Islamic finance in Sri Lanka needs good corporate governance, regulatory and legislative measures

By Riyazi Farook

The Islamic finance is certainly the fastest growing industry in the world, worth over US$ 1 trillion to date- a 28% increase from last year, which clearly demonstrates the industry’s potential despite the global financial crisis and the consequent economy downturn. Interestingly, industry is already catering to as much as 15% non-Muslim customer base throughout the world.

The Sri Lankan financial sector remained comparatively insulated from the global financial crisis, despite the fact, similar to the island’s conventional finance sector Islamic finance has also witnessed the insolvency before even the industry kicked off.

Institutions offering Islamic financial services in Sri Lanka cannot undermine the corporate governance practice, which should be on top of its strategic agenda to credibly protect particularly depositors' and shareholders' resources in the investment pools. Regulatory measures should also ensure Islamic financial service ventures are not just merely attracted to quick profit from the emerging industry but to aim at what global Islamic finance industry being achieved over the last three decades.

Industry Overview

In March 2005, CBSL issued an ordinance to include provisions for Islamic finance in which Sri Lanka became one of the few countries to have specific legislation for Shari’ah-compliant financial operations. The amendment also provided flexibility for conventional financial institutions to establish windows to offer Islamic banking and finance products and services.

According to Islamic Finance News Malaysia Islamic banking sector in Sri Lanka is estimated around US$900 million. Sri Lanka has number Islamic financial services providers including market leader Amana Investments Limited, Muslim Commercial Bank (MCB), People’s Leasing Company - Islamic Financial Services Unit, First Global Group, and ABC Investments (Baraka Islamic Financial Services). Amana Takaful Limited (ATL), the only takaful provider in the country, was introduced in 2002 and ATL was listed on the Colombo Stock Exchange (CSE) in late 2006. Amana Securities Limited (ASL), a subsidiary of Amana Investments Limited, is a trading member of the CSE and is one of just 20 stock-broking companies licensed to operate on the CSE.

The country’s largest bank, Bank of Ceylon, was planning to launch an Islamic banking unit in early 2008, but the bank decided to delay due to the global financial crisis.

In a remarkable development, Amana Investments Limited was recently issued a Letter of Provisional Approval by CBSL. Presently AIL is in the process of fulfilling certain condition listed in the Letter of provisional Approval such as raising of a minimum capital of Rs. 2.5 billion to establish island’s first ever full-fledged Islamic licensed commercial bank named Amana Bank Limited under Section 5 of the banking Act No. 30 of 1988 to carry out Islamic banking business in Sri Lanka aiming to deliver retail, business, and private banking facilities including wealth management, infrastructure financing, bonds, corporate treasury placement and many other financial products and services in the country to attract Shari’ah compliant investment funds from the Middle East and the Far East.

The ‘DJIM Amana Sri Lanka Index' launched in collaboration with Dow Jones Indexes, USA, The DJIM Amana Sri Lanka Index is the only Islamic Index in Sri Lanka, provides access to investors who seeks investment opportunities in Sri Lanka stocks that comply with Shari’ah requirements.

Country’s first ever planned Sukuk issuance attempt to raise approximately Rs. 500 million (US$ 4.5mn) by the Islamic Financial Services Unit, window of the People Leasing Company Co. LTD. - a fully owned subsidiary of People’s Bank (100% State-owned bank) was postponed primarily due to procedural delays and with regard to regulatory authorities, and consequences of the global financial meltdown. However, the company sources said that it is now rescheduling to launch the Sukuk once the investors sentiment and market condition become more favourable.

Corporate Governance PRACTICE

The Corporate Governance, including risk management staged to rigorous debate as corporate scandals and failures around the world shook the financial industry, and indeed Islamic finance industry is not immune to scrutiny. Sri Lanka has also been experiencing increased scams and failures in conventional including Islamic financial industry for last few years, which resulted CBSL to issue a voluntary code of corporate governance practice to financial institutions but, corporate governance code yet to be made mandatory for financial institutions to prevent such scandals and failures in future.

Generally, corporate governance in Islamic finance institutions is quite similar to a combination of both Combined Code and Sarbanes-Oxley, because the corporate governance of an Islamic financial institutions distinguish in many forms to that of its conventional counterparts, most importantly Islamic finance institutions need to ensure that they comply with the Shariah (Islamic law) meaning that unlike secular governance practices Shariah would first examine at the transactional structure to find whether the process involves any activities or elements that contradict the profits generation. Also Islamic financial institutions must invite customers to contribute an active role in the governance process.

