hazard (excessive risk-taking) but also to fraud. Thus prudential standards, minimum disclosure requirements, and effective regulation and supervision are critical elements of the system. In Sri Lanka there is not yet an effective regulator and supervisor of public or private funds nor adequate prudential guidelines. In some cases private funds are established under the Trustee Act (and managed under trusteeship arrangement) while in others they are not, and provident or pension fund assets are not separated from a company's assets. As a first step, the GOSL should establish an office for the Regulator of Provident and Pension Funds. 3.23 Third, the industry should be expanded outside of the EPF/ETF and into private provident/pension schemes to give savers choices, and promote competition in the industry. Experience in other countries shows that risks, costs and rates of return are strongly influenced by whether a pension system is centrally managed by the public sector or decentralized in the private sector. Public sector managers of centralized provident funds are subject to political interference and have little incentive to operate efficiently or eam reasonable returns. Even in countries like Malaysia and Singapore, where fund management had been de-politicized, the centralized provident funds have given low, albeit slightly real, returns. Given the current structure (with responsibilities split between the Ministry of Labor and the central bank) de-politicization does not appear feasible in Sri Lanka. The first step would be for GOSL to reassess the recent ban on the entry of private pension funds. The policy of allowing the establishment of private pension funds was in effect until last year. However, a law which prohibits the creation  - 56 - ANNEX III of new funds that was passed more than 20 years ago, was recently gazetted and became effective. This step is regressive and should be reversed. 3.24 Fourth, the mandatory nature of EPF/ETF should be re-examined. It is not evident that mandatory savings schemes increase overall savings. Mandatory savings for old age might merely re-allocate existing savings in other instruments. Instead, the tax incentives to save through provident/pension funds should be enhanced to encourage people to save for old age over and above other savings objectives. On the other hand, there is clear evidence that payroll taxation distorts labor markets, promoting suboptimal employment in activities that are not captured by the payroll tax. There is also a governance issue. It is probably safe to say that funds centrally collected through a payroll tax by a government machinery would be misallocated. The current captive nature of the EPF/ETF in holding government securities, and the resulting negative returns to savers argues against a centralized mandatory contribution scheme. The current widespread evasion, and the inability of the government machinery to enforce compliance, are another argument. 3.25 The problems of myopia (people don't save for the future) and moral hazard (those who do not save believe that they will be cared for anyway by the state) can be addressed by a minimum social assistance scheme that provides a minimum (not a desirable) safety net against abject poverty. There is no reason for discriminating against the poor today in favor of the poor tomorrow. This safety net should be financed through the general budget rather than through a payroll tax to minimize labor market distortions. C. Insurance Companies Background 3.26 In 1995, total assets of Sri Lankan insurance companies amounted to about Rs. 22.8 billion, or roughly 2 percent of total financial sector assets. The size of the insurance industry in Sri Lanka is small even by developing country standards. The level of annual premium payments is less than US$8 per capita. By comparison, Chile and Malaysia have reached levels of US$30 and US$60 respectively. In industrialized countries, per capita premium payments have been as high as US$1000 in recent years. The average growth in the insurance industry assets during 1989-97 (17.7 percent per annum) was outstripped by the average growth in the financial sector as a whole (18.9 percent). More rapid development in the insurance sector is hampered by over-restrictive regulations, continued dominance of the sector by public sector companies, inadequate oversight and supervision, and structural weaknesses.  - 57 - ANNEX III Structure and Growth 3.27 There are seven insurance companies that currently operate in Sri Lanka. Of these, two are state-owned - the Sri Lanka Insurance Corporation (SLIC) and the National Insurance Corporation (NIC) - and the remaining five are private insurers. SLIC (formerly, Insurance Company of Sri Lanka, ICOSL) was first established in 1961 and, with the nationalization of the insurance business in Sri Lanka, was nationalized under the Control of Insurance Act of 1962. It remained a monopoly insurer in Sri Lanka until 1979 when NIC was established. Since that time until 1987, the insurance business was left to these two state-owned companies. The insurance industry was liberalized through the Control of Insurance (Amendment Act) No. 42 of 1986 and private insurers were again permitted to do business in Sri Lanka. However, foreign equity participation is still not permitted. In 1987, three private insurers -- namely, CTC Eagle Insurance Co., Ceylinco Insurance Co. and Union Assurance -- were established. Janashakthi Life Insurance Co. and Janashakthi General Insurance Co. were established in 1994 and 1995 respectively. In 1993, SLIC and NIC were incorporated as public liability companies. 3.28 For the insurance sector as a whole, gross General insurance premia grew at 18.1 percent per annum over 1989-97, and gross Life insurance premia grew at 29.4 percent per annum over the same period. The growth of the private sector companies in terms of total written premia over this period, at an average rate of 34.8 percent per annum, far outstripped that of the two state-owned companies (at about 16.9 percent). The market share of private sector companies in terms of gross premia increased from 29 percent in 1989 to 41 percent in 1995 in General insurance, and from 18 percent in 1989 to 55 percent in 1995 in Life insurance. However, despite the rapid strides made by the private companies in achieving growth, the two state-owned companies continue to dominate the insurance sector. Of the two state-owned companies, SLIC is by far the major player, being more than eight times as large as NIC in terms of total gross written premiums. Issues and Recommendations 3.29 Investments. Regulations governing investments of insurance company reserve funds remain overly restrictive. As per the Control of Insurance (Amendment) Act No. 42 of 1986, insurers in Life insurance business are required to invest at least 30 percent of their reserve and capital funds in government securities and the balance in approved investments, and insurers in General business are required to invest 20 percent in government securities and the balance in approved investments.5 Approved investments include: (i) approved securities such as govermnent securities; government guaranteed securities; local authority securities; post office savings certificates; shares of DFCC; investments in any approved projects; ordinary shares, preferred shares and debentures of any institution in which GOSL and private individuals participate jointly; (ii) deposits with commercial banks; (iii) deposits and investments with the State Mortgage and Investment Bank or deposits and  - 58 - ANNEX III 3.30 Total insurance industry investments at the end of 1995 amounted to Rs. 11.0 billion, growing at an average rate of 14.4 percent over 1989-95. Both state-owned and private insurers continued to place the bulk of their investments in government securities and Treasury bills. Of the Rs. 11.0 billion outstanding insurance industry investments at the end of 1995, Rs. 5.8 billion (or 53 percent) were invested in government securities and Treasury bills. Investments in government securities and Treasury bills have grown at an average rate of 15.6 percent over 1989-95. Because insurers are carefully complying with the regulations pertaining to investments, they have been slow to direct their investible resources for long-term investment in business and development. 3.31 The proposed amendments to the Insurance Act are aimed, inter alia, at easing the regulations related to investments of insurance company assets (i) to enable insurance companies to pursue a more diversified portfolio management strategy using modem portfolio management techniques and/or fund managers; and (ii) to permit them to invest a larger share of their assets in support of long term development. As noted above, under the existing insurance law, General and Life insurance businesses are required to invest 30 percent and 50 percent respectively of their reserve and capital funds in government securities, and the balance in approved securities. The proposed new insurance law as currently drafted lowers these minimum limits for investment in government securities for General and Life businesses to 20 percent and 30 percent respectively, and empowers the proposed new Insurance Board to approve the types of instruments in which the balance can be invested. Nonetheless, to promote investment in long-term development, and also to help promote the development of the capital markets, the proposed Insurance Board once established should formulate insurance industry investment rules to assure that: (i) insurance companies are free to operate in the Treasury bill as well as the long term bond markets; (ii) state insurers invest a portion of their resources in the capital markets; and (iii) insurers invest in equities and debentures of DFIs as well as capital market instruments such as equities, debentures and unit trusts. 3.32 Level the Playing Field. Because slow economic growth in recent years in Sri Lanka has adversely affected the expansion of the financial sector as a whole, insurers have had to compete with banks and other non-bank institutions for funds. However, while banks in Sri Lanka provide investors higher investment returns as they are not subject to restrictive investment regulations like insurance companies, they do not lend long term funds and do not cover the same risks as insurance companies. Competition for insurance business among the insurers themselves is also intense. In General insurance, this largely takes the form of price competition (service and security receive secondary importance). However, Life insurance is marketed primarily as term insurance investments in the Housing Development Finance Corporation of Sri Lanka Limited; and (iv) investments in quoted public companies.  - 59 - ANNEX III for mortality risk because, as an instrument for financial investment, it is disadvantaged by over-restrictive investment regulations. 