42325 FINANCIAL SECTOR ASSESSMENT SRI LANKA JANUARY 2008 SOUTH ASIA REGIONVICE PRESIDENCY FINANCIAL AND PRIVATESECTORDEVELOPMENTVICEPRESIDENCY BASED THEJOINT IMF-WORLDBANKFSAPREPORT ON This Financial Sector Assessment (FSA) is basedon the work ofthejoint World Bankand IMFFinancial Sector Assessment Program (FSAP) Update team that visited Sri Lanka between June 20 and July 3,2007.' The principal objectives of the FSAP Update were to: (i) developmentsinthefinancialsectorandprogressinstrengtheningfinancialsector assess regulationsince 2002; and (ii) identify measures that would contribute to consolidationof financial stability and to further development o fthe financial sector over the next five years. The structural and developmental aspects ofthe 2007 FSAP Update are summarized here. The stability andprudentialoversight aspects ofthe Update, including the Report on Observance o f Standards and Codes (ROSCs) andtheir findings, are summarized inthe Financial System Stability Assessment (FSSA) that was discussed by the IMFBoard, as part of the Article IV Consultation, inNovember 2007. This FSA should be read together with the FSSA in order to get afull sense of theJindings and recommendations of the 2007 Sri Lanka FSAP Update. Section Iprovides an overview o fthe 2002 FSAP findings. Section I1describes the main findings o f the 2007 FSAP Update addressing bank and nonbank financial institutions, state bank restructuring, pension funds, insurance, capital markets, supervisory framework, access to finance, and legal andjudicial reforms. Section I11summarizes the recommendations for sustaining financial development. Box 1lists the key recommendations as presented inthe Aide-MCmoire. 'The Sri LankaFSAPUpdate team acknowledges the excellent hospitality,cooperation, and opennessof the authoritiesand technicalcounterparts.The team comprisedMessrshlmes.Kiatchai Sophastienphong(Leader, World Bank), AdityaNarain (Deputy, IMF); Jorg Genner, Peter Hayward, Turgut Kisinbay, Tom Kokkola,Mercy MathibeandAndre Santos(all IMF); NagavalliAnnamalai, Gregory GordonBrunner, MarinelaDado, SriyaniHulugalle, LohitaKarunasekera,Yibin Mu, K.R. Ramamoorthy, Carlotta SaporitoandNiranjani Sathiakumaran(all World Bank). * Thetopics covered inthe IMF's FSSAbut not covered inthis FSA are: (i)an analysis of financialsystemstability; (ii) risk mitigationframework includingsystemic liquidity managementframework, anti-money launderingandcombatingthe financingofterrorism (AMLKFT), and safety net and crisis management; and (iii)ROSCs for the BankingCore Principles (BCP) and the Core Principlesfor Systemically ImportantPayment Systems (CPSS). 2 I. BRIEF REVIEWOFTHE2002FSAPFINDINGS 1. The 2002 FSAP notedsignificant strengtheningof the financialsector duringthe preceding20 years. The report indicated that Sri Lanka's legal and regulatory framework had beenregularly updated and bankingsupervision upgraded. New laws on securities markets and insurance hadbeenenacted; andnew banks andinsurance companies, both domestic and foreign, had beenauthorized, resultinginincreased competitionand innovation. The markets for private securities were well regulated andtechnically advanced, while the provident fund sector had expanded to become a significant force inthe local financial system. 2. At the same time, the FSAP pointedto severalstructuralweaknesses in the state banks, the interbank marketsfor foreign exchangeand domestic money as well as government securities markets. The two systemically important state-owned bankswere technically insolvent with highlevels o f nonperforming loans (NPLs) and faced stiff industrialrelationproblems from entrenched unions. The interbank markets suffered from bigswings insystemic liquidity andlargeimbalances inthe positions ofmajor market participants. The primary market for government bonds suffered from the absence of liquid benchmark issues, limitedtransparency and weak competition among primary dealers. Activity inthe secondary market was impededby the use o f physical scrip and the dominant presence of two large state institutions. The report recommended that the functioning o f interbankmarkets for foreign exchange and domestic money required immediate, urgent attention. It stressed that the development o f securities marketswould requireactions to enhance primary market efficiency and secondary market liquidity. 11. MAINFINDINGS THE2007FSAPUPDATE OF 3. The 2007 FSAP Updateteam reassessedfinancialsystem soundness and the regulatory and supervisoryframework for banks and key nonbankfinancial institutions.It also reviewedprogress inimplementingrecommendations made duringthe 2002 FSAP and provided the authorities with a revisedset o fprioritizedrecommendations for financial sector reform. The full FSAP Update report, on which this FSA i s based, includes: e The Aide MCmoire, summarizingthe Update findings and recommendations; e Technical Notes on selected topics (Insurance and Pensions; Capital Markets; Asset Valuation and Provisioning; and Legal and Judicial Reforms); and e Principle-by-principle reassessmentso f Observance o f the Base1Core Principles for Effective Banking Supervision and the Observance o f the CPSS Core Principles for Systemically Important Payments Systems. 