For instance, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Financial Accounting standards 11 provides clear principles and guidelines for Islamic financial institutions to disclose the share of the actual profits and of the funds from the returns they receive and emphasise the their disclosure in the financial statements and annual reports. The CBSL, as frontline regulator should regulate corporate governance practice by improving the levels of disclosure, compelling transparency, reporting standards, risk management and accountability to protect investors and maintain the integrity of this emerging financial industry competitive.

In the absence of sufficient legal and regulatory framework the emerging market unable to remain and perform competitive in the financial industry. A good example, in the UK or USA Islamic finance services industry subject to higher standards of corporate governance requirements and making them attractive for investment. To improve viability of the island’s Islamic finance and get greater benefit from this fastest growing industry, Corporate Governance should be enforced at the core of the Islamic financial institutions in Sri Lanka.

REGULATORY AND LEGISLATIVE ISSUES

The country’s Islamic finance institutions and experts will continue advising the CBSL on the development of new laws and regulations to facilitate the Islamic finance industry. Particularly, Amana Investments Limited has not only established itself as the pioneer of Sri Lanka’s Islamic financial services industry, but in the forefront lobbying the CBSL for relevant changes in the Islamic finance legal framework.

The Islamic finance directive issued by the CBSL supervision department defines Islamic banking and two of its fundamental elements clearly in the legislation. Receiving money for the investment in a commercial venture agreed based on the profit and loss sharing principles including Mudaraba and Musharaka contracts. Second, a contract based on buy and sale transaction agreement based on deferred payment option such as Murabaha.

Islamic Finance Focus Group (IFFG) was recently set up by Islamic finance industry experts and interest groups, including KPMG Sri Lanka. The main objective of IFFG is to advise and lobby the Sri Lankan government, relevant regulatory bodies and parties to allow Islamic finance to compete on a level playing field with conventional financial institutions. IFFG continues to play a pivotal role in the development of new tax legislation and regulations in Sri Lanka to facilitate Islamic finance. In order to achieve this development there are few areas of anomalies in the Sri Lanka’s tax system that required to be addressed carefully for urgent reform and restructure to accommodate all forms of Islamic finance transaction in Sri Lanka.

Some Shari’ah compliant transactions are more affected by the Value Added Tax (VAT) than conventional finance, but this area of legislation is difficult to modify, as it quite similar to the EU tax system. However, it is significant to note that the Sri Lankan tax regime is not as complicated and extensive as the EU, UK or US tax system.

IFFG also working closely with CBSL and regulatory bodies to enable new legislation to be drafted to allow Islamic financial institutions to offer comprehensive range of Shari’ah compliant products without occurring the adverse direct tax consequences. Sri Lankan government should aim these measures to promote the island as a leading centre for Islamic finance in the South Asian region.

Growth Potential

The stable foundations for the future development of Islamic finance in Sri Lanka have yet to be laid firmly. Although future growth cannot be precisely forecasted due to lack of research on the island's Islamic financial market, there is a clear scope for expansion.

With mega post-war development projects in the pipeline such as infrastructure and economy development, the majority in the road sector would that have a positive impact on the construction industry, sovereign sukuk (Bond) issuance will potentially attract widespread international and local investors’ interest. Islamic finance institutions and experts realise the importance of encourage the Sri Lankan government to issue sovereign sukuk as an alternative to government bonds in the future.

On the aspect of development and challenges of Sri Lanka’s Islamic finance industry, Managing Director of the island’s market leader Amana Investments Limited, Faizal Salieh added, “Having completed twelve years of strong presence in country’s financial industry, we are continuously lobbying for regulatory and fiscal legislation to ensure innovation and growth; we are happy that CBSL has introduced promising changes in regulatory framework to support Islamic banking and Insurance Board of Sri Lanka has also licensed Takaful operators. Islamic finance has been supported by the tax authority applying substantial reform so far, but now we need progressive tax neutrality for Islamic financial products. At this stage Islamic finance industry imposing tremendous challenges for market players to ensure good corporate governance, risk management, transparency and Shariah compliance practices.”

The Sri Lankan government has allowed enough avenues in the fiscal and regulatory policy framework to facilitate Islamic finance since 2005. Furthermore, positive support and a favourable financial regulatory environment are encouraging for Islamic financial institutions to set up operations and for local and international investors to participate in taking the country’s Islamic finance industry to new growth.