3.33 Even though the GOSL has taken actions in the last few years to reduce the competitive disadvantages for private companies vis-a-vis state-owned companies, and thus to have a more level playing field, many competitive disadvantages still remain. However, passage of the new insurance law and effective functioning of the proposed new Insurance Board is expected to help eliminate many of these inequities. 3.34 In 1993, the two state-owned companies were incorporated under the Companies Act and, like private insurers, they came under the purview of the Controller of Insurance. This helped level the playing field somewhat because the same regulations now apply to all insurers, private and public. These regulations include the minimum and maximum tariff rates chargeable for various classes of General insurance, and the maximum conmmissions and brokerage fees payable, which previously applied only to private insurers. The practice of appointing institutional agents by state-owned companies, however, continues. These agents receive institutional discounts which helps lower the premia that they are required to pay, thereby giving the state-owned companies a price advantage over their private sector competitors. Under the proposed new law, this practice would be abolished, and only individuals would be allowed to serve as insurance agents. Another positive result of this proposed change is that banks would be unable to serve as insurance agents. Currently, state-owned banks acting as insurance agents tend to place the insurance business of their clients with state insurers giving these insurers a competitive edge over their private competitors. The practice of appointing principal agents, which benefited NIC in the past due to lower commissions payable to principal agents, would also be abolished under the proposed new law. Also, the current requirement of 15 percent compulsory ceding of reinsurance business to NIC, which applies to private insurers but not to SLIC, would be abolished under the proposed new law. 3.35 Even with these proposed changes, at least one area of relative advantage for the state insurers would remain. Currently, public enterprises tend to place their insurance business with state insurers. This issue cannot be addressed through a mere change in the insurance law. In order to remove this inequity and promote free competition, the Government must direct state-owned companies to place their insurance business with both public and private insurers on a competitive basis. 3.36 In order to further promote competition and subject domestic insurers to greater market discipline, the Government should facilitate free entry of foreign insurance companies into Sri Lanka. The Controller of Insurance should implement the recent decision of the Government that allows for fair consideration to be given to applications of foreign firms for conducting business in Sri Lanka. This would help promote  - 60 - ANNEX III competition, increase the efficiency of domestic insurers and facilitate the transfer of new technology to the insurance sector in Sri Lanka. 3.37 Privatization. To increase efficiency, foster free competition in the insurance sector, and benefit insurance company clients through better services and/or pricing, the GOSL had announced several years ago its intention to privatize the two state-owned insurance companies. However, serious efforts to privatize have still not started. Some preliminary steps including independent actuarial valuation of the companies' life funds and non-life technical reserves by consulting actuaries, and an independent audit and valuation of their fixed assets and investments were completed in 1993. In 1995, the GOSL incorporated the insurance companies in the medium term plan of the Public Enterprise Reform Comnmission (PERC). World Bank funded actuarial valuations and review of the companies' financial operations from 1992-94 were completed, and some interim steps to partially address the weaknesses identified in the review and strengthen operations were taken. However, the privatization process still was not started in earnest. The GOSL has now indicated its intention to complete the privatization by the end of 1998, which also appears to be fairly optimistic to achieve. It is recommended that the privatization proceed expeditiously. The GOSL should formally announce the privatization and commence the work immediately. It should then formulate a strategy for privatization and complete the entire process as early as possible. 3.38 Regulatory Framework. Passage of the new insurance law, and establishment and effective functioning of the proposed Insurance Board, are expected to strengthen the regulatory framework for the insurance industry in Sri Lanka. However, steps must be taken to strengthen the administrative arrangements for enforcement of regulation and GOSL supervision, which currently remain weak. The office of the Controller of Insurance must be strengthened through improved staffing, administration procedures and automation. At present, this office is headed by civil servants with little insurance experience, and supported by staff who are also inexperienced in insurance. Other needed improvements in regulation and supervision are as follows: (i) uniform disclosure requirements across public and private insurers should be enforced; (ii) off-site surveillance of insurance companies should be strengthened and on-site inspections commenced; (iii) the 1950s UK mortality rate tables which currently underlie premium calculations should be replaced by new Sri Lanka mortality rate tables that would more accurately reflect the actual situation in the country; and (iv) mandatory annual reviews of Life insurance funds by qualified actuaries should be conducted.  - 61 - Attachment 1.1 SRI LANKA FINANCIAL SECTOR REPORT LOAN CLASSIFICATION AND PROVISIONING 1. Loan classification in Sri Lanka is principally, but not solely, based on the length of time a loan is delinquent. In the 1 980s and earlier, classifications were based on subjective analyses of bank supervisors. While such an approach has merits, it tends to be much more demanding of supervisors and presupposes a large, experienced staff. Moving to a system based more on time of delinquency apparently has established tougher classification and provisioning in Sri Lanka. Provisioning requirements are based on a combination of loan classification and the value placed on loan collateral, where it is present. Substandard credits are those where "the situation of the borrower makes it uncertain that part of the entirety of the facility will be repaid including those that are in arrears for 6 months or more but less than 12 months... .banks are required to make a specific provision to cover the amount of the expected exposure but not less than 20 percent of the amount of outstanding net of any realizable security value....[Doubtful credits have "a high risk of partial default including those that are in arrears for 12 to 18 months... .[Loss credits are those where] the situation of the borrower makes it virtually certain that the facility will not be repaid, including those that are in appears for over 18 months....".' Provisioning requirements for expected exposure are 50 percent for doubtful classifications and 100 percent for loss. 2. The treatment of overdrafts also is relevant for loan classifications and required provisioning. Some banks may be slow or reluctant to treat problem overdrafts as non performing. Such problems should be picked up in on-site exarninations. As suggested by provisioning requirements, bank examiners may classify a loan more severely and require greater provisioning than what would be required solely by the duration of delinquency. However, it is not clear that this is frequently done. A review of one bank's examination report revealed a listing of classified loans and required provisioning, but no write ups on individual loans. If a more severe classification were required than a straight time-based approach, one would have expected a write up of that loan including reasons why a more severe classification was appropriate. This suggests that the examiner in charge relied either on a straight time-based approach or the provisioning determined by the examined bank. It should be noted that the Monetary Board was given authority in 1995 to require a bank to establish specific or general loan loss provisions. 1 Guidelines on the Suspension of Interest on Non-Performing Advances and Classification of Bad & Doubtful Advances for Provisioning Purposes, Effective 1/1/92.  - 62 - 3. Expected exposure depends on the value assigned to collateral. Bank Supervision has issued "Guidelines on the Valuation of Security for Provisioning Purposes." These valuations generally appear to be reasonable for private sector loans secured by collateral. No value is assigned to a mortgage on property until a legal mortgage is executed. Where such execution has occ. rred and an auction is pending the value assigned generally is between a "forced sale value" and a "minimum price" or the latter subject to a 10 percent discount. No value is assigned to unsupported personal guarantees. In the absence of professional valuation, mortgages on plant machinery and equipment are valued at net book value using 20 percent straight line depreciation. Valuations assigned to financial assets (deposits, insurance policies, stocks, etc.) generally appear to be reasonable. What is not altogether clear is whether the valuations assigned adequately factor in the time value of money and legal and other expenses likely to be incurred by the bank in pursuing the collateral. 4. Government guarantees are given full value. It is not clear whether this extends to Government-owned enterprises and whether this practice tends to reduce the pressure on the Government to honor guarantees in a timely manner. When Government- guaranteed loans are in arrears for three months or longer, interest is to be placed in a suspense account. However, that practice has not been consistently pursued by state- owned banks. There is disagreement on this issue between Bank Supervision and bank auditors with the former advocating the "harder line." Even if there is assurance that the Government will always honor obligations, there may be good reason to question whether these will be honored so as to fully compensate for foregone interest.  - 63 - Attachment 1.2 SRI LANKA FINANCIAL SECTOR REPORT BANK FAILURE RESOLUTION 1. Sri Lanka's only commercial bank failure involved the BCCI branch when that bank failed. However, a substantial number of finance companies failed during the late 1 980s and early 1 990s, and both state-owned commercial banks and NSB have received Govermment assistance and might have failed were they not Government-owned institutions. Several of the Regional Rural Development Banks that were owned by CBSL and are in the process of being absorbed by the new Rural Development Banks were also insolvent. In the case of these Government-owned institutions all depositors have been fully protected. In the case of the finance companies, the treatment of depositors was less favorable and inconsistent, reflecting the problems of using an ad hoc approach to addressing the issue of depositor protection when no rules are in place before failures occur. 