Fitch Ratings has expressed a positive outlook on the Central Bank of Sri Lanka’s (CBSL) reintroduction of a consolidation framework for the banking sector, viewing it as beneficial for the sector’s credit profiles. This consolidation is expected to enhance banking franchises, create better-capitalized banks, and aid in compliance with tightening single-borrower limits. Specifically, higher post-merger capital will enable banks to take on larger exposures within revised regulatory caps.
If implemented effectively, this initiative is anticipated to boost market confidence. However, the success of mergers will largely depend on the quality of merger partners, the extent of needed recapitalization, and the availability of regulatory incentives for acquiring banks.
The CBSL initially outlined a Master Plan for the Consolidation of the Financial Sector in 2014, targeting both banks and finance and leasing companies. Renewed emphasis on banks follows earlier efforts to encourage consolidation through increased minimum capital requirements. Most banks met these requirements through retained earnings and capital injections, facilitated by extended regulatory timelines, which minimized merger-driven restructuring.
Sri Lanka’s banking sector consists of 19 domestic banks, including 13 licensed commercial banks and the remainder as licensed specialized banks. The current consolidation plan aims at licensed banks with assets below LKR400 billion. Seven banks rated by Fitch are within this framework, representing less than 5% of sector assets, indicating a potentially modest immediate impact on the system as a whole.
Among these banks, the 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 expected 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 acquisitions suggest some momentum for transactions under this broader policy direction.
The CBSL’s framework involves a scoring system, combining 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, could be subjected to mandatory consolidation. CBSL has previously applied a similar strategy in the finance and leasing sector, where consolidation successfully reduced the number of finance companies, illustrating that structured regulatory pressure can drive sector rationalization.
Mergers are expected to be most credit-positive when smaller banks merge with larger, more established ones. Smaller institutions often have more concentrated or niche business models and higher risk profiles compared to larger peers, potentially limiting the benefits of “peer-to-peer” combinations for stability and franchise strength. Consolidation might also enhance cost efficiency through branch rationalization, ultimately supporting banks’ profitability and decreasing costs for borrowers.
Despite the potential benefits, execution risks remain. Even small targets can bring significant recapitalization needs and restructuring costs relative to an acquirer’s financial buffers, particularly if asset quality issues or integration complexities are underestimated. The framework’s success may hinge on whether CBSL provides clear incentives for acquiring banks to offset short-term capital and earnings pressures, while ensuring prudent underwriting and governance standards are maintained.