3 A. OverallAssessment 4. The authoritieshaveembarkedon a major reformprogramsince the 2002 FSAP,butprogresshas beenunevenacross differentfinancialsector segments. Several legislative and regulatory reforms have taken place and supervision strengthened, and an active agenda exists for ongoing work. However, a number o f key recommendations including those relating to privatization of the state banks have not been pursued, although some efforts have beenmade to addressthe weak financial condition through operational and financial restructuring. The reform agenda for the pension andprovident funds also has not been addressedadequately. 5. Despitea challengingenvironmentof highgovernmentdeficits and civilstrife, the bankingsystem has increaseditsresiliencyto shocks since the 2002 FSAP. The system-wide capital adequacy ratio was still highat 11.7 percent at end-2006, although profitability had strengthened, and gross NPLs as a share o f total loans had dropped from 12.5 in2002 to 5.2 percent in2006, backed by increased provisioning coverage. B. BankingSector 6. The structureof the financialsystem, with its dominanceby banks, hasnot changedmuchsince 2002. Commercial (56 percent) and specialized (11percent) banks together still account for 67 percent o ftotal financial sector assets, withprovident funds holding around 20 percent, andinsurance companies, finance companies, and leasing companies each accounting for around 3 percent. State-owned banks continued to dominate the landscapewith47 percent oftotal bankingsystem assets, despite a decline of 5.1 percent intheir share since 2002. 7. The bankingsystem includes23 licensedcommercialbanks (LCBs) and 14 licensedspecializedbanks (LSBs). The two largestLCBs are state-owned. Another nine banks are privately owned commercial banks and 12 foreign banks have branches. LSBs, which are mostly state owned and have a market share o f about 20 percent o f commercial banks, are not permittedto take demand deposits or undertake foreign currency business but are otherwise treated like LCBs for prudential regulationpurposes. The system also includes a large number o f finance companies that may take savings and time deposits and leasing companies that are fundedby bankborrowings and debentures. 8. The bankingsystem's financialperformancehas improved. The capital adequacy ratio for LCBs remained high-at 11.7percent as of end2006. Rapidcredit expansion helped gross NPLs as a share o f total loans dropped from about 19 percent in2002 to just above 7 percent in2006 as a result o f improved credit risk management and supervision. Improved asset quality i s also evidenced by an increasedprovisioning coverage, which accounted for about 67 percent o fNPLs. Profitability has also strengthened with the Return on Assets (ROA) after tax rising from 0.9 percent in2002 to 1.3 percent in2006. RisingNPLs inthe first half of 2007, however, suggest some reversal. 9. Most commercialbankscontinuedto maintaincapitalin excess of the minimum statutorycapitaladequacyrequirement (CAR) of 10percent in 2006. However, one private bank is slightly undercapitalized, and one major state-owned bank i s severely 4 undercapitalized. The decline inCAR by about 1percent between2005 and 2006 i s attributed to the introduction o f the capital charge requirement for market risk and o f higher risk weights for credit risk inlate 2006. Inaddition, 11LCBs and two LSBs have not been able to meet the increased minimumcapital requirements introduced in2005 andthey have beengivenuntil2009 to comply. C. NonbankFinancialInstitutions 10. A resilienteconomy contributedto the positiveperformanceof nonbank financialinstitutions(NBFIs), specifically,registeredfinance companies and specialized leasingcompanies. Profitability, capital positions, levels and asset quality showed remarkable improvements. The combined share ofNBFIsintotal financial system assets rose from 3.3 percent in2003 to 4.5 percent in2006. Favorable economic developments and performance o f NBFIs facilitated enhancements to the regulatory and supervisory framework-for example, the issuanceby Central Bank of Sri Lanka (CBSL) o f stronger prudential regulations as well as required increases incapital levels, ratings from reputable rating agencies, maximum interest rates on deposits to curb aggressive deposit taking and introduction o f onsite and offsite supervision o f leasing companies. 