Riyazi Farook can be contacted for further enquiries at riyazif@islamicfinanceandbanking.com

Islamic Banking and Finance in Sri Lanka: A Paradigm of Success

By Riyazi Farook


Sri Lanka’s modern financial sector has undergone significant reforms since the early 1990s, notably to reduce the government’s role as a direct financial provider. A wide range of institutions offer financial services, including public and private banks, development finance institutions, merchant banks, investment banks, specialized financial institutions, microfinance institutions, leasing companies and insurance companies.

There is also a burgeoning stock exchange. The government is taking steps to strengthen the institutional and regulatory framework for financial services. A remarkable recent evolution is the reform and reorganization of the Central Bank of Sri Lanka (CBSL).

The monetary unit in Sri Lanka is the rupee (LKR), which consists of 100 cents (US$1 approx LKR 110). In addition to being the island’s monetary authority and the sole bank of issue, CBSL acts as financial adviser to the government.

Currently, more than 15 foreign banks have set up branches in the island nation. What is more significant is that some of these branches have been established for more than 100 years. Sri Lanka also has more than 10 local banks, including two that are state-owned (Bank of Ceylon and People’s Bank).

Sri Lanka is one of the few non-Islamic countries to have legislation for the Islamic banking sector. Following amendments to the Banking Act No 30 of 1988 in March 2005, there is now adequate flexibility for conventional banks to establish Islamic banking windows and launch Islamic financial products. However, efforts in strategic marketing communication to promote and raise awareness of these products are still in the infancy stage.

CBSL has already authorized Islamic banking to be carried out in licensed commercial banks as a regulated and legal activity. However, CBSL is studying the Islamic banking concepts and once the requirements are legislated in the Banking Act, Sri Lanka would have increasing opportunity to establish a full-fledged bank. Meanwhile, senior Muslim ministers are also backing an initiative to allow full-fledged Islamic banks to operate in the country.

Sri Lankan Muslims have long awaited the entry of a full-fledged Islamic financial institution that can provide them the opportunity to invest or deposit their money in a Shariah compliant manner. Islamic microfinance institutions in the rural areas are also keen to capitalize on this need, but most are offering limited service in small communities with a high density of Muslims.

The country has the potential to become an Islamic banking hub for the South Asian region. Nevertheless, only if CBSL expresses its interest and development initiatives does Sri Lanka stand a chance of competing and establishing itself in the market. Therefore, government organizations, monetary authorities and the private sector must work with Islamic banking institutions to achieve this objective.

In light of this, it is high time that Sri Lanka came up with a strategic framework on the Islamic financial sector in order to address the needs of all segments of the community. There are specialized local and overseas institutions and professionals, some of whom are experts in Islamic banking; others may have good managerial skills to contribute to the promotion of Islamic banking and its concepts. Therefore, it is paramount to include such specialists in a discussion on building a conceptual framework for Islamic banking and finance in Sri Lanka.

Players in Islamic finance

The market value of the Islamic banking sector in Sri Lanka is estimated at LKR 70 billion to LKR 100 billion (US$634 million to US$907 million). Islamic financial services providers currently active there include Amana Investments Limited, Ceylinco Islamic Investment Corporation (CIIC), Muslim Commercial Bank (MCB), National Asset Management Limited (NAMAL), First Global Investments Group and ABC Investments.

Amana Investments, established in 1997, leads the country’s Islamic financial services market. Its subsidiary Amana Takaful Ltd (ATL) began operations in June 1999 and is acknowledged as the market leader for Takaful services (commonly perceived as the Islamic alternative to conventional insurance). ATL was listed on the Colombo Stock Exchange in late 2006.

CIIC made its entry in 2003 and is fully backed by Ceylinco Insurance, one of the leading conventional insurance providers in Sri Lanka. CIIC offers both selected Shariah compliant and Takaful products.

New kid on the block MCB — owned by MCB Pakistan — commenced operations early this year. It offers both Islamic and conventional financial products.

NAMAL is the first fund management company in Sri Lanka licensed to manage unit trusts. Together with Amana Capital (a subsidiary of Amana Investments), it launched the NAMAL Amana Equity Fund early this month. The objective of the equity fund is to achieve significant growth over the medium to long term by primarily investing in equity securities that are Shariah compliant.

