Fitch Ratings views the Central Bank of Sri Lanka’s (CBSL) recent reintroduction of a consolidation framework for the banking sector as generally beneficial for the sector’s credit profiles. This consolidation is expected to enhance the strength of banking franchises, create better-capitalized institutions, and facilitate compliance with more stringent single-borrower limits. The increased capital available post-merger should enable banks to handle larger exposures within revised regulatory caps.
Fitch anticipates that if the initiative is implemented credibly, it will boost market confidence. However, the outcomes will depend on the quality of the merger partners, the extent of recapitalization needed, and the regulatory incentives offered to acquiring banks.
Initially, in early 2014, CBSL set forth a Master Plan for the Consolidation of the Financial Sector, encompassing both banks and finance and leasing companies. The renewed attention on banks follows previous attempts to encourage consolidation through heightened minimum capital requirements. Most banks complied with these requirements through retained earnings or capital injections, aided by extended regulatory timelines, thus limiting merger-driven restructuring.
Sri Lanka’s banking sector consists of 19 domestic banks, including 13 licensed commercial banks and the remaining licensed specialized banks. The current consolidation initiative targets licensed banks with assets below LKR400 billion. Seven banks rated by Fitch fall within this framework, but they represent less than 5% of sector assets, indicating that the immediate system-wide impact may be modest.
Two of these banks, Housing Development Finance Corporation Bank of Sri Lanka (HDFC, BB+(lka)/Rating Watch Positive) and State Mortgage & Investment Bank (SMIB, BB(lka)/Rating Watch Positive), are already anticipated to be acquired by Bank of Ceylon (BOC, CCC+/AA-(lka)/Stable) and People’s Bank (Sri Lanka) (PB, AA-(lka)/Stable), respectively. These proposed transactions suggest some momentum within the broader policy framework.
The CBSL framework includes a scoring system that combines evaluations by both the banks and the central bank. Banks scoring below 60% during the assessment period from January 1, 2026, to December 31, 2027, may be subject to mandatory consolidation. A similar approach was previously used in the finance and leasing sector, where consolidation reduced the number of finance companies, demonstrating that structured regulatory pressure can drive sector rationalization.
Mergers are likely to be credit-positive when smaller banks merge with larger, more established institutions. Smaller banks often have more concentrated or niche business models and higher risk profiles than their larger counterparts, which can limit the benefits of “peer-to-peer” combinations in terms of stability and franchise strength. Additionally, consolidation could enhance cost efficiency through branch rationalization, potentially supporting profitability and lowering costs for borrowers.
Despite these advantages, execution risks persist. Even with small targets, recapitalization needs and restructuring costs can be significant relative to an acquirer’s buffers, especially if asset quality issues or integration complexities are underestimated. The success of the framework may depend on CBSL’s ability to provide clear incentives for acquiring banks to counterbalance near-term capital and earnings pressure while maintaining prudent underwriting and governance standards.