11. Observanceof the prudentialnormsby bothNBFIsthemselvesand CBSL is a medium-termchallengeas enforcementfalls considerably behindregulatory enhancements.The legal authority of CBSL's Departmento fNonbank Supervision (DNBS) to take corrective actions (e.g., revocationof a license or suspension o f ownership rights) on its own i s unclear. Yet implementation of the regulations, accompanied by more rigorous supervision, i s necessary to address the riskso fNBFIs' reliance on deposit taking for funding purposes and their considerable asset concentration invehicle leasing and purchase facilities. The implications for the financial systemofNBFIfundingthrough deposits would needto be addressedinthe context o f the upwardtrend ininterest rates and the plansby specialized leasing companies to raise funds from the public by issuing debt instruments (ineffect taking deposit^).^ D. StateBankRestructuring 12. With a quarterofthe totalfinancialsystem assets, the two state-ownedbanks (SCBs)are systemically importantinstitutions.The authorities have identifiedweak areas inthe banks. Restructuringefforts are ongoing, andprogress is regularly monitoredin meetings of the Financial Institutions Monitoring Committee. However, continued weak or marginal performance o f these SCBs poses a concern for the stability o f the financial system inthe mediumterm, andany recapitalizationmay aggravate budgetary deficits. 13. Restructuringeffortsover the pastthreeyears haveyielded some results,but muchremainsto be done. For example, while the restructuringo f People's Bank, accompanied by ADB-assisted recapitalization, has improvedthat bank's overall financial profile, BOC shows less noticeable improvement as it looses market share with its margins The authorities shouldconsider upgradingthe supervisorycapacitywithin CBSL's DepartmentofNonbank Supervision (throughimproved and more relevanttraining andpreparationof proceduralmanualsand systems), developingwell-defined or specific guidelineson licensing and revocationof licenses, introducing manualsand systemsthat definethe essential criteria for adherenceto the Basel Core Principles for useby officers and staff of registeredfinance companies and specializedleasingcompanies. 5 under pressure. Its incremental loan delinquencies and its investmentportfolio suffer significant depreciation under current mark-to-market valuation. E. PensionFunds 14. The pensionssector is dominatedby the CBSL-managedEmployeeProvident Fund,which accountsfor nearly 15 percent of financialsector assets and 18 percent of GDP. The assets managedbythe next largestpensionfund, the Employees TrustFund (ETF), amount to 2 percent of GDP. Most ofthe assets o fthese two institutions are held in the form of government debt. Inaddition, around 185 approved private provident funds (APPFs) hold assets of only around 4 percent o f GDP. These funds are privately administered by individual employers and employer groups, with no specific agency in charge o f their supervision. 15. Pensionreformhas not progressedsince the previousassessment and initiatives to move the publicservice pensionscheme to a funding basishavebeenreversed. The two key recommendations from the 2002 FSAP remaincurrent: (i) EPFneeds to develop the a sound, robust and independentgovernance structure withthe clear objective o f seekingthe best investment returns for members, while taking into account reasonable levels ofrisk tolerance and the individual preferences and circumstances o f workers ifit is to improve investment efficiency; and (ii)a strong regulatory framework for licensing o f approved APPFs as well as for unifiedand independent supervision o f all pension funds is needed. 16. Givenan agingpopulation,the pensionsector needsa comprehensive retirement incomeobjective.Currently differentpension plans ascribe to a numbero f different objectives. The EPF, which covers all private sector employees not belongingto APPFs, ostensibly requires membersto save for retirement.However, balances can be eroded since they are usedas security for housingloans and defaults on such loans by EPF membersare fairly common. The ETF i s viewed as both an employee benefit program and a retirement income program. APPFs seem to have many objectives, and many offer low interest loans to members. Other pensionarrangements offered, particularlybybanks and government bodies (for example, the universities offer a defined-benefit scheme). 17. Many pensionfunds haveundiversifiedinvestmentportfolioswith heavy concentrationsin government securities, The EPFhastaken some small steps to diversify through corporate bonds and equity, but it appears reluctant to use external fund managers. The ETFcites the failed attempt in 1993 to use external fund managers as its reason for not continuing that model. However, it seems -because the ETF withdrew the funds after only two years -that it did not appreciate that equities should be seen as a long-term investment. Some funds, either overtly or covertly, are directedto purchase government securities. The largest APPF, the Universities Fund, is compelled to invest ingovernment securities purchased from state-owned banks. To grow inthe long term, funds need greater investment freedom. Private sector fund managers, under appropriate supervision, should be giventhe opportunity and encouragement to provide fund management services to many government- related funds. 