2. In one instance, all depositors of a failed finance company were fully protected through funds advanced by CBSL. In others, depositors were paid 50 percent of their deposits up to a maximum of Rs. 20,000, and in still others up to Rs. 10,000. The asset collection and recovery process suffered from lack of staff skills and experience. That process is still underway as CBSL attempts to collect by using firms hired on a commission basis. However, the commissions being paid are apparently so low that the results are not very successful. In total, CBSL outlays to depositors and troubled finance companies have exceeded Rs. 2.5 billion. 3. If a private bank in Sri Lanka were to get into serious difficulty, but still had positive value, it could enter into a private agreement with a stronger bank to be acquired at an appropriate price. The Monetary Board has substantial authority to pursue enforcement action which could include, among other things, a demand for a substantial increase in capital. Such action should normally be taken before a bank becomes insolvent. If the bank is unable to comply with such demands, it can and should pursue on its own options to merge or otherwise sell a substantial ownership interest to investors able to recapitalize the bank. This is the preferred option for dealing with troubled banks. For it to be most effective, supervisory authorities must pursue strong enforcement action while the bank is still salvageable. 4. Where a troubled private bank cannot be saved through action in the private sector, more direct Government and central bank participation will be necessary.  - 64 - However, it will be difficult to develop a rational scheme for failure resolution and depositor protection in Sri Lanka as long as such a large share of deposits (about two- thirds) are explicitly or implicitly protected by the Government. Moreover, if a private commercial bank were to fail in the present environment, and depositors were not fully "bailed out", that could substantially negate any efforts to raise the private sector share of Sri Lanka banking. 5. The current laws related to private bank failures in Sri Lanka are not satisfactory. Currently, two alternatives are being contemplated. The first involves liquidation of the failed bank, and in lieu of deposit insurance it establishes a system of creditor priorities that places the claims of small holders of time and savings deposits ahead of other depositors and other unsecured financial creditors. However, the level of that priority position is so small (Rs. 5,000 or less than US$100) as to be largely meaningless. The priority level should be materially raised to be effective to at least Rs. 50,000 - so that in the event of a bank failure there would be some legislated standard to fall back on. Also, the use of a priority, as opposed to a straightforward payment from the central bank, would materially increase the likelihood of recovery from an advance that is related to a legal priority position.2 It should be noted that the 1993 finance company legislation set a small depositor priority at Rs. 25,000. 6. The second contemplated approach to a bank failure situation (Banking Amendments of 1995, Part VIIA) would have the Director of Bank Supervision satisfy the Monetary Board that the failing bank is unable to carry on banking business in Sri Lanka, whereupon the Monetary Board might select another bank to take over its operations, assume its assets and liabilities, including all pending legal action against the failing bank and the terms set forth by the Monetary Board. Subsequently, an audit would take place to determine the value of the acquired bank and the acquiring bank would agree to compensate the acquired bank shareholders for the determined value. Officers and employees of the acquired bank would presumably be offered employment or appropriate compensation. 7. This transaction would require an acquiring bank to agree to a deal that is not appropriately spelled out, and one where the acquiring bank would take on unspecified future exposure and may be asked to pay a sizable amount for an insolvent bank. Under these provisions, the acquired bank would most likely be substantially insolvent. Moreover, other creditors of the insolvent bank would be fully protected, and the Act does not require the Government or the central bank to put in any money to facilitate this transaction. The only banks willing to be acquirers in such a transaction would probably be Government-owned banks. Thus, this approach essentially amounts to establishing a set of legal provisions for a Government-owned bank to take over a 2 Political necessity would surely require the Government or the central bank to provide some protection to small and moderate-sized depositors.  - 65 - troubled or failing private bank. It is not clear whether legislation is needed in order to achieve this. 8. It would be preferable if CBSL considered establishing procedures for some form of purchase and assumption transaction where the central bank could facilitate the acquisition of a failing bank, provide limited protection to depositors, and forestall what might be considerable financial market disruption. Depending on how such a transaction is structured, the ultimate cost could be borne solely by shareholders, junior creditors and large depositors of the failing bank. Similar procedures could be developed for dealing with failing finance companies or other failing deposit takers.  - 66 - Attachment 1.3 SRI LANKA FINANCIAL SECTOR REPORT BANK BRANCH SALES 1. In Sri Lanka commercial bank branches and deposits, particularly retail deposits, are concentrated in the two large state-owned comniercial banks. The management, asset quality and capital of these banks, particularly People's Bank, are less than outstanding. An approach to strengthening the capital position of these banks and placing a greater share of bank resources and future lending in the private sector would be for these state-owned banks to sell some branches to private banks and, possibly, foreign banks in Sri Lanka. Branch sales have played an important role in the US in enabling banks to rationalize their branch structure, improve operating efficiency and, in some instances, strengthen the capital position and the likelihood of survival for troubled banks. 2. In some instances a branch may be worth more to one bank than another because of its particular need to penetrate a market or because of opportunities to combine its activities with another branch thereby saving expenses. Also, a particular branch may be unprofitable for one bank while affording profitable opportunities for another. Among the most clear cut situations where both parties can gain through a branch sale is the case where an undercapitalized bank sells a branch to a bank that is well-capitalized or over-capitalized and is seeking to increase its leverage. 3. In the simplest branch sale structure the purchasing bank assumes deposit liabilities and receives an equivalent amount of assets, less a premium it is willing to pay for the branch. The assets would typically include the value of the branch's physical facilities and/or lease and cash, securities and other assets (possibly including performing loans). In more complex transactions the purchasing bank might agree to purchase some non-performing loans as part of the package. In some instances banks seeking to sell a branch or package of branches have invited interested parties to submit bids, sometimes with the assistance of an investment banking firm. Generally some degree of due diligence will be involved, more so where the sale of loans is part of the contemplated transaction. 4. The price or premium paid for branches generally reflects the value of the anticipated spread on current and future deposits, although there may be value ascribed to income from other services and to unbooked value of physical assets. The valuation of  - 67 - branches and branch deposits will be significantly affected by current and anticipated bank performance, bank taxes and the economic and regulatory environment. 5. Arrangements with respect to the employees of the selling bank will vary. Some may be expected to be absorbed by the purchasing bank with some minimum re- employment guarantee. Some might remain with the selling bank, and some might be offered severance pay in connection with their possible termination. While branch sales have some of the same characteristics and negotiable issues as bank mergers, they are generally much simpler transactions, and once one or two such transactions are effected, they can prove to be fairly straightforward to replicate. Although on the surface such transactions may appear to be zero sum games, they can prove to be very advantageous for both parties.  68 Attachment 1.4 SRI LANKA Bank of Ceylon and People's Bank BOC PB TOTAL (Rupees million) 1995 1996 1997 1995 1996 1997 1995 1996 1997 RELATIVE SIZE l l l l No of branches 297 297 296 323 325 325 620 622 621 No of employees 9954 9987 10096 10881 11133 10978 20835 21120 21074 Market share of the total assets 55.7 32.4 56.6 44.3 44.3 25.0 100.0 100.0 100.0 Market share of the total deposits 0.0 31.3 0.0 46.8 48.5 47.7 100.0 100.0 100.0 Market share of demand deposits 61.5 40.4 73.3 38.5 41.4 42.9 100.0 100.0 100.0 Market share of advances 50.1 27.1 53.7 49.9 49.7 46.3 100.0 100.0 100.0 INCOME STATEMENT DATA Interest income 12,134 13,742 15,971 11,061 12,922 13,313 23,195 26,664 29,284 Interest expense 6,482 8,203 9,586 7,062 9,044 9,014 13,544 17,247 18,600 Net interest margin 5,652 5,539 6,385 3,998 3,878 4,300 9,650 9,417 10,684 Other income 2,686 3,374 4,270 1,530 1,924 2,747 4,216 5,298 7,017 Total net income 8,337 8,914 10,655 5,529 5,802 7,047 13,866 14,715 17,701 Employee expenses 2,339 2,495 3,016 2,620 2,736 3,284 4,958 5,231 6,300 Other expenses 1,277 2,391 2,608 1,599 1,907 2,069 2,877 4,298 4,677 Provisions for doubtful debts 1,890 739 1,248 907 412 - 2,796 1,151 1,248 Profit before taxes 2,832 3,288 3,384 403 746 1,694 3,234 4,035 5,476 Tax 99 827 777 284 217 - 384 1,044 777 Profit after taxes 2,732 2462 2,607 118 529 1,694 2,851 2,991 4,301 INCOME AS % OF AVERAGE TOTAL ASSETS Interest income 10.5 10.3 10.6 12.0 12.2 11.5 11.1 11.1 10.9 Interest expense 5.6 6.2 6.3 7.6 8.5 7.8 6.5 7.2 7.0 Net interest margin 4.9 4.2 4.2 4.3 3.7 3.7 4.6 3.9 4.0 Other income 2.3 2.5 2.8 1.7 1.8 2.4 2.0 2.2 2.6 Total net income 7.2 6.7 7.0 6.0 5.5 6.1 6.7 6.1 6.6 Employee expenses 2.0 1.9 2.0 2.8 2.6 2.8 2.4 2.2 2.4 Other expenses 1.1 1.8 1.7 1.7 1.8 1.8 