The Central Bank says smaller registered finance companies (RFCs) and specialised leasing companies (SLCs) may have to merge and consolidate in order to satisfy new regulations requiring higher levels of capitalisation.

"A number of reforms will be implemented in 2010 which would require higher levels of capitalisation. In this context, consolidation and mergers of companies may be necessary to ensure the viability of small companies in the future," the Central Bank said in its Financial System Stability Review 2009 (FSSR), released last December.

"The resurgence in economic activity in the second half of 2009 onwards will provide opportunities for RFCs and SLCs to expend their business operations. It is necessary that these companies diversify their business into new activities, such as machinery and equipment leasing and expand business in the outstation," it said.

The bank said the current financing models of RFCs and SLCs exposes them to considerable interest rate risk due to the maturity mismatch between their assets (long term loans and leases) and their liabilities (deposits) which a short term.

"RFCs and SLCs should mobilise more medium and long term funds by scrutinising their lease receivables to a greater extent," the bank said.

RFCs and SLCs both suffered severe liquidity problems after depositors panicked and caused a run on deposits held with these financial institutions after unauthorised, unregulated deposit taking institutes failed due to fraud and/or bad management towards the end of 2008.

The Central Bank stepped in and appointed management agents to the RFCs and SLCs in a bid to stabilise these institutions.

While the government appointed an expert panel to look into the problems faced by RFCs and SLCs the Central Bank and the Treasury introduced a stimulus package last April to help these institutions regain healthy liquidity positions and repay depositors, as restoring public confidence in the financial system was of utmost importance.

Properties held by these institutions were purchased at discounted prices through Treasury bonds while the government also provided guarantees for credit facilities provided by banks to RFCs and SLCs. This special package had an estimated value of Rs. 4.25 billion.

The Central Bank also reduced the statutory liquid asset ration applicable to RFCs to provide temporary relief and increased the maximum interest rate payable by RFCs for the mobilisation of deposits, the FSSR highlighted.

"The RFC sector is now rebounding after the stresses experienced in first half of 2009," the Central Bank said.

"The high interest rate environment prevalent in 2008 and in the first half of 2009 and the slowdown in economic activities also affected earnings through a narrowing of interest margins and an increase in non-performing loans."

The Central Bank said because of the heightened level of interest rate, credit and liquidity risks, profitability of RFCs declined in 2009 with some of them reporting losses.

"The business of SLCs has stagnated due to the same factors affecting the RFC sector. In addition to interest rate and credit risk, SLCs also aced funding risks as they were dependent on borrowed funds from banks or through the issue of debt securities for financing their business activities.

"Although the majority of SLCs were profitable, a few made losses," the Central Bank said.