First Global Group is a public limited finance investment company that deals with Shariah compliant investments and financing products and services. Domestically, it is the first institution to promote training and career development programs related to Islamic banking and finance.

Finally, there’s ABC Investments, a relatively new Islamic investment group that claims to have strong funding backing from different countries. It has a memorandum of understanding with the Central Bank of Sudan in which the latter’s experts will provide assistance on training and development to ABC — especially in its Takaful segment — and will be working closely with leading Islamic financial countries for the funding in Takaful as they plan to start off with general insurance.

Barriers in Takaful industry

The Takaful concept is steadily gaining acceptance in Sri Lanka, where there are now 13 licensed insurance companies. Takaful was introduced in 2002 with the entry of ATL, which recently created history in Sri Lanka and the Islamic financial services industry worldwide when it was ranked 203rd in the world’s first comprehensive “Top 500 Islamic Financial Institutions” published by The Banker, the global finance magazine of the Financial Times Group, in its November issue. ATL accounted for US$5.55 million worth of Shariah compliant assets.

A second Takaful operator, Ceylinco Takaful Limited, made its debut in mid-2006. Sri Lanka Insurance Corporation Limited — the republic’s largest and strongest composite insurance provider with LKR 50 billion worth of assets under management — has also announced its intended foray into Takaful. Two of the country’s largest insurance operators (Ceylinco Life and Sri Lanka Insurance Corporation) also plan to offer Takaful products.

The Sri Lankan market, including that for Takaful, faces several challenges, however. One is the current legal environment, which is deemed unfavorable to Takaful operations. Other hurdles are reluctance on the part of regulators to introduce the necessary changes in law to encourage the development of Takaful, a lack of investment opportunities that are Shariah compliant and acceptable to the insurance regulators, a high capital requirement, severe competition, consumer resistance to a new form of insurance based on religious principles and the fact that Muslims represent only about 9% of Sri Lanka’s population.

Overcoming these barriers is more crucial for the Takaful industry in Sri Lanka. Its operators should make a concerted effort to convince insurance regulators to accept the salient features of Takaful and treat it as a new business model. They could also form strategic alliances to promote their products.

Human resource needs

Sri Lanka should aim to produce highly skilled practitioners and professionals as well as specialists and researchers to develop human capital needs for its Islamic banking and financial services industry, both at local and international level. Shariah scholars are scarce but they are highly critical to the success of the republic’s Islamic banking industry and its growth.

International Center for Education in Islamic Finance recently established the faculty of Islamic banking and finance, the first in Sri Lanka. It is hoped that the faculty will fulfill the need to produce a pool of Islamic professionals for the fast-growing global Islamic banking and financial services industry.

Interest-free Banking in Sri Lanka
By Shuhada (Click "Sri Lanka" label on bottom of the article for more)

Background

Banks in any developing nation are essential components of the growth mechanism,facilitating the flow of funds across and within borders. Commercial banking in Sri Lanka was made into a stable institution, with commonly understood practices, by the British during their time of partial then full occupation of the island. The National Savings Bank is the oldest of its kind and inheritor of a very old tradition of savings dating back to 1832. Governor Wilmot Horton, who also introduced rupees and cents to the country in place of British currency has been credited with its inception. In 1885 the post office savings bank as established. The National Savings movement was instituted in 1942 during World War II followed by the savings certificate section of the postal department. Currently more the 30 banks, some owned and run by private individuals, operate in Sri Lanka under regulation by the Central Bank.

Non-interest financing has traditionally been restricted to the informal sector, with transactions taking place within the Islamic communities whilst formal banking practices have remained un-Islamic throughout the post-independence period. As a minority group, the majority of Sri Lankan Muslims are forced to partake in the formal banking system which operates by flexing different forms of interest based services.

The arena

The first interest free bank to be formed on the island was the Amana Investment limited, a sister company of its Malaysian kindred. Since being formed in 1997 as a small investment company it has expanded healthily, meeting a pent-up demand for Sharia compliant financial products, and is now a middle scale institution.

Its mission is to ‘propagate the concept of the viable alternative to modern day interest based banking in the form of a banking system which is Shariah compliant’. Presently it provides services equal to the conventional banks and investment companies. The investment firm has two branches in the capital Colombo and several more scattered throughout the country.

