Central Bank of Sri Lanka Directions on Credit Risk Management for Licensed Microfinance Companies

20 August 2025
MICROFINANCE ACT DIRECTIONS
CREDIT RISK MANAGEMENT
No. 01 of 2025

1. Legal provisions 1.1 In terms of the powers conferred by Section 11 of the Micro
   Finance Act, No. 06 of 2016 read with Section 133(1) of the Central Bank of Sri Lanka Act, No. 16 of 2023, the Central Bank of Sri Lanka hereby issues these directions on Credit Risk Management to all Licensed Micro finance Companies (LMFCs) licensed under the Microfinance Act, No. 06 of 2016.
2. Objectives of
   the directions
3. Applicability
4. Credit risk
   management framework
   2.1
   3.1
   Establish a credit risk management framework through formulation of credit risk management strategy, credit risk management policy, credit risk governance structure including prudential limits and ensuring availability of an effective system in place to identify, measure, monitor and control credit risk, align with the nature, volume and complexity of the activities of LMFCs. These directions outline the key principles for sound credit risk management framework and LMFCs shall adopt the principles and practices provided in these directions.
   3.2 These directions shall be effective from 01.01.2026, subject to
   4.1
   4.2 the transitional provisions given at direction 8, below.
   The credit risk management framework shall have a holistic approach for assessing credit risk and continue to be an integral component of the long-term sustainability of LMFC. The credit risk management framework of LMFC shall at least contain the following elements:
   a) Credit risk management strategy and credit risk management policy; b) Credit risk governance structure; and c) Credit risk management process.

20 August 2025
MICROFINANCE ACT DIRECTIONS No. 01 of 2025
4.3 Credit risk management strategy and credit risk
management policy a) Credit risk management strategy

1. LMFC shall develop its credit risk management strategy
   in line with its business goals, credit risk appetite and the tolerance levels approved by the Board of Directors (BoD). u. At a minimum, the credit risk management strategy shall outline LMFC's willingness to grant credit facilities based on:
   (a) exposure type (personal loans, business loans, finance leasing, working capital loans, pawning, housing loans etc.); (b) Economic sector/activities ( agriculture, consumption, tourism, transport etc.); and (c) Geographical location (province/area wise concentration limits).
   iii. LMFC shall ensure that the credit risk management
   strategy is long-term in nature and able to take into account cyclical aspects of the economy and its impact on the composition and quality of the overall credit portfolio. b) Credit risk management policy
2. LMFC shall have a comprehensive credit risk
   management policy developed and implemented, enabling LMFC to grant and manage its credit portfolio and to evaluate new business opportunities. u. Such policy shall be well defined, documented, duly approved by BoD, consistent with the best practices and regulatory requirements, and reviewed annually and as

20 August 2025
MICROFINANCE ACT DIRECTIONS and when required.
No. 01 of 2025
iii. At a minimum, the credit risk management policy of
LMFC shall include:
(a) The role, responsibility and level of accountability of the BoD and senior management; (b) The delegation of credit granting authority to various levels of management and staff (including authority to approve deviations and exceptions); ( c) Types of credit facilities allowed to be offered by LMFC; ( d) The extent to which LMFC is willing to accept credit risk against its portfolio, including concentration limits, with respect to borrowers/counterparties, group of borrowers, economic sectors/activities, geographic regions and the acceptable types of collaterals; ( e) Procedures for granting credit facilities to related parties to ensure that such transactions are conducted on an arm's length basis and free of conflicting interests; (f) Details on the analysis to be conducted when granting new credit facilities; (g) A list of documentation required for each stage of the credit management process; (h) Details on internal controls to mitigate credit risk; and (i) Details on how credit impaired loans shall be managed and the responsible officer for managing impaired loans.

