Sri Lanka’s banking sector is sound amidst a global rout and early regulatory action taken to prick the bubble, Central Bank Governor Nivard Cabraal has said.

"When all the other countries were expanding credit at very high rate, banking was given massive amounts of loans to fuel the housing as well as the land prices, we did something in reverse," Cabraal said in a video release.

"As a result of that we were able to smoothen and prick this bubble before it could form and have disastrous consequences in the economy."

Cabraal said the Central Bank had brought in an additional one percent provision for all loans and has increased the risk weight of housing loans from 50 percent to 55 percent and tightened capital adequacy of banks well ahead of time.

Economic analysts have said that Sri Lanka’s economy is mostly damaged by government action, usually central bank accommodation of fiscal deficits.

Printing money to plug deficits causes interest rates to fall (financial repression), which in turn leads to high inflation and balance of payments problems.

But in the first half of 2008, Cabraal has been credited with maintaining a tight monetary policy, refusing to finance government and bringing inflation down from a high of 28.2 percent in June to 24.3 percent in September.

The high inflation in early 2008 was partly caused by lax monetary policies in the second half of 2007 and also external inflation imported through the US dollar peg, in the form of high commodity prices.

"Our inflation is still high and we admit that, but at the same time it is on a declining trend," Cabraal says.

"And that is what we need to be a little happy about, because we have been able to foresee some of the problems that others are grappling with and we have been able to take the measures so that our conditions become different."

The Central Bank also collected several hundred millions of dollars by sterilizing external liquidity and boosted its reserves. A central bank usually invests reserves in foreign government bonds.

Cabraal says the bank cut some positions with some private banks before the international turmoil worsened.

"There were some positions held with AAA rated banks, but we were able to read the signs and exit well in advance. So we were not affected by the crisis that has affected the rest of the world," Cabraal said.

On Monday the Central Bank cut the statutory reserve ratio of banks (the portion of customer deposits that should be kept with the central bank) to 9.25 percent, from 10.0 percent.

India has cut reserve ratios three times in quick succession, and the country’s reserve ratio now stands at 6.25 percent

But officials say the Sri Lankan move is not a monetary policy relaxation and Sri Lanka does not use statutory reserves as a monetary policy tool unlike India.

The Central Bank said its targets for the monetary base would be tightened further for the last quarter to counter the effect of the reserve ratio cut.

The reserve cut was expected to improve liquidity of the banking system.

Reserve ratios increase the costs of the commercial banking system and push nominal interest rates up and also give an advantage to other financial institutions which do not have reserve requirements.

Meanwhile bankers say the cut in reserve ratios would also help strengthen bank balance sheets.

Sri Lanka’s Central Bank has been intervening in the forex markets to defend a currency peg, which results in severe liquidity shortages in the banking system.

Such ‘sterilized intervention’ can weaken banks by taking away liquid assets like Treasury securities from the balance sheets of banks and transferring them to the monetary authority.

Analysts say Sri Lankan banks are also short of US dollars, which is a world-wide problem. This has made some banks sell other types of foreign currencies in their portfolios and do swaps to cover short dollar positions, reducing liquid assets further.

A reserve ratio cut can reduce some of the pressure on banks allowing banks to buy more liquid instruments and also use more of the deposits they collect, bringing down reserve cost.

But there is rising concern that continued currency defence by the Central Bank, could undermine the monetary framework. (Lankapage)