Sri Lanka's banking regulator plans to limit exposure of banks to the stock market to prevent the risk of a downturn in equities affecting the financial sector, a senior central bank official said.
P Samarasiri, Assistant Governor of the Central Bank said they were aware that in some countries banks were making high profits lending to the stock market, but added: "When the markets collapse, banks are affected."
Equity Risk
He said the regulator was aware of the risks posed by the booming Colombo bourse, which began a bull run after the island's 30-year ethnic war ended in 2009.The stock market has been among the world's best performing bourses in the last two years, hitting new highs in recent months and raising concerns of a credit fuelled stock market bubble.
Share prices have come down in recent weeks on selling pressure triggered by regulator limits on broker credit to investors.
"The stock market is booming - we know the risks," said Samarasiri.
"We're imposing regulations to ensure banks are not exposed to the stock market that much.
"Still, banks can have innovative devices to lend to stock markets despite the regulations," he said.
Samarasiri, who spoke at a public forum on how the central bank revived finance companies that collapsed two years ago, did not give details of the proposed restrictions on bank lending to the stock market.
But the central bank is believed to be considering imposing a cap on the use of bank guarantees by investors to apply for initial public offers.
Recent IPOs have been heavily oversubscribed mainly with bank guarantees, raising concern that small investors were being edged out and of the risks of bank exposure to the stock market.
The island's capital markets watchdog, the Securities and Exchange Commission, has imposed limits on IPO allocation of shares for those applying with bank guarantees, asking companies to reserve a proportion of shares for small investors and mutual funds.
One of the first triggers of the Great Depression was a collapse of a stock bubble fired by earlier loose Federal Reserve monetary policy.
Excess Liquidity
Fed's excessively printed money ended up in margin trading accounts as the economy could not absorb the liquidity, which fired a stock bubble.
"The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom," Alan Greenspan who later became chairman of the Federal, Reserve wrote nearly four decades after the depression.
"Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom.
"But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed."
Greenspan himself had been blamed for firing a housing bubble by trying to reverse deflation from 2001 leading to the current downturn.
The current limit of margin credit to 50 percent was first brought in the US following the experience in the run up to the great depression.
Analysts have warned that among the top 20 shareholders of some of the dodgiest stocks in Colombo are margin trading accounts.
Sri Lanka's banking system also has about 80 billion rupees of excess reserves, or about a quarter of the monetary base, which are sterilized overnight.