6 F. InsuranceSector 18. Although smallby globalstandards-total insurancepremiums representabout 1.5 percentof GDP -the insurancesector has grownin recentyears. Less than 10 percent o f the population, however, i s said to have any form o f insurance allowing considerable scope to increase the level o f ~overage.~ The market is highly competitive suggesting some pricing may be unsustainable. Foreign companies are free to enter the market, but they have generally had a modest impact. 19. A numberof positivedevelopmentssince the 2002 FSAPincludethe privatizationof the two state insurancecompaniesandthe creation of the Insurance Boardof Sri Lanka (IBSL) as an independentsupervisor.The National Insurance Corporationwas privatized in2001and 2002, and Sri LankaInsurance Corporation, the country's largest insurer at the time, was privatized in2003. Tariff controls inseveral lines of business, such as fire and motor insurance, have beenremoved allowing companies to price the businessbasedon market forces. The IBSLbeganoperation as a division ofthe Securities and Exchange Commission(SEC) in2001 becomingan independent agency inMay 2005. 20. The IBSL is introducinga number of initiativesto improveinsurancecompany reporting. In2007, all insurance companies will be requiredto seek a rating from a recognized rating agency. They also will be requiredto seek stock exchange listing by 2009 and become subject to the SEC's disclosure requirements.Companies most likely will be requiredto report their capital and solvency positions as a result of listing. While these are positive steps, ISBL should further enhancetransparency by publishingsolvency and operating ratios for all insurance companies insimple, easily understood formats. 21. The IBSL is under-resourcedand needsto buildits capacitythrough training andhiringqualifiedstaff. Currently two professional supervisors are responsible for 15 insurance companies. The Act appears to provide the IBSLscope to hire employees. The IBSLhasplans to increase its stafffrom 17to 27, although its salaries are not sufficient to attract qualified staff from the insurance sector. Furthermore, it is preventedfrom hiringby directives from withinthe Ministry o f Finance. G. CapitalMarkets 22. The governmenthas taken a numberof positivesteps in promotingthe developmentof marketsfor its securities.These includethe introduction o fthe RealTime Gross Settlement (RTGS), the Scripless Security Settlement System (SSSS), andthe Central Depository Systemfor government securities. Inaddition, it now allows foreign investors to investinupto 5 percent o fthe total value of T-bonds outstanding. As a result, the proportion of marketable government securities to total domestic government debt has increased from about one-half to two-thirds. 23. The narrow investorbase and captivesources of large funds pose significant challengesto debt marketdevelopment.The EPF andNational Savings Bank (NSB) alone hold 43 percent o f government securities. The excessive fragmentation of the T-bonds (there are 52 series) also impedesthe development o f the benchmark yield curve. Promoting There are currently 15 insurancecompanies, comprising12 compositeinsurers, 2 general insurersand one life company. 7 collective investment schemes, gradually relaxing further the restrictions on foreign investors' participation, and developing a medium-term, benchmark-oriented issuance strategy are measures that would promote market development through diversification o f the investor base. Macroeconomic developments influence investor demand for government bonds. The 60 percent decline inT-bond secondary market activities inrecent years reflects the weak confidence o f investors inlong-termgovernment securities. Containing fiscal deficits and inflation would go a long way to boosting investor demand for T-bonds. 24. The limited investorand issuer bases are also an impediment to the development of markets for private securities.Although state-owned institutions play a dominant role in the economy, they do not participate actively inthe capital markets. The EPF, the ETF, and theNational Savings Bank (NSB) capture a significant amount ofthe nation's funds held mainly ingovernment securities. Captive sources o f government funding, together with the lack of corporate debt supply, leave little space for the development o f collective investment schemes, which remainconspicuously absent from the market. Measures to promote development o f the private securities markets could focus on exploring new sources of private issuancesthat could promote the development ofthe private securities. These include securitization o f the expanding housingloanportfolios o f banks; gradual divestment of equity instate-owned enterprises through listings on the stock exchange; promotion of collective investment schemes designedto attract retail