Banking and Financial Institutions

🟢 Lite — Quick Review (1h–1d)

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Banking and Financial Institutions — Key Facts for Sri Lanka A/L Examination

Key Concepts:

• Central Bank: Controls money supply, issues currency, sets policy rates
• Commercial Banks: Accept deposits, lend money, provide financial services
• Non-Bank Financial Institutions: Finance companies, insurance, pension funds
• Monetary Policy: Central Bank tools to control inflation and economic activity

Sri Lanka’s Central Bank:

• Central Bank of Sri Lanka (CBSL): Established 1949
• Located in Colombo
• Implements monetary policy via CBSL Act No. 16 of 2022 (replaced Monetary Law Act)

⚡ A/L Exam Tip: Banks operate on fractional reserve banking — they keep only a FRACTION of deposits as reserves, lending out the rest!

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🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

Banking and Financial Institutions — Detailed Study Guide

Commercial Banks

Functions of Commercial Banks:

Primary Functions	Description
Accepting deposits	Current, savings, fixed deposits
Lending money	Personal, business, housing, vehicle loans
Payment services	Cheques, transfers, cards
Foreign exchange	Currency exchange, remittances

Secondary Functions	Description
Safe custody	Lockers, documents storage
Agency services	Bill collection, standing orders
Investment services	Demat accounts, portfolio management
Advisory	Financial planning

Types of Bank Deposits:

Deposit Type	Features	Interest
Current account	Withdraw on demand, no interest, overdraft facility	None
Savings account	Earns interest, passbook, moderate withdrawals	Low interest
Fixed deposit	Fixed term (1 month-5 years), higher interest	Higher interest
Recurring deposit	Regular monthly deposits	Graduated interest

Sri Lankan Commercial Banks:

• State banks: People’s Bank, Bank of Ceylon
• Private banks: Commercial Bank, Sampath Bank, HNB, DFCC
• Foreign banks: Standard Chartered, Citi, HSBC (limited operations)

Credit Creation Process:

How Banks Create Money:

Initial deposit of Rs. 1,000
Required reserve ratio: 20%

Bank A: Keeps Rs. 200 as reserve, lends Rs. 800
This Rs. 800 deposited → Bank B keeps Rs. 160, lends Rs. 640
This Rs. 640 deposited → Bank C keeps Rs. 128, lends Rs. 512
...and so on

Total money created: 1,000 + 800 + 640 + 512 + ...
                = 1,000 × (1/0.20)
                = Rs. 5,000 (Money Multiplier = 1/Required Reserve Ratio)

Money Multiplier:

Money Multiplier = 1 / Required Reserve Ratio (RRR)
               = 1 / 0.20
               = 5

Central Bank Functions

Central Bank of Sri Lanka:

Function	Description	Mechanism
Currency issue	Sole authority to issue currency	Notes, coins
Banker to government	Manages government accounts	Treasury operations
Banker’s bank	Holds reserves of commercial banks	Settlement of inter-bank transactions
Lender of last resort	Provides emergency liquidity	Standing facility
Monetary policy	Controls money supply and credit	Policy rates

Monetary Policy Tools:

Quantitative Tools:

Tool	Mechanism	Effect
Policy interest rate	Central Bank rate influences all rates	Raises/lowers cost of borrowing
Open market operations	Buy/sell government securities	Increases/reduces bank reserves
Statutory reserve ratio (SRR)	% of deposits banks must hold	Affects lending capacity
Repurchase agreements	Short-term liquidity operations	Fine-tuning

Qualitative Tools:

• Moral suasion: Requesting banks to act in certain ways
• Selective credit controls: Directives on specific lending

Sri Lanka’s Monetary Policy Framework:

• Inflation targeting (since 2021)
• Standing Deposit Facility (SDF) and Standing Lending Facility (SLF)
• Corridored policy rate system
• CBSL aims for inflation around 5%

Non-Bank Financial Institutions

Types of Non-Bank Financial Institutions (NFIs):

Institution	Function
Finance companies	Term loans, hire purchase, leasing
Insurance companies	Risk coverage, savings products
Pension funds	EPF, ETF, private pensions
Unit trusts/Mutual funds	Collective investment schemes
Leasing companies	Asset leasing
Microfinance institutions	Small loans to informal sector

Sri Lankan NFI Examples:

• Finance companies: Central Finance, Merchant Credit, Asia Capital
• Insurance: Ceylinco Life, Sri Lanka Insurance, AIA Lanka
• Pension: Employees’ Provident Fund (EPF), Employees’ Trust Fund (ETF)
• Microfinance: SARDS, Samata, BRAC Lanka

Finance Companies vs. Banks:

Feature	Commercial Bank	Finance Company
Deposits	Accepts deposits (guaranteed)	Cannot accept demand deposits
Lending	All types	Mostly term loans, HP, leasing
Regulation	Central Bank	Central Bank (registered)
Scale	Larger	Smaller
Services	Full service	Limited service

Employees’ Provident Fund (EPF):

• Mandatory savings for formal sector employees
• 12% employer + 8% employee contribution
• Managed by Central Bank
• Pays interest (set annually)
• Lump sum on retirement

Employees’ Trust Fund (ETF):

• 3% employer contribution
• Smaller than EPF
• Portable between employers

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🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Banking and Financial Institutions — Complete Notes for A/L Sri Lanka

Electronic Banking and Digital Finance

Electronic Payment Systems:

System	Description	Sri Lankan Use
ATMs	Automated teller machines	Widely available
Point of Sale (POS)	Card payment at merchants	Growing acceptance
Internet banking	Online account management	Urban adoption
Mobile banking	Smartphone banking apps	Rapidly growing
EFT/NEFT	Electronic fund transfers	Interbank transfers
SLIPS	Sri Lanka Interbank Payment System	Bulk payments
LankaPay	National payment network	Card processing

Mobile Money and E-Wallets:

• eZ Cash (Sri Lanka’s first mobile money)
• m-Cash, Dialog Finance
• Key features:
  • Cash-in/cash-out at agents
  • Person-to-person transfers
  • Bill payments
  • Airtime purchase
• Regulated by Central Bank

Digital Banking Trends:

• App-only banks emerging globally
• Traditional banks investing in digital platforms
• Blockchain in banking (Letters of Credit)
• Biometric authentication

Sri Lanka’s Digital Finance Push:

• Financial inclusion drive
• LankaPay QR code standardization
• Mobile money inter-operability
• Government digital payment platforms (BOC Pay, etc.)

Financial Markets

Types of Financial Markets:

Market	Function	Sri Lankan Example
Money market	Short-term funds (<1 year)	Interbank call deposits
Capital market	Long-term funds (shares, bonds)	CSE
Foreign exchange market	Currency trading	Banks’ FX desks
Credit market	Borrowing and lending	Banking system

Colombo Stock Exchange (CSE):

• Established 1985
• Securities trading: Equities, debentures, unit trusts
• Listed companies: 300+ (as of recent years)
• Indices: ASPI, S&P SL20
• Electronic trading

How Stock Markets Work:

• Companies list to raise capital
• Investors buy shares (ownership)
• Price determined by supply and demand
• Market capitalization = share price × total shares

Primary vs. Secondary Markets:

Market	Function	Transaction
Primary	New share issuance	Company sells new shares, receives capital
Secondary	Trading existing shares	Investors trade among themselves

Bond Market:

• Government bonds: Treasury bills, bonds (Govi Anthiya Malawa)
• Corporate bonds: Listed companies, institutions
• Interest rates and bond prices inversely related

Money Market Instruments:

• Treasury bills (91-day, 182-day, 364-day)
• Commercial paper
• Repurchase agreements (repos)
• Interbank call deposits

Risk Management in Banking

Types of Banking Risks:

Risk Type	Description	Mitigation
Credit risk	Borrower default	Credit assessment, collateral
Liquidity risk	Unable to meet obligations	Liquidity buffers, central bank support
Market risk	Price fluctuations	Hedging, VaR models
Operational risk	Systems, processes, fraud	Internal controls
Interest rate risk	Rate changes affecting profitability	Gap analysis, matching
Foreign exchange risk	Currency fluctuations	Forward contracts, hedging

Non-Performing Loans (NPLs):

• Loans where repayment is 90+ days overdue
• NPL ratio = NPLs / Total loans
• High NPLs = credit risk materialising
• Sri Lanka: NPL ratios rose during 2022 economic crisis

Capital Adequacy:

• Banks must hold sufficient capital
• Protects against losses
• BASEL III framework (international standard)
• Minimum Capital Adequacy Ratio (CAR): 8% (typically higher in Sri Lanka)

Sri Lanka’s Banking Crisis Management:

• 2022 economic crisis stressed banking system
• CBSL provided liquidity support
• Some banks faced capital adequacy challenges
• Restructuring and consolidation discussions

Islamic Banking in Sri Lanka

Islamic Banking Principles:

Principle	Explanation
Ribā (Interest)	Prohibited; profit/loss sharing
Gharar (Uncertainty)	Excessive uncertainty avoided
Maysir (Gambling)	Speculation prohibited
Halal (Permissible)	Funds only in halal activities

Islamic Banking Products:

Product	Mechanism	Compared to Conventional
Murābahah	Cost-plus financing	Trade credit
Ijārah	Lease to own	Hire purchase
Mudārabah	Profit sharing (rabb al-māl provides capital)	Partnership
Wakālah	Agency arrangement	Commission-based

Islamic Banks in Sri Lanka:

• Amãn Bank (first Islamic bank, 2007)
• Islamic banking windows by conventional banks
• Islamic finance growing in Sri Lanka

Sri Lanka’s Financial Sector Regulation

Regulatory Framework:

Regulator	Area
Central Bank of Sri Lanka	Banking, finance companies, payment systems
Securities and Exchange Commission (SEC)	Capital markets, listed companies
Insurance Regulatory Commission of Sri Lanka (IRCSL)	Insurance companies
Ministry of Finance	Overall policy oversight

Central Bank’s Supervisory Role:

• On-site examinations
• Off-site surveillance
• Statistical reporting requirements
• Prompt corrective action framework

Protection of Deposits:

• Depositor insurance scheme (up to certain limit)
• Failed banks: Resolution and deposit insurance

Credit Rating:

• Companies rated by credit rating agencies
• Ratings affect borrowing costs
• Sri Lankan agencies: ICRA Lanka, Lanka Rating

Financial Inclusion:

• Government priority
• Banked vs. unbanked population
• Mobile money as inclusion tool
• Financial literacy initiatives

⚡ A/L Exam Tip: For banking questions, remember that banks are INTERMEDIARIES — they take deposits and lend them out. The difference between lending rates and deposit rates is the “spread” which is their main income!

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