2.0 August 202S
MICROFINANCE ACT DIRECTIONS
4.4 Credit risk governance structure
No. 01 of 202S a) LMFC shall have a sound credit risk governance structure for successful implementation of an effective credit risk management framework. b) BoD and senior management shall play a pivotal role in the oversight of the credit risk management framework of LMFC. The responsibilities of BoD shall include at a minimum:

1. Developing and approving a documented credit risk
   management strategy; n. Approving and reviewing credit risk management policy developed by the senior management and its effective implementation;
   iii. Ensuring that senior management is fully capable of
   managing the credit facilities granted by LMFC and such activities are done within the credit risk management strategy and policy;
   iv. Ensuring that credit risk management strategy and policy
   are effectively communicated throughout LMFC and relevant staff in LMFC are aware of the established approach to credit risk management;
   v. Ensuring that adequate controls, including management
   reporting and internal audits, are in place to monitor that the risks being taken are in accordance with internal policies agreed upon; v1. Monitoring of adherence to regulatory, supervisory and other legal requirements; and v11. Reviewing analysis and stress test conducted by LMFC.

2.0 August 2025
MICROFINANCE ACT DIRECTIONS No. 01 of 2025 c) Senior management ofLMFC shall be responsible for:
i. Adopting the credit risk strategy set out by BoD;
ii. Developing and implementing documented credit risk
management policy and procedures; m. Establishing a communication system that disseminates the credit risk management strategy and policy to the staff engaged in the credit risk management processes; 1v. Ensuring that sufficient resources and competent personnel are allocated to manage and control the daily operations related to credit risk management functions;
v. Establishing a comprehensive credit risk reporting
process; v1. Complying with regulatory, supervisory and other legal requirements;
vii. Developing and implementing adequate internal controls
to mitigate credit risk;
viii. Developing appropriate Management Information
System (MIS) and submitting reports to BoD; and 1x. Perform internal audit periodically to verify the effectiveness of the credit risk management framework including policies and compliance with these policies.
4.5 Credit risk management process
An effective credit risk management process shall include the identification and assessment of potential risk inherent in any credit facility. At a minimum, this process shall formalize LMFC's approach to the following:
a) Appraisal and approval of credit facilities

1. L~1FC shall ensure that the LMFC receives sufficient
   information for assessment of the risk profile of the borrower/counterparty. At minimum, LMFC shall have

!l.c> August 2025
.~--~
l. GOVERNING BOARD
MICROFINANCE ACT DIRECTIONS No. 01 of 2025 basic information set out in Annex I (A), Section 1 relating to the borrower and credit facility. u. LMFC shall ensure that documents used in the credit granting process such as loan applications, guarantor statements, and related fonns, are in compliance with applicable laws, rules, and regulations. m. LMFC shall have credit risk scoring system/grading system to assess the creditworthiness of the borrower/ counterparty, and such system shall be consistent with the nature, size and complexity of LMFC's activities.
iv. LMFC shall have a team of staff with sufficient
knowledge, skills and experience to assess credit risk and ensure that the credit decision making process is rigorous, timely and efficient.
v. LMFC shall establish standardized loan approval criteria,
and a comprehensive assessment process, as outlined in
Annex I (A), Section 2.
b) Measurement of credit facilities

1. LMFC shall setup a mechanism for measuring the risks
   in all credit exposures, in line with Sri Lanka Accounting Standards(SLAS) and Sri Lanka Financial Reporting Standards (SLFRS).
2. LMFC shall estimate the expected credit losses by
   computing the probability of default, loss given default and exposures at default for LMFC's credit exposures at individual level or ponfolio level and recognize such measurement in a timely manner in accordance with the applicable Accounting Standards. Minimum guidelines for assessment of expected credit losses are outlined in
   Annex I (A), Section 3.