1.4 1.8 1.7 Profit before taxes 2.4 2.5 2.2 0.4 0.7 1.5 1.6 1.7 2.0 Tax 0.1 0.6 0.5 0.3 0.2 0.0 0.2 0.4 0.3 Profit after taxes 2.4 1.8 1.7 0.1 0.5 1.5 1.4 1.2 1.6 BALANCE SHEET DATA Total assets 116,036 133,371 151,254 92,455 106,215 116,189 208,491 239,586 267,443 Total deposits 83,697 89,177 101,288 73,651 84,111 92,431 157,348 173,288 193,719 Of which demand deposits 16,986 18,895 20,223 10,613 11,424 11,849 27,599 27,600 27,601 Total advances 57,924 61,747 74,673 57,740 60,978 64,480 115,663 122,725 139,153 Total capital 9,054 10,368 11,648 2,780 3,185 4,892 11,834 13,553 16,540  69 BOC PB TOTAL (Rupees million) 1995 1996 1997 1995 1996 1997 1995 1996 1997 Contingent liabilities/assets 44,631 62,832 76,637 18,290 10,288 15,526 62,921 73,120 92,163 Deposits\total assets 72.1 66.9 67.0 79.7 79.2 79.6 75.5 72.3 72.4 Demand deposits\total deposits 20.3 21.2 20.0 14.4 13.6 12.8 17.5 15.9 14.2 Advances\total assets 49.9 46.3 49.4 62.5 57.4 55.5 55.5 51.2 52.0 Capital\total assets 7.8 7.8 7.7 3.0 3.0 4.2 5.7 5.7 6.2 Advances\deposits 69.2 69.2 73.7 78.4 72.5 69.8 73.5 70.8 71.8 Cont. liab./total assets 38.5 47.1 50.7 19.8 9.7 13.4 30.2 30.5 34.5 RATIO ANALYSIS-FINANCING Interest on advances 8,477 9,446 9,906 9,263 10,774 9,589 17,739 20,220 19,495 Interest on advances\total advances 14.6 15.3 13.3 16.0 17.7 14.9 15.3 16.5 14.0 Interest on deposits 3,989 5,000 5,809 5,883 8,491 8,350 9,872 13,491 14,159 Interest on deposits\total deposits 4.8 5.6 5.7 8.0 10.1 9.0 6.3 7.8 7.3 Interest spread 9.9 9.7 7.5 8.1 7.6 5.8 9.1 8.7 6.7 Non-interest income\total income 32.2 37.9 40.1 27.7 33.2 39.0 30.4 36.0 39.6 Total operating expenses (net of prov.) 3,616 4,886 5,624 4,219 4,643 5,353 7,835 9,529 10,977 Total oper. expensetotal assets 3.1 3.7 3.7 4.6 4.4 4.6 3.8 4.0 4.1 Profit after tax\capital 30.2 23.7 22.4 4.3 16.6 34.6 24.1 22.1 26.0 Profit after tax\total income 18.4 14.4 12.9 0.9 3.6 10.5 10.4 9.4 11.8 RATIO ANALYSIS-EFFICIENCY Employee expense\total net income (%) 28.0 28.0 28.3 47.4 47.2 46.6 35.8 35.5 35.6 Employee expense\employees (Rs 'MIL) 23.49 24.98 29.87 24.08 24.58 29.91 23.80 24.77 29.89 Total assets\employee 1165.72 1335.45 1498.16 849.69 954.06 1058.38 1000.68 1134.40 1269.07 Employees\branch(person) 33.52 33.63 34.11 33.69 34.26 33.78 33.60 33.95 33.94 Total assets\branches 390.69 449.06 510.99 286.24 326.82 357.50 336.28 385.19 430.67 Total net income\branch 28.07 30.01 36.00 17.12 17.85 21.68 22.36 23.66 28.50 Accumulated provisions 7,248 7,934 7,934 4,886 5,009 5,009 12,134 12,943 12,943 Non-performing assets 9486 10039 10871 12497 15525 9486 22536 26396 Provisions/total advances (%) 12.5 12.8 10.6 8.5 8.2 8.2 10.5 10.5 9.3 Provisions/non-performing assets (%) 76.4 79.0 73.0 #DIV/0! 40.1 32.3 127.9 57.4 49.0 Non-performing loans/total advances 16.4 16.3 14.6 0.0 20.5 20.5 8.2 18.4 19.0 Capital adequacy ratio (%)-average 12.98 13.98 12.69 n.a. 8.02 5.50 #VALUE! 11.00 9.10 (Average total assets) 109,567 124,703 142,313 86,236 99,335 99,335 195,803 224,038 241,648 Sources: Audited Financial Statements/ Central Bank  - 70 - Attachment 1.5 SRI LANKA COMMERCIAL BANKING & FINANCIAL SECTOR ASSETS (Rupees Billions unless otherwise stated) CHANGES 1984 1989 1997 1984-89 | 1989-97 Annual Growth Rate GDP atthe current price 153.7 251.9 890.0 10.4% 17.1% Broad money at end of the year 43.4 76.4 288.3 12.0% 18.1% Inflation rate (Colombo Consumers' Price Index) 553.1 830.2 2089 9.1% 12.2% ASSETS Central Bank 33.3 62.7 183.9 13.5% 14.4% Commercial Banks 53.6 106.4 464.1 14.7% 20.2% of which: State Banks 35.3 69.6 267.4 14.5% 18.3% Private Domestic Banks 4.9 16.9 138.9 28.1% 30.1% Foreign Banks 13.4 19.9 57.8 8.3% 14.3% FCBUS (Net of foreign liabilities) 4.3 12.8 59.7 24.6% 21.2% NDB/DFCC 2.5 6.8 44.4 22.7% 26.4% NSB 12.4 20.9 83.8 11.0% 19.0% SMIB 0.6 2.5 5.8 32.1% 11.1% Finance & leasing companies 4.6 8.3 29.3 12.5% 17.1% EPF/ETF 12.8 37.9 159.7 24.2% 19.7% Insurance companies 3.6 6.2 22.8 11.6% 17.7% TOTAL ASSETS 127.7 264.5 1053.5 15.7% 18.9% TOTAL ASSETS IN 1984 PRICE 127.7 176.2 278.9 6.0% 5.9% Absolute Change in % Total Assets/GDP 83.1% 104.6% 118.4% 21.6% 13.8% Total Assets/Broad Money 294.0% 346.2% 365.4% 52.2% 19.2% Broad Money/GDP 28.2% 30.2% 32.4% 2.0% 2.2% Commercial Bank Assets/GDP 34.9% 42.1% 52.1% 7.2% 10.0% Commercial Bank Assets/Broad Money 123.4% 139.3% 161.0% 15.8% 21.7% PERCENTAGE OF TOTAL ASSETS Absolute Change in % Central Bank 26.1% 23.7% 17.5% -2.4% -6.2% Commercial Banks 42.0% 40.2% 44.1% -1.8% 3.9% of which: State Banks 27.7% 26.3% 25.4% -1.4% -0.9% Private Domestic Banks 3.8% 6.4% 13.2% 2.5% 6.8% Foreign Banks 10.5% 7.5% 5.5% -2.9% -2.0% FCBUS (Net of foreign liabilities) 3.3% 4.8% 5.7% 1.5% 0.9% NDB/DFCC 1.9% 2.6% 4.2% 0.7% 1.6% NSB 9.7% 7.9% 8.0% -1.8% 0.1% SMIB 0.5% 0.9% 0.6% 0.5% -0.3% Finance & leasing companies 3.6% 3.1% 2.8% -0.5% -0.3% EPF/ETF 10.1% 14.3% 15.2% 4.3% 0.9% Insurance companies 2.8% 2.3% 2.2% -0.5% -0.1% TOTAL 100.0% 100.0% 100.0% 0.0% 0.0% Source: Central Bank of Sri Lanka  71 SRI LANKA COMMERCIAL BANKS Attachment 1.6 SUMMARY STATISTICS State Private Foreign All Banks (Rupees million) 1995 1996 1997 1995 1996 1997 1995 1996 1997 1995 1996 1997 RELATIVE SIZE No of branches 620 622 621 214 240 267 - 37 38 834 899 926 No of employees 20,835 21,120 21,074 7,953 8,532 9,633 - 2,057 2,017 28,788 31,709 32,724 Market share of the total assets 62.0 57.6 57.6 26.5 29.9 29.9 11.5 12.4 12.4 100.0 100.0 100.0 Market share of the total deposits 63.5 58.6 58.6 26.6 30.8 30.8 9.8 10.6 10.6 100.0 100.0 100.0 Market share of demand deposits 74.9 62.0 62.0 25.1 22.3 22.3 0.0 15.6 15.6 100.0 100.0 100.0 Market share of advances 62.3 52.6 52.6 26.6 35.7 35.7 11.1 11.7 11.7 100.0 100.0 100.0 INCOME STATEMENT DATA Interest income 23,195 26,664 29,285 9,321 12,365 14,700 4,254 5,531 6,245 36,770 44,560 50,230 Interest expense 13,544 17,247 18,600 5,895 8,254 9,586 2,474 3,214 4,119 21,914 28,715 32,305 Net interest margin 9,650 9,417 10,685 3,427 4,111 5,114 1,780 2,317 2,126 14,856 15,845 17,925 Other income 4,216 5,299 7,016 2,113 2,314 2,911 1,459 1,408 1,894 7,788 9,021 11,821 Total net income 13,866 14,716 17,701 5,540 6,425 8,025 3,239 3,725 4,020 22,645 24,866 29,746 Employee expenses 4,958 5,231 6,300 1,512 1,861 2,310 653 790 920 7,123 7,882 9,530 Other expenses 2,877 4,299 4,676 1,810 2,232 2,927 1,212 1,477 1,627 5,899 8,008 9,230 Provisions for doubtful debts 2,796 1,151 1,247 380 465 641 141 146 676 3,317 1,762 2,564 Profit before taxes 3,234 4,035 5,078 184 1,848 2,118 1,233 1,395 854 4,651 7,278 8,050 Tax 384 1,044 777 479 449 432 545 552 230 1,408 2,045 1,439 Profit after taxes 2,851 2,991 4,301 1,358 1,399 1,685 688 844 624 4,898 5,234 6,610 INCOME AS % OF TOTAL ASSETS _ Interest income 11.1 10.0 10.9 10.5 8.9 10.6 11.0 9.6 10.8 10.9 9.6 10.8 Interest expense 6.5 6.4 7.0 6.6 5.9 6.9 6.4 5.6 7.1 6.5 6.2 7.0 Net interest margin 4.6 3.5 4.0 3.8 3.0 3.7 4.6 4.0 3.7 4.4 3.4 3.9 Other income 2.0 2.0 2.6 2.4 1.7 2.1 3.8 2.4 3.3 2.3 1.9 2.5 Total net income 6.7 5.5 6.6 6.2 4.6 5.8 8.3 6.5 7.0 6.7 5.4 6.4 Employee expenses 2.4 2.0 2.4 1.7 1.3 1.7 1.7 1.4 1.6 2.1 1.7 2.1 Other expenses 1.4 1.6 1.7 2.0 1.6 2.1 3.1 2.6 2.8 1.8 1.7 2.0 Profit before taxes 1.6 1.5 1.9 0.2 1.3 1.5 3.2 2.4 1.5 1.4 1.6 1.7 Tax 0.2 0.4 0.3 0.5 0.3 0.3 1.4 1.0 0.4 0.4 0.4 0.3 Profit after taxes 1.4 1.1 1.6 1.5 1.0 1.2 1.8 1.5 1.1 1.5 1.1 1.4 BALANCE SHEET DATA _ Total assets 208,491 267,443 267,443 89,117 138,978 138,977 38,818 57,737 57,737 336,426 464,158 464,157 Total deposits 157,348 193,718 193,718 65,908 101,750 101,750 24,366 34,870 34,870 247,622 330,338 330,338 Of which demand deposits 27,599 32,073 32,073 9,260 11,542 11,542 - 8,088 8,088 36,859 51,703 51,703 Total advances 115,663 139,153 139,153 49,285 94,534 94,534 20,681 31,052 31,052 185,630 264,739 264,739 Total capital 11,834 16,540 16,540 6,925 10,065 10,065 4,493 6,654 6,654 23,252 33,259 33,259 Contingent liabilities-assets 62,921 92,162 92,163 32,421 51,020 51,020 30,308 99,209 99,209 125,650 242,391 242,392 Deposits\total assets 75.5 72.4 72.4 74.0 73.2 73.2 62.8 60.4 60.4 73.6 71.2 71.2  72 State Private Foreign All Banks (Rupees million) 1995 1996 1997 1995 1996 1997 1995 1996 1997 1995 1996 1997 Demand deposits\total deposits 17.5 16.6 16.6 14.0 11.3 11.3 0.0 23.2 23.2 14.9 15.7 15.7 AdvancesUotal assets 55.5 55.5 55.5 55.3 55.3 55.3 53.3 53.3 53.8 55.2 57.0 57.0 Capital\total assets 5.7 5.7 5.7 7.8 7.8 7.8 11.6 11.5 11.5 6.9 7.2 7.2 Advances\deposits 73.5 73.5 73.5 74.8 74.8 74.8 84.9 89.1 89.1 75.0 80.1 80.1 Cont. liab./total assets 30.2 30.2 30.2 36.4 36.4 36.4 78.1 171.8 171.8 37.3 52.2 52.2 RATIO ANALYSIS FINANCING Interest on advances 17,739 19,495 19,496 9,321 11,194 11,194 4,254 3,946 4,650 31,314 34,635 35,340 Interest on advances\total advances 15.3 15.3 14.0 18.9 18.9 11.8 20.6 12.7 15.0 16.9 13.1 13.3 Interest on deposits 9,872 14,159 14,159 5,895 7,935 7,935 2,474 2,280 2,451 18,241 24,374 24,545 Interest on deposits\total deposits 6.3 6.3 7.3 8.9 8.9 7.8 10.2 6.5 7.0 7.4 7.4 7.4 Interest spread 9.1 9.1 6.7 10.0 10.0 4.0 10.4 6.2 8.0 9.5 5.7 5.9 Non-interest income\total income 18.2 19.9 24.0 22.7 18.7 19.8 34.3 25.5 30.3 21.2 20.2 23.5 Total oper. expenses (net of prov.) 7,835 9,530 10,976 3,322 4,093 5,237 1,865 2,266 2,546 13,022 15,890 18,760 Total oper. expense\total av. assets 3.8 3.6 4.1 3.7 2.9 3.8 4.8 3.9 4.4 3.9 3.4 4.0 Profit aftertax\capital 24.1 18.1 26.0 19.6 13.9 16.7 15.3 12.7 9.4 21.1 15.7 19.9 Profit after tax\total income 10.4 9.4 11.8 11.9 9.5 9.6 12.0 12.2 7.7 11.0 9.8 10.7 RATIO ANALYSIS-EFFICIENCY I Employee expense\total net income (% 35.8 35.5 35.6 27.3 29.0 28.8 20.2 21.2 22.9 31.5 31.7 32.0 Employee expense\employees(Rs 'MIL. 0.238 0.248 0.299 0.190 0.218 0.240 #DIV/O1 0.384 0.456 0.247 0.249 0.291 Total assets\employee 10.0 12.7 12.7 11.2 16.3 14.4 #DIV/01 28.1 28.6 11.7 14.6 14.2 Employees\branch(person) 33.6 34.0 33.9 37.2 35.6 36.1 - 53 34.5 35.3 35.3 Total assets\branches 336.3 430.0 430.7 416.4 579.1 520.5 - 1519.4 403.4 516.3 501.2 Total net income\branch 22.4 23.7 28.5 25.9 26.8 30.1 - 105.8 27.2 27.7 32.1 Accumulated provisions 12,134 12,942 12,942 3,623 1,977 1,977 1,220 1,245 16,977 16,977 16,164 Non-performing assets 9,486 26,396 26,396 4,697 9,505 9,505 2,155 3,224 16,338 16,338 39,125 Provisions/total advances (%) 10.5 9.3 9.3 7.4 2.1 2.1 5.9 0.0 4.0 9.1 6.4 6.1 Provisions/non-performing assets (%) 127.9 49.0 49.0 77.1 20.8 20.8 56.6 #DIV/01 38.6 103.9 103.9 41.3 NPA/total advances (%)-average 8.2 19.0 19.0 9.5 10.1 10.1 10.4 0.0 10.4 8.8 6.2 14.8 Capital adequacy ratio (%)-average n.a. 10.5 10.5 n.a. 10.96 10.96 12 13 10.98 10.98 Sources: Audited Financial Statements/ Central Bank.  73 Attachment 1.7 SRI LANKA PRIVATE COMMERCIAL BANKS FINANCIAL STATISTICS 1997 (Rupees million) HNB SLB CBOC SPB UBC PAB Branches 85 49 29 1 Employees 3,433 1,889 1,131 120 INCOME STATEMENT DATA Interest income 4,964.00 2,936.00 1,977.60 389.20 Interest expense 3,355.00 1,781.60 1,192.70 290.20 Net