Until recently, the institution had no competition from other Islamic Finance Institutions. However, the formal financial sector is now at a critical juncture where its cannot afford to ignore the demand for Islamic Banking. This was materialized most recently when one of the islands top insurance firms, Ceylinco Insurance, set up Ceylinco Islamic Investment Corporation (CIIC). Entering the market in 2003 it is now competing for a share of the Islamic customer base.

CIIC Ltd says it will operate as a commercial financing institution functioning on the basis of Islamic principles under the ‘Shariah’ concept and will operate purely on profit sharing basis providing fund management, financial facilities and services to all people with viability and capability to sustain it self and grow in the process. CIIC currently has three branches.

Financial products

Foremost amongst operations will be the functioning of Murabaha. Under this concept the asset or goods are purchased by Ceylinco Islamic {which should own the asset/ goods even for a short time} and sell to the client at cost plus a negotiated profit. The sale may also be on a deferred payment basis. CIIC would engage in ‘buying and selling’ of assets (goods as allowed under shariah) including land & buildings. Operations are expected to expand and cover trade finance, imports and exports, an area that is already handled by Amana Investments.

With regard to Mudarabah, an investment account where one party is the investor (rabbulmal) and the other fund manager (mudarib), the former will agree to provide funds and CIIC (the fund manager), the expertise. Similar services are available from the Amana organization.

Islamic leasing known as Ijara is very similar to the western concept of an opening leasing. When the asset is purchased it will be under the ownership of CIIC but in the possession of the lessee. The rent will be fixed after surveying the market. At the end of the lease period the asset will be offered for sale at market value to the lessee. Under this concept both CIIC and Amana extend leasing facilities towards vehicle, house hold items, office equipment, manufacturing, trading & service industries, and consumer items.

Marketing Strategies

Amana Investment Ltd., does not have a marketing strategy, but the marketing division's functions are focused on maintaining a high standard of customer services. Its doors are open at any time, even after normal operation hours a customer can walk into the company and is able to obtain information. Marketing takes place in and ad hoc manner and there is no rigid strategy plan in place. Each branch does its own marketing and the business development manager is responsible for implementing the decisions.

Likewise, CIIC also operates sans a marketing strategy. As it is in its infant stage it does not have a marketing division. Assistant managers take the responsibility for the marketing function. According to the manager of Amana Investment Ltd., this flavor comes from the top-level directors and flows to the bottom level employees. Customer satisfaction is highly valued. Furthermore, manager of Amana Investment stressed emphasis on the internal customer concept. They have been conducting training programme to enhance the relationship between employees (internal customer) and break traditional boundaries in order to provide value added services to end (external) customers. Amana obtains services from professionals in order to develop a marketing culture within their organization. They obtain training from professional bodies such as the British Council in Sri Lanka.


Channels of distribution in services perform to extend beyond the sale and services function to cover liaisons with advertising and public relation agencies (eg. Trustee Board of Mosque). Gathering of this information is necessary for planning and marketing activities. Product development at Amana is the manager’s responsibility. Similarly, CIIC branch official’s liaise with trustees of Mosques to acquire fund and investment opportunities. Nevertheless, the most important distribution channel for both institutions is a branch.

Both firms have located their branches where the Muslims population density is high. Interest free banking in Sri Lanka faces a considerable trouble in locating their branches due to the fact that the Muslims community within the country live in a highly scattered way. Even the non-Muslim customers can be target and the data shows a growing interest in ethical investments amongst the wider population.

Outlook

When considering the future of the two firms in Sri Lanka we can expect fierce competition for acquiring funds for interest free investments both between each other and from new entrants. Already the signs are positive. June 1999 witnessed the commencement of operations of Amana Takaful, an alternative insurance system that is Sharia complaint. Operating with strategic alliances with some large players like Takaful Malaysia and Asean Retakaful International Labuan Limited, the organization has also enjoyed strong growth, be it form a small base. Whilst not in direct competition with CIIC or Amana, it has an authorized share capital of over Rs 1 billion ($10.5 million) and a paid-up capital of Rs 75 million. Takaful financial products include commercial and private fire protection, home insurance, accident cover, motor insurance, marine cargo insurance, family protection plans.

Intelligence reports reveal that ‘ the Sri Lanka market is gathering momentum towards the 'Islamic Concept' of financing and under the new Banking Act which is in the final stages in the parliament, all commercial banks and the designated banks operating in Sri Lanka would be permitted to have a 'window' for operation under the Islamic concept.