investors; andprovisions for large pension funds to expand their private securities portfolio. H. SupervisoryFramework 25. Significant progress has beenmade inthe framework and capacity enhancements for effective banking supervision. Since the 2002 FSAP, the legal framework has been improved andprudentialregulations strengthened. More importantly, thepractice ofsupervisionandthe BankingSupervision Department (BSD)nowhas a complement o f trained and qualified staff that enjoy a good reputation for integrity and competence. Despite these improvements, some weaknesses persist that could adversely affect the supervisory effectiveness of CBSL. 26. A framework for overall riskassessment is still evolvingfrom a compliance- basedapproach. On-site examinations are lengthy, infrequentand consist o f detailed examinations o f credit files. The current practice does not pay sufficient attention to the management and quality o f internal systems and controls. Some use i s made o f external auditors' work but little reliance is placed on internal audit work. Risk management systems andprocessesare unevenly implementedacross banks. Bankboards are not seen as effective and do not yet play a central role inguiding the risk management process. 27. Credit concentrationriskis not mitigated becauseof the large exposure regime. The single borrower limitsare unusuallyhighinrelationto capital and are not always driven by considerations o f safety and soundness. The limits are also less comprehensive thanthose found inthe country's accounting standards. As credit concentrationi s a major source of bank failure, the supervisor needs robust and reliable tests for a case-by-case determination o f single exposure breaches. This capability is currently lacking. 28. The framework for consolidatedsupervisionis developingbut needs to be strengthenedto suit the changing landscapeof the financial industry. Prudential 8 regulations are not consistently applied on a consolidated basis. Banks are permittedto invest inany activity "not inconsistent withthe businessofbankingandthe provisionoffinance." Banksmay ownnonfinancial businesses such as property development companies. The CBSL needs to continue establishing links with other domestic regulators andto remove significant barriers to the exchange of information. These suggestions apply as well to relations with overseas authorities. 29. Credit riskis stilla significantchallenge.Asset quality is subject to risk inan environment where banks rely heavily on collateral inthe absence o f reliable financial statements. This could prove harmful ifasset prices were to decline. Rising interest rates are puttingpressure on liquidity,andcapital andasset quality indicators (which are largely based on delinquency) have begunto deteriorate. I. AccesstoFinance 30. Commercialbanks,especiallyprivateones, play a modestrole in financing rural enterprises.However, banksincreasingly have beenusingthe postalnetwork to expandtheir delivery of financial services to rural small andmediumenterprises (SMEs) andhouseholds. They have also recently expanded their lending to (SMEs) as corporate lendinghas become highly competitive with little room for market share growth. Five private commercialbanks are developing SME strategies, credit scoring and risk management capacity with IFC assistance. 3 1. The Credit InformationBureau(CRIB) expandedits coverageto includeother nonbankfinancialinstitutions.The proposed amendment to the CRIB Act that hasbeen approved by the Cabinet will include utility service providers and MFIs. These enhancements would boost accessto credit by SMEs constrained by collateral requirements. Shortage o f collateral is highlightedby SMEs as a major impediment inthe Investment Climate Assessment prepared in2004. 32. For the mostpart, the government'spast policiesto address unevenaccess have notbuilt the conditionsfor expandingservices to underservedgroups. Despite good intentions, policies such as the state ownership o f financial institutions, subsidies or interest rate controls and debt forgiveness programs have met little success. Hence, the government's current planto merge LankaPutraBank (LPB), SME Bank, National Development Trust Fund(NDTF) andthe Private Sector Infrastructure Development Corporation (PSIDC) into a single entity is a concern; the FSAP team urges a cautious approach. Inorder to define the role and functions o f the mergedentity, the government recently hired consultants to provide recommendations on the process. It also reorganized the financial sector cluster within the National Council for Economic Development (NCED) andplaced it under thejoint chairmanship o f the Secretary o f the Ministry o f Finance and the Governor of CBSL to better coordinate donor assistanceinthe areao f access to finance. 