':J-.0 August 2025
MICROFINANCE ACT DIRECTIONS No. 01 of 2025
iii. LMFC at a minimum shall categorize the credit facilities
into stages one (1), two (2), and three (3) as outlined in
Table 1, Annex I (B).
iv. LMFC shall duly incorporate the outcomes of set
measures m developing/reviewing the credit risk management strategy and credit risk management policy, particularly in the areas of approval of credit facility, pricing, limit-setting, identification of credit impaired loans and credit loss allowances. c) Monitoring of credit facility

1. LMFC shall have a system that enables it to monitor and
   assess the credit risk involved in exposures to each type of credit facility. u. LMFC shall deploy proper MIS which assists LMFC to comprehensively monitor their credit portfolio and any associated credit risk. The high quality and accurate information generated from MIS shall be used to take decisions by the BoD and senior management and facilitate the on-going assessment of credit risk.
   iii. LMFC shall perform stress testing to identify possible
   events or future changes in economic conditions that could have unfavorable effects on LMFC's credit exposures and assess LMFC's ability to withstand such unforeseen changes.
   iv. An effective credit monitoring process shall ensure the
   following:
   (a) Update the financial condition of the borrower/ counterparty at regular intervals. The frequency of such updates may be determined by the LMFC, considering the size and tenure of the facility;

2,.0 August 2025
MICROFINANCE ACT DIRECTIONS No. 01 of2025 (b) Assess, where applicable, collateral coverage relative to the borrower's/ counterparty's current condition; ( c) Identify contractual payments in arrears and classify as credit impaired loans in a timely manner; (d) Reflect the borrower's/ counterparty's updated financial condition into LMFC's credit risk scoring system/ grading system; and {e) Monitor the credit quality, maintain regular contact with the borrower/counterparty, and conduct follow￾up actions.
v. The management of credit impaired loans shall be
undertaken by LMFC in a structured and targeted manner, with a focus on improving recovery process and providing feedback to further strengthen LMFC's credit risk management strategy and credit risk management policy. v1. Write off shall be undertaken by LMFC in a timely mam1er and reflect realistic repayment and recovery expectations. At a minimum, LMFC shall set out the circumstances, conditions and approving authority under which a credit facility can be written-off based on the write-off policy approved by the BoD and maintain adequate information on written-off credit facilities.
5. Granting 5.1 No LMFC shall grant any accommodation to;
accommodation a) Its holding company or ultimate parent company or any other party that exerts substantial interest over the LMFC; b) Any of its Directors and any Directors of parent company;

:u:, August 2025
6. Prudential
limits
MICROFINANCE ACT DIRECTIONS No. 01 of 2025 c) Chief Executive Officer (CEO)/General Manager (GM); and d) Relatives ofb) and c) above.
5.2 The LMFC shall grant accommodation to individual borrowers,
and Community Based Organizations (CBO) and group of borrowers subject to the prudential limits specified in Direction
6.1 below.
6.1 The maximum amount of accommodation that may be granted
by the LMFC shall not exceed the following percentage of core capital of such LMFC subject to the direction 7 below; a) Individual Borrower Limit The maximum amount of single accommodation or the aggregate of accommodations granted by LMFC and the outstanding amount of accommodations at any point of time from an individual borrower and a CBO, shall not exceed zero point three per cent (0.30 % ) and one per cent (1.0%), respectively, of the core capital of such LMFC as shown in the latest audited financial statements. b) Group Borrower Limit The maximum amount of single accommodation or the aggregate of accommodations granted by LMFC and the outstanding amount of accommodations at any point of time from any group of borrowers and any group of CBOs, shall not exceed zero point five per cent (0.5%) and one point five per cent (1.5%), respectively, of the core capital as shown in the latest audited financial statements of such LMFC. c) Aggregate Limit The aggregate of all single accommodation granted to, and outstanding in respect of, the categories of

2,D August 2025
7. Exclusion of
accommodations from prudential limits
8. Transitional
Provisions
9. Definitions
MICROFINANCE ACT DIRECTIONS No. 01 of 2025 borrowers referred to in a) and b) above, where accommodation granted to non-CBO borrowers and CBOs exceeds zero point two five per cent (0.25%) and zero point five per cent (0.5%), respectively, of the LMFC's core capital, as reported in the latest audited financial statements, shall not exceed 40% of the total outstanding accommodations of LMFC as shown in the latest audited financial statements.
6.2 Numerical examples for the computation of prndential limits are
7.1
8.1
9.1 given in Annex I (C).
Where accommodations have been granted against cash or gold as collateral, the value of such collateral may be deducted from the relevant credit facilities, when computing the maximum amount of accommodations under direction 6 above. A transitional period until 01.07.2026 will be granted for the implementation of directions 4.3, and 4A above. The following definitions shall be applicable for the purpose of these directions; a) "Individual Borrower" shall mean; any single company, public corporation, firm, a CBO, an association of persons or a natural person. b) CBO shall be a registered legal entity and be able to legally accept loans as per its statute such as its Memorandum of Association/ Articles of Association, Constitution or By-Laws. c) "Group of Borrowers" shall mean the aggregate to;