interest margin 1,609.00 1,154.40 784.90 99.00 Other income 1,151.70 759.80 409.00 74.70 Total net income 2,760.70 1,914.20 1,193.90 173.70 Employee expenses 745.30 508.00 249.20 45.40 Other expenses 1,049.10 555.90 430.60 83.20 Provisions for doubfful debts 241.30 197.40 65.20 2.10 Profit before taxes 725.10 652.90 448.90 40.80 Tax 172.00 110.00 127.20 5.80 Profit after taxes 553.10 542.90 321.70 35.00 INCOME AS % OF TOTAL ASSETS Interest income 9.4 10.6 10.7 11.0 Interest expense 6.4 6.4 6.5 8.2 Net interest margin 3.1 4.2 4.3 2.8 Other income 2.2 2.7 2.2 2.1 Total net income 5.3 6.9 6.5 4.9 Employee expenses 1.4 1.8 1.4 1.3 Other expenses 2.0 2.0 2.3 2.3 Profit before taxes 1.4 2.4 2.4 1.2 Tax 0.4 0.5 1.0 0.2 Profit after taxes 12.0 17.5 23.8 11.5 BALANCE SHEET DATA Total assets 52,573.00 27,659.20 18,421.10 3,545.60 Total deposits 39,303.20 20,155.50 12,156.00 2,768.20 Of which demand deposits 4,620.90 3,102.60 1,350.70 304.40 Total advances 28,929.30 15,690.80 10,944.00 1,989.30 Total capital 3,013.80 3,420.40 1,437.80 281.40 Contingent liabilities-assets NA NA NA NA  74 (Rupees million) HNB SLB CBOC SPB UBC PAB DepositsUotal assets (%) 74.8 72.9 66.0 78.1 Demand deposits\total deposits (%) 11.8 15.4 11.1 11.0 Advances\total assets (%) 55.0 56.7 59.4 56.1 Capital\total assets (%) 5.7 12.4 7.8 7.9 Advances\deposits (%) 73.6 77.8 90.0 71.9 Cont. Iiab./total assets (%) NA NA NA NA NA RATIO ANALYSIS-FINANCING Interest on advances 4,964.00 2,936.00 1,977.60 389.20 Interest on advances\total advances (%) 17.2 18.7 18.1 19.6 Interest on deposits 3,355.00 1,781.60 1,192.60 290.20 Interest on deposits\total deposits 8.5 8.8 9.8 10.5 Interest spread 8.6 9.9 8.3 9.1 Non-interest income\total income 41.7 39.7 34.3 43.0 Total operating expenses (net of prov.) 1,049.10 555.90 430.60 83.20 Total oper. expense\total av. assets (%) 0.0 0.D 0.0 0.0 Profit after tax\capital (%) 0.4 0.5 1.7 4.1 Profit after tax\total income (%) 0.4 0.9 2.0 6.6 RATIO ANALYSIS-EFFICIENCY Employee expense\total net income (%) 27.0 26.5 20.9 26.1 Employee expense\employees(Rs '000) 0.22 0.27 0.22 0.38 Total assets\employee 15.31 14.64 16.29 29.55 Employees\branch(person) 40.39 38.55 39.00 120.00 Total assets\branches 618.51 564.47 635.21 3,545.60 Total net income\branch 32.48 39.07 41.17 173.70 Accumulated provisions 1,161.30 1,880.30 542.30 15.80 Non-performing assets NA Provisions/total advances (%) 0.0 0.1 0.0 0.0 Provisions/non-performing assets (%) NA NPA/total advances (%)-average NA Capital adequacy ratio (%)-average 8.38 17.6 12.4 9.5 HNB - Hatton National Bank SPB - Sampath Bank Limited Source: Annual Reports/Audited Financial Statements  - 75 - Attachment 1.8 SRI LANKA FINANCIAL SECTOR REPORT Finance Companies Selected Financial Statistics March 1995 and 1996 1996 1996 Growth 1997 1997 Growth (Rs. m) Percent Percent (Rs. m) Percent Percent Assets 14,600 100.0 26.9 17962 100.0 23.0 -liquid assets 1,600 11.0 18.3 2093 11.6 30.7 -investments 1,045 7.2 1.9 1145 6.4 9.5 -advances 9,447 64.7 35.1 11671 65.0 23.5 -fixed assets 1,189 8.1 7.6 1356 7.5 14.0 -other assets 1,318 9.0 28.6 1698 9.5 28.8 Liabilities/Equity: 14,600 100.0 26.9 17962 100.0 23.0 -deposits 8,793 60.2 22.4 11088 61.8 26.1 -borrowings 1,242 8.5 27.4 1203 6.7 -3.1 -other liabilities 2,345 16.1 74.1 3022 16.8 28.9 -shareholders equity 1,193 8.2 4.6 2648 14.7 19.3 Net income after taxes 338 4.3 473 39.9 Return on Assets (%) 2.3% 2.6% 2.6 Return on Capital (%) 28.3% 17.9% 17.9 Source: Central Bank of Sri Lanka and Association of Finance Companies  -76 - Attachment 2.1 SRI LANKA FINANCIAL SECTOR REPORT MONEY AND BOND MARKETS 1. In Sri Lanka the money and bond market consists largely of Treasury Bills and the inter-bank call money market. The primary market for Treasury Bills consists of the re-issue of maturing bills and new issues which are sold through a weekly auction by approved dealers. Since the main function of the inter-bank market is to facilitate short- term liquidity management among banks, the inter-bank call money market is confined primarily to commercial banks. It appears that most Treasury Bills are held by investors to maturity or sold back to the primary dealer with whom the investor has an account. There does not appear to be an active secondary market with substantial inter-dealer trading or market making at this time. Commercial paper, negotiable certificates of deposit, and other forms of private money market instruments are absent from the market. Corporate bonds list on the stock exchange but the market is not large or very active. Several studies have been conducted recommending that steps be taken to improve the operations of the market for govermnent securities. Although steps have been taken to improve the weekly auctions of Treasury Bills, including the creation of a network of primary dealers, the infrastructure for the market including modern systems for clearance, settlement, and secondary market trading are not yet developed. 2. The absence of an adequate infrastructure has hindered the development of a private money and bond market. Moreover, the SEC only has jurisdiction over listed securities and a credit rating agency does not exist. However, a rating agency is expected to be established soon by a reputed international company. In most countries, the private debt securities markets consist mainly of a network of bank and non-bank dealers in such instruments. While corporate bonds often list on an organized exchange, most trading takes place over-the-counter. In nearly every Asian emerging securities market, there is a regulatory mandate that a private issuer of debt securities obtain a credit rating prior to a public offering. In Sri Lanka, it will be necessary to establish a regulatory framework for the non-listed securities market. It will also be necessary to clearly define the roles of the SEC and the Central Bank with respect to the private market for non-listed debt securities and establish a regulatory framework for non-bank dealers in such instrument (i.e., investment banks and merchant banks). 3. Definition of a Debt Security. The first step in delineating the role of the SEC and Central Bank in the debt securities market is to define the meaning of the term security. Clearly, the SEC should have authority over the private issuers of securities -- both listed and non-listed (i.e., over-the-counter). The legal definition of security is  -77 - important from an investor's protection standpoint and in deflIing the jurisdiction of the regulatory bodies supervising the financial markets and intermediaries. The legal definition of the term securities can be rather complex. The most common forms of securities are stocks, notes, and bonds, but other financial instruments (i.e., derivatives or securitized assets) might also be included in the definition of the term security. 4. There must be clarity with respect to the responsibilities and authority of the SEC and those responsible for the regulation of commercial banks and other internediaries comprising the financial sector. This is important in order to ensure that some issuers of securities, or similar instruments, and intermediaries (i.e., merchant banks and investment banks) do not escape regulation. This is most likely to occur in instances where an intermediary does not fall within the legal definition of a bank or securities firm (i.e., broker-dealer). The role of each regulatory body must be clear with respect to the supervision of money market and bond market instruments issued by private sector firms, the government, and governnent owned enterprises. It would appear highly desirable for the SEC to have responsibility over derivative products as they are introduced to the market. 5. Need for a Credit Rating Agency. A credit rating agency can play an important role in the development of an efficient money and bond market by making debt instruments more comprehensible to individual investors. Credit ratings have been employed to regulate the investment policies of pension funds and insurance companies, and to serve as a bridge between institutional investors and issuers, and between the local capital markets and the international markets. 6. The establishment of a credit rating agency is normally a private endeavor because the independence of a rating agency is crucial to its successful operation. If the government is too closely involved in the operations of a credit rating agency, the objectivity of the ratings may come into question. Nevertheless, the success of a credit rating agency ultimately depends upon government policy actions which are conducive to the development of the money and bond market. A dynamic debt securities market is unlikely to develop in the absence of market determined interest rates, an adequate benchmark to facilitate the pricing of new issues, or in an unstable macroeconomic environment. In addition, the government must signal to potential investors (including those willing to commit capital to the establishment of a regional credit rating agency) that it is committed to the long-term development of the capital market. A rating agency on the lines described above is to be set up shortly. 7. One obstacle to the establishment of a credit rating agency in emerging markets is that the legal and regulatory status of such an agency is often unclear. The status of a securities rating company is not set forth in the current Sri Lankan Securities Act. This deficiency is being looked into by the Central Bank. 8. In order to facilitate the establishment of a credit rating agency, it is essential that the tax treatment of investment in the money and bond markets be clear. In particular, attention should be given to the removal of dis-incentives to investment in financial market  -78 - instruments such as a stamp duty or similar tax at the time of the initial offering or with respect to secondary market trading. Allowing foreign portfolio-investors to participate in the Sri Lankan private debt securities market will also help spur the demand for credit ratings. Table 1 Characteristics of Credit Rating Industry in Selected East Asian and Latin American Countries No. of First Mandatory Gov't Gov't Reg. Rating Rating Rating for Joint Equity Oversight Country Agencies Year Corp. Debt Venture* Interest by: Argentina 7 1992 Yes Yes No SC Chile 4 1994 Yes Yes one SC Colombia 1 1994 Yes Yes No SC Indonesia 1 1995 Yes No No SC India 3 1988 Yes No one SC/CB Korea 3 1985 1/ No one SC/CB Malaysia 1 1991 Yes No No SC/CB Mexico 4 1989 Yes Yes No CNBV Philippines 1 1982 No No No SC/CB Thailand 1 1993 Yes No Yes SC Venezuela 9 1994 Yes No No SC Note: SC = Securities Commission, or equivalent regulatory body; CB = Central Bank. * The use of the term Joint Venture means that a least one local credit rating agency in the country is involved in a joint venture or a local firm may be a subsidiary of a foreign rating agency. l/ Ratings are mandatory in Korea only for non-guaranteed corporate bonds. Source: Role of Credit Rating Agencies in Asian and Latin American Securities Markets, Emerging Markets Institute, Springfield, VA, Spring 1996. 