The majority of foreign banks have considerably lower cost structures, having better cost-to-income ratios and a lower cost to average assets (with the exception of HSBCSL, due its large credit card portfolio). The superior cost-to-income ratios of the banks have been driven not only by better cost structures but also by higher levels of income.

The composition of operating costs varies considerably among the three sectors, with personnel costs comprising over 65% of operating expenses for the state banks and 35% for the foreign banks. Premises and establishment expenses at 0.5% of average assets (domestic private banks: 1.1%) are also considerably lower for the foreign banks due to the comparatively lower number of branches required to generate the same volume of business (see the "Assets/ branch" line in Table 4). State banks, despite their high number of branches, spend less on added frills, and as such also have a lower ratio of 0.7%. Other overheads such as expenses remitted to head office for systems, internal audits and IT comprise the bulk of foreign bank expenses (1.7% of average assets for FY08 compared to just 1.0% for the domestic private banks). These are indicative of the clear difference in the target markets of the three sectors, with the foreign banks concentrating on a niche market comprising mainly multinationals, large corporates and high net worth individuals based in a smatter geographical area - namely the Colombo district.

Personnel costs to average assets for the foreign banks were 1.3% for FY08, compared with 1.7% and 2.3% for the domestic ‘private LCBs and state banks respectively. The lower cost is largely driven by the Lower headcount following from the higher degree of service automation at these banks (automation costs are reflected in the other overheads components which was higher for the foreign banks. The foreign banks have often pioneered the introduction of new banking technologies (such as HSBCSL’s introduction of ATMs in 1986 and Easy Pay Machines for automated cheque deposits and bill payments in 2006).

As shown in Table 4, the foreign banks generate a higher level of business per branch and per staff member. This is indicative of their main target market, which comprises a small number of large ticket customers (compared to the domestic banks which have a larger customer base but who are relatively lower in value). The number of staff per branch is much higher for the foreign banks because they (particularly HSBCSL) have a large number of staff employed for their credit card operations which do not require a separate branch presence. Staff costs are high for the state banks due to considerable pension costs they bear on account of defined benefit pension schemes.

As with the rest of Sri Lankan banking sector, the funding base of the foreign banks is dominated by deposits. However, deposit concentrations at the foreign banks are significantly higher than at the domestic private banks. This is mainly due to the large number of multinational and corporate deposits held by the foreign banks. The top 20 deposits for the majority of domestic banks account for less than 10% of their total deposit base compared with the large foreign banks which have deposit concentrations (top 20 deposits) varying from about 18% to over 50%. These banks have a considerably larger equity cushion than their domestic counterparts, and they are also able to source some level of funding through their head offices if the need arises. As such, they have not had to raise sub-debt in the recent past.

The minimum capital requirement (MCR) for LCBs was increased to LKR2.5bn in 2005. Foreign banks, although they operate as branches, are also expected to comply with this requirement by the regulatory deadline which has been extended to end-2009. At end-2008, there were four foreign banks which had not met the MCR. However, Fitch notes that the intention of the MCR was to encourage consolidation within the banking sector and therefore the agency views equity to assets and capital adequacy ratios (CAR) as better measures of capitalisation.

Although the foreign banks’ equity to asset ratio has been decreasing over the last 2.5 years, it was still high at 11.4% at FYE08 compared with less than 10% for the domestic private banks and less than 5% for the state banks. All the foreign banks were well capitalised in terms of capital adequacy, with CARs in excess of regulatory requirements (core CAR: 5% and total CAR: 10%) and above those of banks in the domestic bank sector. At FYE08, the total CAR was 16.8% (FYE07:20.3%) for the foreign banks compared with 13% for the entire LC13 sector. The CAR for the observed sample at FYE08 was 12.6% (FYE07:15%) was lower (than the total foreign bank sector) on account of non-payment of dues by a state-owned entity on oil hedging contracts entered into with two of the banks. However, this was still above regulatory requirements and is despite the fact that these banks had relatively higher volumes of risk weighted assets. As such, the CAR is driven mainly by the very high degree of capitalisation (as evidenced by the high equity assets ratio - see the Interest Margins chart) of these banks. The larger foreign banks were also better equipped for the implementation of Basel 11 in January 2008 on account of systems support from within the group. Some of these banks were reporting Basel 11 ratios to their group offices prior to the January 2008 deadline.

Capital creation has historically been high among the larger foreign banks due to their requirement to build their capital bases in tight of single and aggregate borrower limits. However, in 2007 and 2008, the two largest foreign banks have repatriated a major portion of their profits to their respective head offices.

Recent derivative transactions by some foreign as well as local banks with a stateowned entity have exposed the larger banks to the risk of capital toss. However, the full impact of these transactions on the capital of the branches is yet to be seen as they are pending the conclusion of an arbitration process to settle a dispute with regard to the payment of dues on these transactions.

Liquidity in the financial system has been gradually tightening over the last year on account of rising NPLs, a slump in real estate prices and high inflation resulting in an increasing demand for liquid assets. Following a large outflow of foreign currency in September 2008, due to withdrawals of foreign investments in government securities as well as settlement of large oil bills, the banking system faced an extended liquidity shortage. In an attempt to ease liquidity pressures in the banking sector, the CBSL reduced the statutory reserve ratio to 9.25% in October 2008 and further to 7.75% in November 2008 and 7% in February 2009. However, following the collapse of certain unregulated financial institutions, and the effects of this on segments of the regulated financial sector including one LCB, many banks tightened their self-imposed inter-bank lending limits resulting in sudden spikes in inter-bank rates.

The foreign bank sector carries a high percentage of liquid assets compared with the LCB sector - liquid assets to total assets was 34% at FYE08 (LCB sector: 25.4%). The statutory liquid assets ratio for the foreign bank sector at 46.1% for the domestic banking unit) and 52.1% for the foreign -currency banking unit (as per the CBSL) has been significantly higher than at the domestic banks. Key sources of liquidity are deposits with other LCBs, and large portions of government securities. These securities also include investments in Sri Lanka Development Bonds (SLDBs) - tax- free US dollar-denominated Government of Sri Lanka bonds - which generate considerably higher yields. Although these can be treated as liquid assets from a regulatory standpoint, pressures in the foreign -currency markets could have an impact on local US dollar liquidity which would affect the banks’ ability to dispose of these bonds in the secondary market. Due to their ability to access US dollar liquidity via their head offices, the larger foreign banks are less vulnerable to such risks. In general, Fitch is of the view that these banks are better geared to face a liquidity shortfall in the market due to the higher levels of liquid assets carried on their balance sheets and their ability to access short-term liquidity via their head offices if required.

Owing to the more difficult operating environment, with tower business volumes, higher NPLS and decreasing property values, the profitability of the overall banking sector was tower in FY08. Yet the foreign banks were able to maintain and even improve profitability during the year, showing some resilience to the prevailing climate. This is largely a factor of their target market which to a large extent has been able to withstand both internal and external pressures. The larger foreign banks in particular have a competitive advantage among the multinationals, large corporates and high net-worth individuals due to their international presence, and the greater perception of stability within this segment.