1. An individual, his close relations or to a company or firm
   in which he has a substantial interest.
2. A company and one or more of the following;

2.D August 2025
MICROFINANCE ACT DIRECTIONS a. its subsidiaries; b. its parent company;
c. its associate company;
d. its joint ventures;
No. 01 of 2025 e. a subsidiary of its parent company; or £ a company in which such company or its subsidiary, or its parent company, or a subsidiary of its parent company, has a substantial interest.
iii. CBO and its related leg.al entities.
d) "Relative" in relation to an individual means spouse and dependent child of such individual. e) "Dependent child" shall mean a child who is under the age of eighteen years; or a child under the age of twenty￾five years who is unmarried and unemployed, or a child, irrespective of the age, who suffers from a physical or mental disability that renders him incapable of earning his livelihood. f) "Substantial Interest" means holding of beneficial interest by another company or an individual or his close relation whether singly or taken together, exceeding ten percent (10%) of the stated capital. In relation to a firm the beneficial interest held is applicable to an individual or his close relation of such firm. g) "Parent", "Subsidiary", "Associate" and " Joint Ventures" as defined in Sri Lanka Accounting Standards (SLAS). h) "Accommodation" shall mean credit exposures and investment exposures as given below;

.2.0 August 2025
MICROFINANCE ACT DIRECTIONS No. 01 of 2025

1. Credit Exposure shall include all on-balance sheet
   accommodations and off-balance sheet accommodations; a. On-balance sheet credit exposure shall mean term loans, pledge loans, hire purchase loans, leasing facilities, pawning advances and reverse repurchase agreements against debt securities and other instruments of similar nature. b. Off-balance sheet credit exposure shall mean a commitment to accept contingent liabilities, including guarantees and bonds.
   ii. Investment exposure shall include all financial
   investments excluding investments in government securities. i) "Amount of Accommodation" shall be the total of on balance-sheet accommodations and off-balance sheet accommodations as specified below;
2. Amount of on-balance sheet accommodations: The
   amount of on-balance sheet accommodations shall mean the total of the accommodation limits prevailing at any given date or the total outstanding amount of all accommodations, whichever is higher. In the case of fully drawn term loans, the outstanding amount of accommodations shall be reckoned as the amount of accommodations.
   ii. Amow1t of off-balance sheet accommodations: The
   amount of off-balance sheet accommodations shall mean the total of the accommodation limits prevailing at any given time or the outstanding amount of accommodations, whichever is higher excluding the

,2.0 August 2025
10. Revocation
Directions
MICROFINANCE ACT DIRECTIONS No. 01 of 2025 of 10.1 undrawn amount of credit facilities recognized under on balance sheet accommodations. j) The outstanding amount of accommodations shall be the carrying value as per the financial statements of both on￾balance sheet and off-balance sheet accommodations. The Micro Finance Act Directions No. 07 of 2016 on Regulatory Framework for Accommodations is revoked from the effective date of these directions. Dr. P N andalal Weerasinghe Chairperson of the Governing Board and Governor of the Central Bank of Sri Lanka