The legislation will legalize the operations of Islamic Banking in Sri Lanka and would enable institutions to meet fully the demand for Sharia compliant financial products. Expected to be passed shortly, it will provide opportunities to new entrants, and strengthen the hand of exiting players.

Sri Lanka and the Scope for Islamic banking

By Faizal Salieh (Click "Sri Lanka" label on bottom of the article for more)

Introduction

Sri Lanka is one of the few non-Islamic countries to have legislated for Islamic banking. The revised Banking Act No 30 of 1988, as amended in 2005,allows both commercial banks and specialized banks to operate on a Shariah compliant basis, including: “the acceptance of a sum of money in any manner or form from any person for a fixed period of time for investment in a business venture of the bank on the basis that profits or losses ofthe venture will be shared with the person fromwhom such money is accepted in a manner deter-mined at the time the money is accepted.” Thislandmark legislation came in after years of inten-sive discussions and lobbying by Amana Invest-ments, the pioneer Islamic services provider in the country, with the Central Bank of Sri Lanka.

Political environment

Sri Lanka is a democratic socialist republic which gained inde-pendence in 1948 from colonial powers. The President is thehead of state, wielding executive powers based on the Frenchmodel, and is elected for a term of six years. The national legis-lature is the parliament, with 225 members elected for five years. Local government is devolved to nine provincial councils elected once every four years. The newly elected President, Mahinda Rajapakse, is keen toresolve the country’s ethnic Tamil problem which has pre-vented the economy from reaching its full potential. The CeaseFire Agreement with the Liberation Tigers of Tamil Elam (LTTE) is still operational. The present regime’s “pro-business and pro-poor” approach, which was strongly emphasized in its budgetfor 2006, is comparable to that of India. In his inaugural policystatement Mr Rajapakse indicated the need for an active pri-vate–public partnership process to rebuild a new Sri Lanka.

Demography

The majority of the country’s 19.5 million population is Bud-dhist (77%), while Muslims constitute about 8.5%. Populationgrowth in 2004 was around 1.1%. The workforce is estimated to be about 8 million with labour participation (working population) of around 48% and unem-ployment at 8.5% as at the end of 2004. The service sector accounts for 45% of total employment.

Economy

Although relatively small, the economy has been quite resilient to the shocks and impacts of the longstanding ethnic conflict and the tsunami of 2004. The implementation of the ceasefire agreement with the Tamil rebels in 2001 and the pursuit of a negotiated peace settlement have helped the economy to record positive growth rates.The economy grew by 5.1% during the first half of 2005 despite the setbacks caused by the tsunami disaster. It is expected to record a growth of 5.3% for 2005. The country’s per capita GDP at market prices for the first time crossed the US$1,000 mark in 2004, recording US$1,031.

Sri Lanka is one of the few non-Islamic countries to have legislated for Islamic banking

The services sector is the largest sector in the economy, representing 54% of GDP. Agriculture contributes about 20% and manufacturing 26%. Expatriate worker remittances are a major source of funding the trade deficit. The capital account is closed but the current account is partly liberalized. The local currency is determined by market forces. Since May 2004 a rising trend in inflation has been observed with substantial demand pressure still prevailing. The year-end inflation is projected to be 10%–11% based on improved supply side factors and monetary policy measures, though thepublished figures indicate 13%–14% in September 2005. Interest rates showed an increasing trend in 2005 with the Average Weighted Deposit Rate (AWDR) moving from 5.3% in January to 6.2% in December. Weighted Average Prime Lending rates moved from 9.8% to 12.2% during the correspondingperiod. The yield on 12-month Treasury Bills increased from7.65% to 10.4% during the first eight months of 2005. Based on the expected budget deficit in 2006, higher oil prices and the pressure on the local currency, the upward trend in interestrates is likely to continue. International trade improved significantly with a 12.7% growth in exports, and an 11.3% growth in imports, while services and remittance increased substantially during the first eight months of 2005. Aided by the high growth in remittances and other inflows, the overall balance of payments has turned to a surplus of around US$190 million by the end of the first eight months of 2005. Gross official reserves increased to US$2.2 billion or 3.2 months’ of imports in that period. The budget deficit was 5% of GDP (5.4% in 2004). Prospects for 2006 are promising according to the Central Bank of Sri Lanka, with a projected 6% economic growth. Key structural reforms in the power and telecommunication sectors and the labour markets are being facilitated by the government. The banking, insurance and equity markets embody the major part of Sri Lanka’s financial sector.