9. For a rating agency to be economically viable in Sri Lanka, there must be a sufficient quantity of debt instruments that are eligible for a rating. This critical mass of debt instruments could include private money market instruments, corporate bonds, municipal securities. state-enterprise debt, Government debt and, as the market begins to  -79 - mature, mortgage. The first place to start is with the markets for government securities. Efficient markets in Government treasury bills and bonds can facilitate the development of the private money and bond market by providing a benchmark and providing an infrastructure (i.e., trading mechanisms, clearance, settlement, depository etc.) which could be extended to private debt instruments, thereby facilitating the creation of a critical mass of marketable debt instruments which could also be subject to a mandatory credit rating. 10. Once a credit rating agency is determined to be viable in Sri Lanka, the government should consider mandating that all publicly offered debt securities, including private money market instruments, should be subject to a mandatory rating requirement. While it may be useful for the rating agency to rate corporate stock offerings, this should not be mandated by the government. 11. If economically viable, the credit rating agency should be organized. Ownership might consist of a group of local shareholders with no single shareholder owning more than 10 percent of the shares. While Government institutions might be allowed to participate as owners, it would seem appropriate to limit any such participation to no more than 25 percent of the initial paid-in capital. Alternatively, a local credit rating agency could be established as ajoint venture with an established international credit rating agency. Without proper technical assistance from an established credit rating agency, it is unlikely that a local credit rating company will have the credibility with investors and technical competence needed to gain the confidence of domestic and international investors.  -80 - Attachment 2.2 SRI LANKA FINANCIAL SECTOR REPORT THE FUND MANAGEMENT INDUSTRY AND FOREIGN PORTFOLIO INVESTMENT The Fund Management Industry 1. In 1992, the unit trust industry commenced operation with the start-up of four unit trusts in quick succession. At present there are 10 fund management companies operating in Sri Lanka. Each of the local Sri Lankan fund management companies has a foreign partner. There was an upsurge of activities in init trusts in 1997. Diversification of the investment focus also changed along with the increase in number. Also, the securities regulations have been modified to allow the Sri Lankan fund managers to sponsor more than one open-end investment fund (i.e., mutual fund). Thus, it will be possible for the fund manager to offer investors a wider range of investment funds such as (i) stock funds, (ii) funds investing exclusively in debt instruments, or (iii) diversified funds investing in stocks, corporate bonds and Government securities. In addition to the four open-end fund currently available to Sri Lankan investors, there are also six closed-end investment companies listed on the CSE. In Sri Lanka, the foreign fund managers participating in the Sri Lankan securities market have facilitated the development of-the local fund industry in keeping with Government policy to encourage the development of the local fund industry as well as encourage foreign portfolio investrnent. 2. In Sri Lanka, unit trusts are defined to be collective investment vehicles, where funds are pooled and invested on behalf of unit holders by a professional fund management company. From the outset, each of the four unit trusts had a common objective: "income and growth." The funds of the unit trusts are invested in equity securities and other domestic financial instruments such as bonds and warrants. The portfolio is divided into units and investors can buy and sell the units which are traded on the basis of the net asset value of the unit. As investors make additional contributions to the pool, additional units are issued and fund managers invest the cash on behalf of the unit holders.' In general, the development of the domestic fund management industry has been encouraged by government policy actions. The Government established the regulatory framework for the fund industry under the supervision of the SEC. It also granted a five- year tax holiday to unit investment trusts and it has encouraged foreign participation in the ownership of the local fund management industry. However, the SEC has had in place Securities and Exchan-e Commission of Sri Lanka, Administrative Report, 1995, at page 36.  -81 - restrictive regulations which has impeded the growth of the unit investment business by limiting each fund management company to managing a "single" fund. Thus, it is not surprising that each of the four unit trusts have the same broad investment objectives. In 1997, this policy was changed. As a result, each fund manager potentially will be able to manage more than one unit trust. In the past, the SEC has also been criticized by the fund management industry for being relatively timid in approving new funds. With the policy liberalizations in place, it can be expected that more specialized unit investment trusts will be launched in the future. Thus, for example, unit trusts could be launched that invest in "growth " stocks or a particular industry such as plantations. Also, income funds could be launched which would invest in Treasury bills, corporate debentures, commercial paper, or other money market instruments. One innovative product that could be introduced into the market with appropriate government policy support, would be a "privatization unit trust" managed by private fund managers but consisting of a basket of privatized companies to be offered to the public in the future. 3. In 1995, the SEC created a Unit Trust Code. The Unit Trust Code brings into a single Code rules and regulations that were scattered in several documents which had been formulated on an ad hoc basis since the inception of the unit trust industry. Although the inforrnal guidelines issued by the SEC were being followed by the unit trust industry, this codification of the unit trust regulatory framework was a highly desirable regulatory initiative. Because the Unit Trust Code is mandatory, it creates greater uniformity and certainty with respect to the implementation of the regulations. This will result in greater investor protection by making it easier for the SEC's audit division to monitor compliance and, if necessary, to bring enforcement actions. 4. When the tax holiday that helped launch the unit trust business comes to an end during the coming year, the unit trust industry faces serious problems unless corrective actions are taken. Currently, unit trusts are taxed in the same way as a listed company with the unit holder treated like a share holder. When the tax holiday is over, the income of a unit trust will be taxed at the source with dividends and other income to the shareholder also subject to the provisions of the income tax law for individuals. Thus, unit holders will be taxed twice. This does not make economic sense. Moreover, it will create a significant tax distortion relative to other forms of investment such as bank accounts or the purchase of Treasury Bills. Clearly, it would be desirable to exempt the Unit Trust from taxation but to tax the shareholders in the unit at the prevailing tax rates applicable to income on interest or dividends and capital gains. Under this arrangement, it would be necessary for the fund to report income and capital gains distributions separately to each investor. As is common in the Asia region, capital gains on the appreciation of an equity investrnent in a listed company is tax exempt. Foreign Portfolio Investment and Participation 5. Few restrictions apply to foreign portfolio investment in the equity shares of companies listed on the Colombo Stock Exchange (CSE). Moreover, foreign finns have been allowed to participate in the local fund management industry, the stock brokerage  -82 - business, and the investment banking business. This policy has facilitated the development of the stock market infrastructure and the local fund management industry. However, foreigners are not pernitted to invest in corporate debt securities listed on the stock exchange, or government debt instruments. Also, foreign investors have not been permitted to own shares or units of the unit trust which are available to local investors only. While many other factors are involved (i.e., macroeconomic and political instability), it appears that the exclusion of foreign participation from the private debt market, has hindered the development of the infrastructure for the market. 6. Government policy has been favorable to foreign portfolio investment in companies listed on the CSE. Foreign portfolio investors, however, are not permitted to purchase debt securities of listed companies. In general, foreign portfolio investment in the shares of limited liability companies listed on the CSE is not restricted. Investments made after June 5, 1990 are not subject to exchange control regulations. Thus, foreign portfolio investment in the Sri Lankan equity market is permitted for country funds, regional funds, investment, and trust funds with prior approval from the Ministry of Finance. Companies incorporated outside Sri Lanka and individuals residing outside Sri Lanka are also permitted to invest in the local equity market. 7. Under Sri Lankan exchange control regulations, investment and the repatriation of the proceeds from such investment must take place through a Share Investment External Rupee Account (SIERA) opened with a commercial bank. Foreign investors may also make payments through their foreign broker. In this instance, there must be evidence of an inward remittance of foreign currency for the payment and the payment must take place through the foreign brokers' SIERA. With the exception of commercial banking, insurance companies, and residential housing, foreign investment in listed companies normally is permnitted up to 100 percent of the equity in each company. In the case of banks falling within the scope of the Banking Act (No. 30) of 1988, foreign investors are permitted to own up to 49 percent of local Sri Lankan banks. For companies involved in residential housing and mining, foreign investment is limited to 40 percent ownership in such companies.2 Under regulations issued by the Controller of Insurance, foreign investment in Sri Lankan insurance companies is not permitted. In Sri Lanka, however, the insurance industry is relatively small with about 70 percent of the insurance industry premiums written by the two state-owned insurance companies. Foreign investors may sometimes be granted concessions from such restrictions. The Sri Lankan Growth Fund, for example, was granted permission to acquire the shares of insurance companies.' In 1997, foreign investors accounted for nearly one-half of the Rs 1 1.2 billion in trading volume on the CSE compared to only 35 percent six years ago. Without the continued support of the foreign investment community through joint venture stock brokerage and 2 Under the Articles of Association, an individual listed company may restrict foreign participation in the ownership of the company. 