Annex I (A)
Section 1
1.1.Information on borrower
(i) Natural Persons - Occupation, Employer, Salary/Income, Financial position/Net worth and any other relevant information. (ii) Others - Constitution (proprietorship, partnership, society, club, co-operative, CBO), Business background and history, Organization structure, Management team/Directors, Shareholders/proprietor/ partners, financial position and performance, and any other relevant information. 1.2.Information on credit facility (i) Description of facility type (ii) Purpose of facility (iii) Terms of facility- limits, interest rates, repayment schedules, expiry dates (iv) Collateral - types, valuation amount, valuation date and where applicable, name of the valuer. (v) Guarantors - names, financial position and net worth (vi) Business Sector in which the loan is given (i.e., agriculture, manufacture, retail etc.)
Section 2
2.1.The guidelines for establishment of standardized loan approval criteria and a comprehensive assessment process (i) Establishing clear and well-documented criteria for loan approvals These criteria shall cover, at a minimum, the eligibility requirements for borrowers, the determination of loan amounts, applicable interest rates, repayment schedules, and any collateral requirements, where applicable. (ii) Adopting a comprehensive credit risk assessment framework supported by a standardized template for evaluating the creditworthiness of borrowers. This framework should include, but not be limited to, the following key components:

(a) Assessment of the borrower's repayment capacity and credit history, including past repayment behavior and existing financial obligations. (b) Evaluation of the borrower's own financial contribution to the proposed facility, if any. ( c) Review of the quality and adequacy of collateral offered, if applicable. (d) Analysis of the proposed loan's terms and conditions, and the intended purpose of the loan. (iii)Establishing the credit assessment process shall incorporate both quantitative and qualitative analyses. (a) Quantitative assessment shall include the use of financial positions and performance (previous, current and projections) (b) Qualitative assessment shall include interviews with the borrower to gather qualitative insights into the borrower's capacity and willingness to repay the loan. 2.2.Conditions to be fulfilled when granting credit facilities to CBO: The following conditions must be satisfied when extending credit facilities to CBOs. (i) A tri-party Memorandum of Understanding shall be executed among the LMFC, the CBO and with any partner organization which the CBO is affiliated, outlining the responsibilities related to loan repayments. (ii) The CBO shall provide a board resolution duly passed, authorizing the borrowing funds fromLMFC. (iii)The LMFC shall evaluate the CBO's bank statements, audited financial statements, corporate governance practices, and other relevant financial and operational indicators prior to approving the loan. (iv)The LMFC shall assess the repayment capacity of the CBO, while the CBO shall evaluate the repayment ability of the ultimate borrowers under its purview.
Section 3
3.1. LMFC may consider the following when assessing loss allowance for Expected Credit
Loss (ECL) for credit facilities;
(i) Loss allowances for ECL- Clear criteria and methodologies for calculating loss allowances for ECL applicable to the LMFC's entire credit portfolio, in alignment with Sri Lanka Accounting Standards, SLFRS 9: Financial Instruments.

(ii) Classification of Credit Facilities into stages one (1), two (2), and three (3)-Guidelines on the staging of credit exposures based on changes in credit risk, as required under the expected credit loss model ( e.g., SLFRS 9). However, LMFC shall adhere minimum criteria specified in Annex I(B), Table I for categorizing credit facilities as specified m direction 4.5 (b) (iii). (iii)Sources of Data - Identification of internal and external data sources used in the development, calibration, and application of ECL models, ensuring data relevance, reliability, and sufficiency. (iv)Key Assumptions - Documentation and justification of assumptions applied in the estimation of ECL, such as macroeconomic forecasts, probability of default (PD), loss given default (LGD), and exposure at default (EAD). (v) Methodologies- Specification of the quantitative and qualitative methodologies used for calculating ECL, including models and techniques adopted for different types of credit exposures. (vi)Model Validation -Procedures for the internal audit function to validate ECL models to ensure their accuracy, robustness, and continued relevance under evolving economic and credit conditions, at a minimum following the implementation of the model and upon any material change. (vii) Frequency of ECL Calculation - Determination of the intervals at which ECL assessments are conducted (e.g., monthly, quarterly, or semi-annually), depending on the nature and size of the credit portfolio. (viii) Back-testing of Data - Implementation of back-testing practices to compare predicted losses against actual outcomes, thereby enhancing the reliability and accuracy of ECL models. (ix)Reporting Lines and Responsibilities - Establishment of clear internal reporting structures and accountability for the preparation, review, and approval of ECL estimates, ensuring proper governance and oversight.

