PROPOSED AMENDMENTS TO THE BANKING ACT

FINANCIAL REPORTING IMPACT

Q: What necessitated the introduction of a new banking act?

A: Enacted in 1988, the Banking Act No. 30 of 1988 is over 35 years old; it is outdated, necessitating modernisation to better align with existing realities. Enhancing financial stability was also crucial to regulate the banking sector and ensure stability, amid local and global financial and economic challenges. Accordingly, the government has gazetted amendments to the act via the Banking (Amendment) Act No. 24 of 2024.

In addition, improving corporate governance is essential for long-term financial system stability and to avoid conflicts of interest, and ensure independence of the banking system. The appointment of suitable and qualified individuals to board and senior management positions will also improve the performance of banks.

There was also a need to facilitate the recovery and resolution of banking entities by providing a clear framework for resolving distressed banks and establishing safety nets. Promoting consolidation within the banking sector by regulating mergers and acquisitions was also a priority alongside better regulation of foreign banks.

Q: And what are the main changes the amended act promotes in relation to ownership and control of banks?

A: The amended act prevents any party – individually, collectively or acting in concert with others – from acquiring a ‘material interest’ in a bank without the prior written consent of the Central Bank of Sri Lanka.

The definition of material interest has been broadened to include holdings of more than 10 percent of the voting shares as well as having significant influence over a licensed commercial bank.

Q: Are there any financial reporting implications arising from the above?

A: The manner in which ‘significant influence’ is defined in the amended act resembles aspects of its definition in accounting standards. This is likely to prevent shareholders of banks from treating a bank as an associate entity and applying the equity accounting model in the future.

Application of the equity accounting model results in the shareholder recording the percentage share of net assets of the bank on its balance sheet – and likewise, the percentage share of the bank’s profit or loss on its income and expenditure statement.

Q: What powers are vested with the Central Bank to enforce these stipulations?

A: It’s important to note that what the act prevents is any party from acquiring a material interest in a bank without the approval of the Central Bank. This also implies that one may retain or acquire a material interest with the Central Bank’s approval.

The act is silent on the conditions or context under which such approval would be granted. The Central Bank is likely to be given this authority for flexibility in managing situations of market stress, promoting foreign investments, securing the rights of the state in public sector banks and so on.

The regulator is afforded specific powers to direct the bank to remove the name of such a shareholder from the share register where material interest is acquired or retained in contravention of the above requirement.

In addition, the Central Bank may also direct the bank to dispose of such material interest.

In such instances, until a disposal is effected, the Central Bank will have sweeping powers to constrain such parties, by actions such as, suspending the exercise of voting rights, prohibiting the issuing of further shares to such shareholders (except in a liquidation), prohibiting the payment of any sums due (including any form of distribution) and requesting the Colombo Stock Exchange’s (CSE) Central Depository System (CDS) to impose a restriction on trading of shares held in excess of the defined ‘material interest.’

Q: What other notable changes are there in relation to financial reporting?

A: The amended act mandates licensed commercial banks to maintain accounts and records, and prepare financial statements in accordance with applicable accounting standards.

The previous reference to financial statements was limited to the need to prepare a profit and loss account and balance sheet for each financial year. This has been broadened and clarifies the need to prepare a complete set of financial statements in line with applicable accounting standards. This aligns with the basis under which banks already prepare their financial statements.

In relation to areas such as loan loss provisioning, it is now clear that the regulatory provisioning principles are only applicable in regulatory returns and for meeting other regulatory requirements while provisioning in the financial statements should be based on accounting standards (SLFRS 9).

Q: And what are the changes impacting the appointment of external auditors?

A: A new section – S 39(7A) – has been incorporated, requiring the engagement partner of the auditor of a licensed commercial bank to be a member of the Institute of Chartered Accountants of Sri Lanka (CA Sri Lanka or ICASL) and not disqualified in or outside Sri Lanka from being appointed as an auditor.

Additionally, S 39(7B) mandates that every licensed commercial bank must change its auditor every six years and the engagement partner every three years. According to the newly added section, auditors who are already appointed must comply with these requirements within a period of two years.

Furthermore, S 39(8) has been repealed, which previously stated that S 39 would not apply to a licensed commercial bank that is a public corporation.

This is a significant change in policy since at present, there’s no requirement to rotate audit firms while the requirement to rotate the audit partner is triggered after five years.

Given that the current external auditors (firms) of banks have held office in most cases for more than six years, this requirement will trigger auditor rotation for most banks.

The new rule is comparable to those in other regional territories such as India, Bangladesh and the Maldives. However, it is more aggressive compared to some territories like Singapore and the UK, where the mandatory rotation of audit firms is triggered over a 10-20 year period.

Q: Are there any other changes impacting auditors – and if so, what are they?

A: A new section – S 39(1A) – has been incorporated, imposing a duty on the auditor to report critical findings to the Director of Bank Supervision upon the discovery of significant losses incurred or likely to be incurred, which could reduce the capital, irregularities or unsafe practices that would jeopardise the interests of depositors and creditors, and insufficient assets to cover depositor or creditor obligations.

Additionally, S 39(2) has been repealed and substituted with a requirement for auditors to issue the audit report within two months of the end of a financial year.

Although this is a new requirement, most banks already publish their audited financials within two months of their year end.

Furthermore, the auditor is expected to report whether the financial position of the bank is accurately reflected, whether it complies with regulations and whether any explanations or information provided upon request are satisfactory.

This in effect is an extension to the statutory scope of an auditor, which aims at opining on the true and fair nature of the financial statements in accordance with the applicable accounting standards. Accordingly, it’s likely to be structured as an engagement separate from the statutory audit.

This new requirement places a direct onus on auditors to report specified matters to the Central Bank of Sri Lanka. This represents a departure from the existing setup where the external auditor’s statutory obligation is primarily towards shareholders of the bank.

Q: What is the requirement for licensed commercial banks to divest their shares in non-financial subsidiaries within a five year period?

A: A new section – S 17(4A) – has been included, requiring licensed commercial banks to divest non-financial subsidiaries that don’t provide services to the bank or its group.

This requirement appears to be aimed at retaining the focus of banks on the provision of financial services and preventing them from owning or investing in entities that fall outside the regulation of the Central Bank.