33. Although semi-formalinstitutionshave madeimportantsocial andeconomic contributionstoward meetingthe criticalneeds of poor households,microfinance suffers from severalproblems.The main constraints to the development ofmicrofinance include: poor policies, a narrow range o f products, weak financial performance, dependency on subsidized funds and lack o f a proper regulatory framework. Participation o fprivate commercial banks inthe microfinance sector i s minimal; however, a wide range o f other 9 formal and semi-formal institutions, reportedly as many as 14,000, are involved. The majority do not specialize infinancial services. Instead, they combine microfinance with other development or welfare programs, including community building, social transfers, solid waste management and education. The tsunami encouraged the proliferationo f this type o f assistance. However, in2006, MFIproviders established a micro finance network to coordinate assistance and the network transformed itselfinto a legal entity. 34. Several institutions are involvedinsupervisingmicrofinance, such as the Ministryof Cooperativesand the MinistryofNationBuilding.The proposed Micro Finance Institutions (MFI)Act recommends consolidating the responsibility for microfinance under CBSL. All MFIswith a capital base greater than a certainamount to be determined by the Monetary Boardwill berequiredto apply for a license fiom CBSL. CBSL is planningto adopt a two-tier approach to supervisingmicrofinance institutions. It would supervise only the holding or parent companies while their subsidiariesor affiliates wouldbe supervised by the holdingor parent companies themselves. Externalauditing firms wouldbe engagedto audit these holding or parent companies. J. Legal andJudicialFramework 35. Commendableprogresshas beenmadeinupdatingthe legal frameworkfor the financialsector. The newCompanies Act, Payment and Settlement Systems Act, Anti- Money LaunderingLegislation, Payment Devices Frauds Act. Amendments to financial sector laws such as the Securities and Exchange Commission Act, Finance LeasingAct, Monetary Law Act (MLA) and Banking Act (BA) were passed. However, delays inthe enactment of laws remain a major concern as evidenced by the 13 years it took to promulgate the Companies Act. Enactment delays severely limit Sri Lanka's ability to keepabreast with the latest domestic and global developments. Accordingly, theprocess ofdrafting and vetting needs to be strengthenedand the lags betweenfinalization, approval and submission to Parliament to be reduced. 36. While the 2005/06 amendmentsto the MLA and BA haveenhancedthe legaland regulatoryframeworkto some extent,the needfor a more streamlined, modern,non overlappingand comprehensivelaws remains,For instance, most powers of CBSL under the current law are exercised bythe Monetary Board andnot by the governor. The autonomy of CBSL is confined to the appointment and removal of the governor. Liberal powers to lend to the government andto extend credit for development purposes place CBSL ina conflict of interest position vis-a-vis monetary policy. The right o f the Minister o f Finance and the government to overrule the Monetary Board i s retained inthe MLA. According to CBSL, this particular right was exercised only once inits entire history, Le., in 1954. Amendmentsto the Monetary Law Act were introducedin2002 with regardto the objectives of CBSL, reserve requirements,the RTGS and SSSS and liquidation procedures for specializedbanks. Amendments to the BA that came into effect inJanuary 2005 introducedproceduralaspectsof licensing, fit andproper criteria, off shore banking by specialized banks, additional disclosure requirementsand provisions relating to offences.A comprehensivereview of the financial and banking legislation startedin2003 with assistance from the IMF and World Bank. Amendmentsto the FinanceLeasingAct that enablethe securitizationof finance leasing also were introducedrecently. 10 111. FINANCIAL DEVELOPMENT RECOMMENDATIONS 37. Making moreprogressin risk-focusedsupervision will be an important requirement for the successful implementationofBase1I1as plannedbythe Central Bank of Sri Lanka. The boards of LCBs and LSBs will needto play a more effective role inthe risk management process as well. Implementing consolidated supervision, includingthrough improvedinformation sharing among regulators usingmore fully the Inter-regulatory InstitutionsCouncil and removing legal impedimentsto information sharing, is another key reform agenda item. 38. The two state-ownedlicensedcommercialbanks continue to face structural weaknesses and liquiditymanagementproblems. The government's restructuring efforts brought some improvements, however, highcost-income ratios drivenby staff and pension costs and the government's interference inthe banks' lendingoperations continue to affect their performance adversely. 39. Further efforts are neededto improveinsurancesupervision.The Insurance Boardo f Sri Lanka i s establishing a sound basis for effective supervision, including through risk-based supervision, improvedreporting, and measures to improve transparency. However itis hamperedby a lack ofresources. The Policy Holder ProtectionFund, which was set up to provide a safety net for policyholders should insurance companies fail, is beingusedto meet IBSL's budget shortfall. Inaddition, the absence o f a comprehensive supervisory framework for pension funds i s a concern. 