3 See: Sri Lanka Growvth Fund, Preliminary Placing Memorandum dated 7th February, 1994 at page 6.  -83 - money management firms as well as continued trading support, the CSE would be a less viable institution. 8. Under the current tax scheme for Sri Lanka, capital gains derived from the sale of portfolio investments in a listed company are not subject to a capital gains tax. Capital gains on unlisted Sri Lankan securities is subject to taxation. Dividends are subject to a 15 percent withholding tax. In Sri Lanka, double taxation treaties do not exempt withholding tax.4 For the remittance of dividends abroad, tax clearance must be obtained, confirming that applicable withholding tax has been paid. Since Sri Lankan companies deduct the tax at the source, this is a fairly routine administrative matter. At the present time, foreign investors are not permitted to purchase corporate or government debt securities. Also, they are not permitted to purchase Sri Lankan unit investment trusts. This policy has hindered the development of the debt securities market and the unit trust business which has not achieved its full potential. 9. There are two closed-end country funds as well as many regional and global investment funds registered with the MoF for the purpose of investing in Sri Lanka. In 1996, the net asset value of such funds was about US$60 million. The two closed-country funds -- the Regent Sri Lanka Fund Limited and the Sri Lanka Growth Fund were established in 1993 and 1994, respectively. For investment in Sri Lanka, such funds must obtain approval from the Ministry of Finance as well as adhere to certain principles. In addition to meeting the home country regulatory requirements, closed-end country funds investing in Sri Lanka are expected have to the following attributes: 0 maintain a developmental character (i.e., in addition to investment in the secondary market, the fund must plan to invest in initial public offerings and unlisted shares); 0 arrange for the transfer of fund management technology to Sri Lanka and be willing to participate in the equity of fund management companies located in Sri Lanka; 0 possess experience in structuring country funds, particularly in the Asian region; 0 exhibit a suitable fund structure with respect to the fund itself, fund management, investment advice, custodianship, investment guidelines and arrangements for listing. 0 have a reasonable fee structure; and 0 invest an initial amount of at least US$25-30 million. Securities Services: Colombo Sri Lanka, Hong Kong Bank, member HSBC Group, August, 1996 at page 7.  -84 - 10. The Regent Sri Lanka Fund Limited is designed to enable non-Sri Lankan investors to invest indirectly in Sri Lanka. The investment policy objective of the fund is to achieve capital growth by investing in a diversified portfolio consisting primarily of equities listed on the CSE and equity related securities, including convertible bonds and warrants issued by Sri Lankan companies outside Sri Lanka. The Fund is a limited liability company incorporated in the Cayman Islands. It is listed on the Irish Stock Exchange. During the initial subscription period, about US$30 million in capital was raised in the form of 3 million participating shares offered at an initial subscription price of US$10.30. 11. Under the investment policy adopted by the Regent Sri Lanka Fund's directors, the following are the main criteria for investment: (i) no more that 10 percent of the funds' net asset value may be invested in a single company; (ii) no more than 5 percent of the funds net asset value may be invested in unlisted securities, other than securities evidencing indebtedness issued or guaranteed by governments or banks or linked to listed securities; (iii) in the case of privatization where the manager reasonably expects that the company will be listed within six months of the acquisition of shares, the investment maximum is 10 percent of the funds net asset value; (iv) the fund may only invest in equity or equity-linked securities of companies or bodies incorporated or established in Sri Lanka; (v) the fund may not acquire more than five percent of the share capital of any listed Sri Lankan company; (vi) without the express consent of the directors, the fund may not invest in any other open-end mutual fund or open end collective investment scheme other than those listed on the CSE which invest primarily in equity securities issued by CSE listed companies. Furthermore, the fund may not invest in land or commodities, commodities contracts, or commodities futures contracts. 12. The Sri Lanka Growth Fund is also listed on the Irish Stock Exchange. The primary objective of the fund is to achieve capital appreciation through investments in companies operating in Sri Lanka through investrnents in equity securities listed on the CSE. If available, the fund may also invest in Sri Lankan companies listed on major international stock exchanges. The fund may also invest in unlisted companies in Sri Lanka or in the listed securities of non-Sri Lankan companies which derive a significant part of their revenue or profit from Sri Lanka, or have or expect to have substantial assets in Sri Lanka. The Sri Lanka Growth Fund identified five sectors that its investment manager believed would present opportunities for investment: (i) infrastructure development projects, (ii) export processing companies, (iii) textile production, (iv), agricultural processing (i.e., plantation companies), and (v) tourism related projects. With regard to unlisted securities, the fund will not invest more than 25 percent of its net asset value in such securities. The fund is not intended to be a provider of "venture" capital. Consequently, the fund will only invest in unlisted companies that have a reasonable expectation of obtaining a listing within a reasonable period of time. 13. Sri Lanka has also issued regulations regarding regional funds. Regional funds are defined to be a fund floated abroad for the purpose of investing in the Asia region  -85 - by persons or institutions who are non-residents. Regional funds investing in Sri Lanka are expected to fulfill the following criteria: O arrangements for the transfer of fund management technology to Sri Lanka; O experience in investment in securities markets with particular reference to Asian emerging markets; 0 suitability of the fund's operating structure -- the fund itself, fund management, investment advice, custodianship, and investment guidelines; and 0 experience in the fund management business.  - 86- Attachment 2.3 SRI LANKA FINANCIAL SECTOR REPORT Comparative Capital Markets Data Table 2.1: Stock Markets Capitalization and Trading Volume, 1986-1997 (US$ Billions) Market Capitalization Trading Volume Year World Developed Emerging World Developed Emerging 1986 6,513 6,276 238 3,574 3,491 83 1987 7,830 7,511 319 5,847 5,682 165 1988 9,728 9,245 483 5,997 5,689 409 1989 11,714 10,976 738 7,468 6,303 1,166 1990 9,394 8,782 611 5,512 4,618 894 1991 11,290 10,436 855 5,016 4,411 606 1992 10,833 9,950 883 4,778 4,166 613 1993 13,964 12,377 1,587 7,703 6,634 1,069 1994 15,154 13,242 1,912 10,066 8,446 1,620 1995 17,788 15,892 1,896 11,662 10,633 1,029 1996 20,178 17,952 19,485 13,588 12,001 1,587 1997 23,541 21,312 2,230 19,485 16,783 2,701 Source: IFC's Emerging Stock Market Factbook (1996 & 1998 ). Note: p preliminary  - 87- Table 2.2: Stock Market Capitalization South and East Asian Emerging Stock Markets (USS Billions) Country/Year 1990 1991 1992 1993 1994 1995 1996 1997 China - 2.0 18.3 40.5 43.5 42.1 113.8 206.4 Korea 110.6 96.4 107.4 139.4 191.8 182.0 138.8 41.9 Philippines 5.9 10.2 13.8 40.3 55.5 59.0 80.6 31.3 Taiwan, China 100.7 124.9 101.1 195.2 247.3 187.2 273.6 287.8 India 38.6 47.7 65.1 98.0 127.5 127.2 122.6 128.5 Indonesia 8.1 6.8 12.0 33.0 47.2 66.6 91.0 29.1 Malaysia 48.6 58.6 94.0 220.3 199.3 222.7 307.2 93.6 Pakistan 2.9 7.3 8.0 11.6 12.3 9.3 10.6 11.0 Sri Lanka 0.9 1.9 1.4 2.5 2.9 2.0 1.8 2.1 Thailand 23.9 35.8 58.2 130.5 131.5 141.5 99.8 23.5 TOTAL 340.2 391.6 479.3 911.3 1,058.8 1,039.6 1,239.8 855.2 Source: IFC's Emerging Stock Market Factbook (1996 & 1998). Note: p = preliminary  - 88- Table 2.3: Stock Market Capitalization as a Percent of Gross Domestic Product South and East Asian Emerging Stock Markets (Percent) Country/Year 1990 1991 1992 1993 1994 1995 1996 China - 0.5 4.2 7.5 8.4 6.0 25.3 Korea 45.1 32.7 34.9 42.1 49.6 40.0 8.6 Philippines 12.9 21.9 25.3 72.7 80.1 79.3 37.4 Taiwan, China 63.3 70.2 48.3 89.0 103.8 - India 12.7 17.7 24.4 39.0 44.3 39.2 36.1 Indonesia 7.6 6.0 9.4 22.8 27.5 33.6 42.8 Malaysia 113.8 124.4 162.1 364.2 275.3 261.1 94.3 Pakistan 7.0 17.5 16.5 23.9 24.2 15.3 16.9 SriLanka 11.4 21.1 14.4 23.8 25.0 16.2 15.1 Thailand 29.7 39.0 52.5 105.2 91.6 84.7 12.7 Source: IFC's Emerging Stock Market Factbook (1996 & 1998).  - 89- Table 2.4: Number of Listed Companies South and East Asian Emerging Stock Markets Country/Yea 1990 1991 1992 1993 1994 1995 1996 1997 r China - 14 52 183 291 323 540 764 Korea 669 686 688 693 699 721 760 776 Philippines 153 161 170 180 189 205 216 221 Taiwan, China 199 221 256 285 313 347 382 404 India-Bombay - 2,556 2,781 3,263 4,413 5,398 5,999 5,843 Indonesia-JSE 125 141 155 174 216 238 253 282 Malaysia 282 321 369 410 278 529 621 708 Pakistan 487 542 628 653 724 764 782 781 SriLanka 175 168 190 200 215 226 235 239 Thailand 214 276 305 347 289 416 454 431 TOTAL NA 5,086 5,594 6,388 7,627 9,167 10,242 10,449 Source: IFC's Emerging Stock Market Factbook (1996).  - 90- Table 2.5: Percent Change in IFC Total Return Stock Index South and East Asian Emerging Stock Markets (Index Computed in U.S. Dollars) Country/Yea 1990 1991 1992 1993 1994 1995 1996 1997 r China - - - -7.3 -33.0 -12.4 91.5 33.0 Korea -25.3 -15.9 3.6 20.9 19.0 -5.7 -38.2 -68.7 Philippines -53.9 58.9 18.3 134.9 -0.6 -14.1 20.3 -61.9 Taiwan, China -50.9 -0.6 -26.6 89.0 22.5 -30.7 37.4 -7.7 India 18.8 18.4 22.9 18.8 7.4 -34.2 -2.1 7.1 Indonesia -0.6 -42.3 2.9 113.4 -19.3 12.0 19.9 -73.7 Malaysia -11.2 12.1 27.9 102.9 -21.5 3.6 24.5 -71.7 Pakistan 11.1 172.1 -18.4 56.2 -8.5 -31.1 -19.5 26.1 SriLanka - - - 65.4 -0.4 -38.0 -11.2 11.1 Thailand -20.7 -19.2 40.3 103.0 -11.3 -1.4 -36.6 -79.3 Source: IFC's Emerging Stock Market Factbook (1996 & 1998).  -91- Table 2.6: Price Earnings Ratios South and East Asian Emerging Stock Markets Country/Year 1990 1991 1992 1993 1994 1995 1996 1997 China - - - - - 16.5 27.8 34.5 Korea 16.4 21.3 21.4 25.1 34.5 19.8 11.7 17.9 Philippines 11.3 11.3 14.1 38.8 30.8 19.0 20.0 10.9 Taiwan, China 25.0 22.3 16.6 34.7 36.8 21.4 28.2 28.9 India 17.8 25.4 33.7 39.6 26.7 14.2 12.3 15.2 Indonesia 20.3 11.6 12.2 28.9 20.2 19.8 21.6 10.5 Malaysia 23.6 21.3 21.8 43.5 29.0 25.1 27.1 9.5 Pakistan 7.0 23.9 21.9 27.6 23.3 15.0 11.7 14.8 SriLanka - - 27.8 17.6 8.1 9.7 11.7 Thailand 8.7 12.0 13.9 27.5 21.2 21.7 13.1 -32.8 Average 16.3 18.6 19.4 32.6 26.7 18.07 18.3 12.1 Source: IFC's Emerging Stock Market Factbook (1996 & 1998).  92 Attachment 3.1 SRI LANKA Development Finance Corporation of Ceylon (Rs. 000) Yearended 31st March 1995 1996 1997 1998 INCOME STATEMENT INTEREST INCOME: Loans & Advances 1,676,080 2,210,874 2,168,222 2,621,073 Treasury Bills/ Placements with Banks etc. 21,110 67,939 303,955 192,651 Other interest income 2,798 3,083 2,813 2,862 Total Interest Income 1,699,988 2,281,896 2,475,990 2,816,586 NON - INTEREST INCOME Income From Leasing Activities 0 0 0 0 Income From Fee Based Activities 35,455 34,447 40,573 56,380 Dividend Income 59,561 61,677 60,184 82,219 Other Income 239,229 63,834 24,217 35,880 Turnover Tax Recovered 0 0 0 Defense Levy Recovered 0 0 0 Total Non Interest Income 334,245 159,958 124,974 174,479 TOTAL INCOME 2,034,233 2,441,854 2,600,964 2,991,065 EXPENSES Long-term Borrowings 603,680 758,611 1,007,800 1,077,115 Other Term Borrowings. 19,564 74,598 10,514 55,627 Loan Stock I Bonds 185,658 360,763 442,538 321,838 Other Interest 5,695 17,420 42,528 51,563 Total Interest Expenses 814,597 1,211,392 1,503,380 1,506,143 Other Financial Cost 0 0 0 0 Total Financial Cost 814,597 1,211,392 1,503,380 1,506,143 GROSS PROFIT 1,219,636 1,230,462 1,097,584 1,484,922 PROVISIONS FOR BAD DEBT/FALL IN VALUE OF INVESTMENTS Amount Written Off Est. Identified Written off Provision for bad debts less recoveries 60,091 41,878 Investment losses 2,797 28,044 Total provisions 62,888 69,922 68,490 146,154 ADJUSTED GROSS PROFIT 1,156,748 1,160,540 1,029,094 1,338,768 Staff Cost 90,151 103,273 104,916 119,604 Depreciation 13,893 14,069 17,019 25,592 Turnover Tax 66,326 97,206 189,066 228,948 Defense Levy 49,265 79,851 General Admininstrative Expenses 41,679 55,228 67,512 69,036 Subtotal: Other Administrative Cost 171,163 246,354 273,597 323,576 TOTAL ADMINISTRATIVE COST 261,314 349,627 378,513 443,180 PROFIT BEFORE EXEPTIONAL ITEMS 895,434 810,913 649,581 895,588  93 Year ended 31 st March 1995 1996 1997 1998 Exceptional Items 0 0 0 46,165 PROFIT BEFORE TAX 895,434 810,913 649,581 849,423 Taxation 204,231 220,612 179,087 289,617 PROFIT AFTER TAX 691,203 590,301 470,494 559,806 ii. BALANCE SHEET ASSETS Cash 198,925 806,580 474,455 614,754 Money at Call & Short Notice 16,200 166,449 1,877,766 549,000 Treasury Bills/Interest Bearing Securities 32 1,002,471 Subtotal: Cash & Short Tern Funds 215,157 1,975,500 2,352,221 1,163,754 Loans and Advances 8,678,235 10,414,299 12,025,588 12,691,710 Loan loss provision/interest suspended 562,762 697,481 1,240,831 641,760 Subtotal: Loans and Advances 8,115,473 9,716,818 10,784,757 12,049,950 Lease Rentals 1,344,429 1,799,730 1,969,168 2,039,540 Provision For Doubtful Recoveries 6,225 17,296 36,614 68,876 Subtotal : Lease Rentals 1,338,204 1,782,434 1,932,554 1,970,664 Investments in Quoted Securities 714,732 959,095 1,136,230 2,085,452 Other Investments 674,828 735,471 620,914 1,473,483 Provision for Diminution in value of Investment 3,031 3,031 3,031 1,031 TOTAL INVESTMENT 1,386,529 1,691,535 1,754,113 3,557,904 Fixed Assets 60,938 64,088 75,439 100,082 Other Assets 120,040 46,489 86,297 181,687 TOTAL ASSETS 11,236,341 15,276,864 16,985,381 19,024,041 LIABILITIES AND EQUITY Dividends payable 105,778 105,778 105,778 123,407 Taxes payable 94,535 54,836 25,473 113,519 Borrowings 6,043,202 8,645,035 9,623,833 10,218,401 Other Liabilities 358,234 377,838 964,800 1,592,491 Debentures 1,340,583 2,314,845 2,122,249 2,104,469 TOTAL LIABILITIES 7,942,332 11,498,332 12,842,133 14,152,287 Share Capital 226,667 302,222 302,222 302,222 Reserves 1,102,782 1,024,027 1,024,027 1,106,694 Retained Profits 1,964,560 2,452,283 2,816,999 3,462,838 Convertible Stock 0 0 0 0 Subtotal: Capital Funds 3,294,009 3,778,532 4,143,248 4,871,754 TOTAL EQUITY & LIABILITIES 11,236,341 15,276,864 16,985,381 19,024,041  94 Year ended 31st March 1995 1996 1997 1998 iii. RATIO ANALYSIS No of Employees 199 201 200 214 Assets/Employee 56,464 76,004 84,927 88,897 Advances/Employee 43,609 51,812 60,128 59,307 Profit Before Tax/Employee 4,500 4,034 3,248 3,969 Capital/Total Assets 29% 25% 24% 26% Capital /Total Liabilities 41% 33% 32% 34% Interest Expense/Interest Income 48% 53% 61% 53% Staff Cost/Total Administrative Cost 34% 30% 28% 27% Total Expense/Total Income 40% 50% 58% 50% Profit After Tax/Total Capital Funds 21% 16% 11% 11% Non-interest Income/Total Income 16% 7% 5% 6% Provisions/Total Advances 6% 6% 9% 5% Interest Income/Total Advances 17% 19% 18% 19% Interest Expense/Total Borrowings 13% 14% 16% 15% Interest Spread 3% 5% 2% 4% Income Statement (% of Total Avg. Assets) Interest Income 17% 17% 15% 16% Fee & Other Income 3% 1% 1 % 1 % TOTAL INCOME 20% 18% 16% 17% Interest Expense 8% 9% 9% 8% Other Financial Expense 0% 0% 0% 0% Provisions and Written-Offs 6% 5% 8% 4% Staff Expense 1% 1% 1% 1% Other Administrative Expense 2% 2% 2% 2% TOTAL EXPENSES 3% 3% 2% 2% Net Interest Margin 8.7% 8.1% 6.0% 7.3% Profit Before Tax 8.8% 6.1% 4.0% 4.7% Profit After Tax 6.8% 4.5% 2.9% 3.1% Balance Sheet (% of Total Assets) Cash & Short Term Funds 2% 13% 14% 6% TOTAL ADVANCES 84% 75% 75% 74% Investment 12% 11% 10% 19% Fixed and Other Assets 2% 1% 1% 1% Capital Funds 29% 25% 24% 26% AVERAGE ASSETS 10,231,272 13,256,603 16,131,123 18,004,711  95 Attachment 3.2 SRI LANKA NATIONAL DEVELOPMENT BANK (Rs. 000) Year ended 31st March 1994 1995 1996 1997 INCOME STATEMENT INTEREST INCOME: Loans & Advances 1,945,245 2,034,807 2,573,199 2,969,658 Treasury Bills/ Placements with Banks etc. 14,657 160,069 115,554 244,171 Other interest income 0 0 0 0 Total Interest Income 1,959,902 2,194,876 2,688,753 3,213,829 NON - INTEREST INCOME Income From Leasing Activities 52,966 100,133 0 0 Income From Fee Based Activities 31,976 43,843 52,574 74,854 Dividend Income 45,560 85,112 68,265 87,826 Other Income 166,678 70,932 47,005 140,631 Tumover Tax Recovered 76,141 108,721 144,243 Defense Levy Recovered Total Non Interest Income 373,321 408,741 312,087 303,311 TOTAL INCOME 2,333,223 2,603,617 3,000,840 3,517,140 EXPENSES Long-term Borrowings 1,059,583 1,245,172 1,537,119 1.848,854 Other Term Borrowings 33,780 145,564 203,196 274,500 Loan Stock / Bonds 33,000 33,000 33,000 19,250 Other Interest 0 0 0 0 Total Interest Expenses 1,126,363 1,423,736 1,773,315 2,142,604 Other Financial Cost 0 0 0 0 Total Financial Cost 1,126,363 1,423,736 1,773,315 2,142,604 GROSS PROFIT 1,206,860 1,179,881 1,227,525 1,374,536 PROvISIONS FOR BAD DEBT/ FALL IN VALUE OF INVESTMENTS Amount Written Off Est. Identified Written off Provision for bad debts less recoveries Investment losses Total provisions 89,447 57,589 -28,156 135,321 ADJUSTED GROSS PROFIT 1,117,413 1,122,292 1,265,681 1,239,215 Staff Cost 77,606 92,490 103,478 119,987 Depredation 14,086 14,615 14,506 15,555 Tumover Tax 9,725 4,665 6,863 Defence Levy General Admininstrative Expenses 34,146 33,605 48,608 81,624 Subtotal: Other Administrative Cost 57,957 52,885 69,977 97,179 TOTAL ADMINISTRATIVE COST 211,704 254,096 317,698 217,166 PROFIT BEFORE EXEPTIONAL ITEMS 905,709 868,196 937,983 1,022,049 Exceptional Items 25,000 0 0 0 PROFIT BEFORE TAX 880,709 868,196 937,983 1,022,049 Taxation 198,000 232,000 231,000 283,879 PROFIT AFTER TAX 682,709 636,196 706,983 738,170  96 Year ended 31st March 1994 1995 1996 1997 ii. BALANCE SHEET ASSETS Cash 125,178 69,537 28,985 468,508 Money at Call & Short Notice 333,900 228,960 286,624 2,123,024 Treasury Billslinterest Bearing Securities 113,077 597,578 983,638 1,375,321 Subtotal: Cash & Short Term Funds 572,155 896,075 1,299,247 3,966,853 Loans and Advances 12,288,063 13,945,348 16,353,610 18,773,091 Loan loss provision/lnterest suspended 1,275,020 1,415,050 1,618,147 1,729,043 Subtotal: Loans and Advances 11,013,043 12,530,298 14,735,463 17,044,048 Lease Rentals 567,338 918,030 1,321,621 1,310,954 Provision For Doubtful Recoveries 231,230 366,042 481,422 506,871 Subtotal : Lease Rentals 336,108 551,988 840,199 804,083 Investments in Quoted Securities 838,155 988,225 1,273,282 1,397,905 Other Investments 874,493 1,473,712 1,560,386 2,402,495 Provision for Diminution in value of Invest. - - - 53,411 TOTAL INVESTMENT 1,712,648 2,461,937 2,833,668 3,746,989 Fixed Assets 124,577 113,252 118,903 139,532 Other Assets 31,383 70,161 90,201 573,959 TOTAL ASSETS 13,789,914 16,623,711 19,917,681 26,275,464 LIABILITIES AND EQUITY Dividends payable 70,101 78,934 96,597 233,545 Taxes payable 201,391 223,342 235,697 275,869 Borrowings 9,539,370 11,909,684 14,295,671 19,693,990 Other Liabilities 1,022,480 897,733 1,164,965 1,442,056 Debentures 0 0 0 0 TOTAL LIABILITIES 10,833,342 13,109,693 15,792,930 21,645,460 Share Capital 175,000 175,000 175,000 358,333 Reserves 2,502,742 3,057,074 3,672,374 4,156,939 Retained Profits 3,830 6,944 2,377 114,732 Convertible Stock 275,000 275,000 275,000 Subtotal: Capital Funds 2,956,572 3,514,018 4,124,751 4,630,004 TOTAL EQUITY & LIABILITIES 13,789,914 16,623,711 19,917,681 26,275,464  97 Year ended 31st March 1994 1995 1996 1997 iii. RATIO ANALYSIS No of Employees 223 230 258 Assets/Employee 74,546 86,599 101,843 Advances/Employee 62,535 71,103 72,764 Profit Before Tax/Employee 2,853 3,074 2,861 Employee cost/employee 348 402 401 Employee cost/Net Income 9% 11% 11% 12% Capital/Total Assets 21% 21% 21% 18% Capital /Total Liabilities 27% 27% 26% 21% Interest Expense/linterest Income 57% 65% 66% 67% Employee Cost/Total Administrative Cost 37% 36% 33% 55% Total Expense/Total Income 48% 55% 59% 61% Profit After Tax/Total Capital Funds 23% 18% 17% 16% Non-Interest Income/Total Income 16% 16% 10% 9% Provisions/Total Advances 12% 12% 12% 11% Interest Income/Total Advances 15% 15% 15% 16% Interest Expense/Total Borrowings 12% 12% 12% 11% Interest Spread 3% 3% 3% 5% Income Statement (% of Total Avg. Assets) Interest Income 15.1% 14.4% 14.7% 13.9% Fee & Other Income 3% 3% 2% 1 % TOTAL INCOME 18% 17% 16% 15% Interest Expense 8.7% 9.4% 9.7% 9.3% Other Financial Expense 0% 0% 0% 0% Provisions and Written-Offs 12% 12% 11% 10% Staff Expense 1 % 1 % 1 % 1 % Other Administrative Expense 0% 0% 0% 0% TOTAL EXPENSES 2% 2% 2% 1 % Net Interest Margin 6.4% 5.1% 5.0% 4.6% Profit Before Tax 6.8% 5.7% 5.1% 4.4% Profit After Tax 5.3% 4.2% 3.9% 3.2% Balance Sheet (% of Total Assets) Cash & Short Term Funds 4% 5% 7% 15% TOTAL ADVANCES 82% 79% 78% 68% Investment 12% 15% 14% 14% Fixed and Other Assets 1 % 1 % 1 % 3% Capital Funds 21% 21% 21% 18% AVERAGE ASSETS 12,977,015 15,206,813 18,270,696 23,096,573