Financial sector

The commercial banking sector constitutes about 65% of the total assets in the financial system. There are 22 commercial banks operating in Sri Lanka, comprising two large state-owned banks, nine private banks and 11 foreign banks. Their total assets as at the end of July 2005 was about US$11.76 billion. The two state banks account for about 48% of the total assets whilst the foreign banks account for 14%. The average growthrate of deposits in the banking system has been around 15% over the last five years. The two state-owned banks – Bank of Ceylon and Peoples Bank – along with Commercial Bank of Ceylon and Hatton National Bank, account for a large chunk of the current market both in terms of deposits and advances. The performance of the banking sector improved during the first half of 2005, as reflected by the growth in capital funds and increased profits of banks. Customer deposits are the main source of funds for banks and constitute about 75% of their liabilities.

The country’s financial system is largely a bank-based one, and not really market based. The capital markets are underdeveloped and have not posed real competition to the banking sector. The low level of financial disintermediation has resulted in high interest spreads for the banks. Public confidence in the banking system is high as there has been only one bank failure since the country’s independence in 1945 – that of Pramuka Bank, a small savings bank, which collapsed in 2002. The new Government has since announced its commitment to resurrect this bank. Consolidation is gathering momentum in the banking system as the regulators have begun directing banks towards higher capitalization, better risk management practices, higher operational efficiencies and strict internal controls. The banking system is preparing itself to comply with Basel II. There are 13 licensed insurance companies in Sri Lanka including one Takaful operator (Amãna Takaful). The total premium collected in 2004 amounted to US$239.11 million, while the total assets of the insurance companies amounted to US$705.57 million. The insurance penetration level measured in terms of total gross premium as a percentage of GDP is around 1.5% and the insurance density or per capita premium amounts to US$14.80. This offers a promising growth opportunity for strong insurance companies and banks who can offer bancassurance products. The Takaful concept in insurance is seeing increasing market acceptance, and two of the largest insurance operators have announced their intention to offer Takaful products to the market in 2006. The equity market has remained relatively small despite a long period of existence. Market capitalization is about US$6 billion, or 15% of GDP. The largest securities market is government securities. The Colombo Stock Exchange (CSE) has gained over 27% in2005 in terms of All Share Price Index. The daily average turnover on the CSE was around US$4.63 million in 2005, with shares of more than 200 companies being traded. The Securities and Exchange Commission of Sri Lanka is the capital market regulator in the country and monitors the CSE.

Scope for Islamic banking

Islamic banking has been a long-cherished need among SriLanka’s Muslims since the creation of market awareness in 1997, when Amana entered the market as the pioneering Islamic financial institution offering Shariah compliant deposit and financing products. There have been other attempts at village and provincial levels to create Islamic fund-type operations, but their success has been limited due to, among other reasons, their being unregistered entities with little professionalism and the absence of aprofit motive. Of late, the Ceylinco Group has formed a company that offers PLS-based products to the market. Amana has led the market both in terms of creating awareness and providing Shariah compliant financial solutions. Whilst the group was able to obtain early regulatory approval to operate its Takaful insurance business, the regulatory approval for a banking licence has taken well over seven years, as it involved fundamental changes to the Banking Act. Amana is now at the head of the queue for a licence to operate as a fully fledged Islamic commercial bank following the new legislation; some of the existing conventional banks are expected to open Islamic banking windows with a view to preventing their Muslim customers from migrating to Islamic banks. It is also possible that the market might see a few new entrants to Islamic banking, although the Central Bank has upped the minimum capital requirements for licensing substantially. The size of the Islamic market is estimated at around US$500 million – US$600 million. The regulators are becoming alive to the growing Islamic market segment, both local and global, and the global developments and trends in Islamic banking. Some of the key challenges they face in this regard include developing appropriate mechanisms to regulate Islamic banks, facilitating inter-bank transactions and developing relevant inter-bank and treasury instruments for the investment of surplus funds by Islamic banks. Further relevant changes to the fiscal and legislative environments will soon be necessary to facilitate Islamic banking transactions. Yet another challenge facing the industry is the competency gap in human resources, both at the regulatory and market levels. Islamic bankers and Shariah scholars are scarce resources and are critical success factors to the industry’s future growth and development. All in all, Sri Lanka is an emerging market and the scope for Islamic banking looks both positive and exciting.