40. Positivedevelopmentshave also takenplaceinthe capitalmarkets, but the untappedpotentialis considerable.The fiagmentationofT-bond issuance and the current cash management practices hamper the development of a benchmark yield curve. The investor base remains narrow, with large captive and state-managed sources o f government fundingrenderingit difficult to conduct competitive auctions of government securities. The private securities market suffers from limited bases o f both issuers and investors, due to the state-owned enterprises' dominant role inthe economy andthe role o f the state-owned institutional funds as captive sources o f funds. 41. Although commendableprogresshas been madeinupdatingthe legal frameworkfor the financialsector, the list of unfinishedagenda of legal reformsis long. Itincludes, inthe short term, the needto: submit for enactment a revamped MLA and Banking Act; reviewthe draft micro finance law to address the concerns o f capacity, moral hazard etc; allocate sufficient resources to the Registrar o f Companies to implementthe new Act; and prepare a clear road map for AML/CFT implementation. Inthe mediumterm, the authorities should consider finalizing the securitization law and remove tax impedimentsfor securitization; amend the Companies Act to incorporate effective restructuringprovisionsor introduce a comprehensive Insolvency Law; introduce a secured transaction law andregistry for movable securities; and establish formal information sharingamong the regulators. 42. The key recommendations of the FSAP update team as providedinthe Aide MCmoire are summarized inBox 1below. 11 Box 1:Key Policy Recommendations Recommendation Time Frame6 1. Strengthen bank supervisory and regulatory framework Issue guidelines to banks on comprehensive riskmanagement and move to risk focused Short term supervision 0 Review and strengthenregulations on large exposure limits and related party lending Applyprudentialrequirements on a consolidatedbasis andimprove communicationwith other supervisors Develop and announce approach to better risk-based supervision before Base1I1 implementationdate 2. Make recently introduced prudential norms for NBFIsoperational Upgrade supervision capacity o f Departmento f Supervision o fNBFIs Medium term Develop well-defined or specific guidelines for licensing and revoking licenses Introduce manuals and systems that define essential criteria for compliance with BCP for use by officers and staff o fregistered finance companies and specialized leasing companies 3. Expedite restructuring of state commercial banks Implement recommendations by Strategic Enterprise Management Agency (SEMA) on Short term streamlining cost structures 0 Improve the legal framework to remove current impediments to bank debt recovery Medium term Gradually divest part o f the government's holdings to enhance market discipline and governance 4. Enhance supervision of insurance sector 0 Enhance supervisory capacity inIBSL commensurate with supervisory approach Short term 0 Manage the proposed re-insurer as a separate entity operating on a commercial basis 0 Permit IBSL to hire human resources at market rates 5. Introduce supervisory framework for pension funds 0 Introduce an overall pensions strategy and create a regulator for the pension sector Medium term 0 Implement a robust independent governance structure for the EPF and encourage portfolio diversification among all types o f funds 6. Remove constraintson access to finance by SME, the urban poor, the rural poor, and micro enterprises 0 Eliminate/minimize subsidized interest rates (LPB, Samurdhi, CBSL) Short term 0 Encourage public-private partnerships (SLP and commercial banks) 0 Reduce state involvement where the private sector and NGO sector are effective and utilize Medium term the existing institutional structure 0 Reconsider the role for Lankaputra as a second tier agency for SMEs 7. Deepen capital markets 0 Strengthen governance and capacity o f Securities and Exchange Commission Medium term 0 Expand issuer base 0 Expand investor base 0 Strengthen coordination o f between SEC and Colombo Stock Exchange (CSE) during inspections 0 Review regulatory framework ifCSE is to be de-mutualized 8. Strengthen legal and judicial framework 0 Submit for enactment, a revamped MLA and Banking Act Short term 0 Prioritize and have a clear road map for AMLEFT implementation 0 Finalize Securitization law and remove tax impediments Medium term 0 Amend Companies Act to incorporate effective restructuring provision or introduce a comprehensive Insolvency Law A short-term recommendationis envisagedfor introductionwithin the nexttwo years while amedium-termone would be launchedwithin 2-5 years.