Annex I(B)
Table 1: Classification of credit facilities based on the past due days
Facility type
Credit exposures repayable on daily/weekly/bi-weekly basis i.e. any repayment base less than one month. Credit exposures repayable on monthly or more than monthly intervals*. Performing Loans Non-Performing Loans Stage 1 Stage 2 Stage 3 Credit facilities that are performing regularly or have payments due or unpaid for less than or equal to 30 days from the due date. Credit facilities that are performing regularly or have payments due or unpaid for less than or equal to 60 days from the due date. Payment is due and Payment is due and unpaid for more than 30 unpaid for more than 60 days but less than or days from the due date. equal 60 days from the due date. Payment 1s due and Payment 1s due and unpaid for more than 60 unpaid for more than 90 days but less than or days from the due date. equal 90 days from the due date. *it includes quarterly, half yearly, yearly installments and bullet payments.

Annex I (C)
Numerical Examples for Computation of Prudential Limits

1. Calculation of Individual Borrower Limits for a company with a core capital of Rs. 500.0 mn
   as shown in the latest audited financial statements a) For an Individual Borrower:
   i) Limit= 0.3% of Latest audited core capital ii) Individual Borrower Limit= 0.003 x Rs. 500 mn = Rs.1.5 mn The maximum total exposure (granted and outstanding at any point of time) to a single individual borrower should not exceed Rs. 1.5 mn. b) For a Community-Based Organization (CBO):
   i) Limit= 1.0% of Latest audited core capital ii) CBO Limit= 0.01 x Rs. 500 mn = Rs. 5 mn The maximum total exposure (granted and outstanding at any point of time) to a CBO should not exceed Rs. 5 mn.
2. Calculation of Group Borrower Limits for a company with a core capital of Rs. 500.0 mn as
   shown in the latest audited financial statements a) For a Group oflndividual Borrowers:
   i) Limit= 0.5% of Latest audited core capital ii) Group of Individual Borrowers= 0.005 x Rs. 500 mn = Rs. 2.5 mn The maximum total exposure (granted and outstanding at any point of time) to a group ofbonowers (e.g.: an individual and his/her close relations) must not exceed Rs. 2.5 mn. b) For a Group ofCBOs:
   i) Limit= 1.5% of Latest audited core capital ii) Group ofCBOs = 0.015 x Rs. 500 mn = Rs. 7.5 mn The maximum total exposure (granted and outstanding at any point of time) to a group of CBOs must not exceed Rs. 7 .5 mn.
3. Calculation of Aggregate Limits:
   A. Assumptions:

• Latest audited Core Capital of LMFC, as shown in the latest audited financial
  statements = Rs. 500.0 mn
• Total Outstanding Accommodations, as shown in the latest audited financial statements
  = Rs 1,000.0 mn

B. Thresholds for Aggregate of Accommodations:
i) Calculate the threshold for Large Exposure subject to the Aggregate Limit Borrower Type Threshold as a % Amount of latest audited Core Capital Non-CBO 0.25% 0.0025 x Rs. 500 mn = Rs. 1.25 mn Borrowers CBO Borrowers 0.5% 0.005 x Rs. 500 mn = Rs. 2.5 mn ii) Identification of Large Exposures Borrower Borrower Type Outstanding To be classified as a Name Amount (capital Large Exposure or outstanding+ not interest accrued) Rs.mn Mr.A Non-CBO 1.5 Yes (exceeds Rs. l.25mn) Mr.B Non-CBO 1.1 No Mr. C and his Non-CBO 1.3 Yes wife (group borrowers) CBO 1 CBO 2.8 Yes (exceeds Rs. 2.5 mn) CBO2 CBO 2.4 No Group of CBO 3.0 Yes CBO3 Calculations:

1. Identify "large" accommodations:

• Mr. A (Rs 1.5 mn), Mr. C and his wife (Rs 1.3 mn) -+ Non-CBOs
• CBOl (Rs 2.8 mn), Group ofCBO 3 (Rs 3. mn)-+ CBOs
• Total of"large" accommodations= 1.5 mn + 1.3 mn + 2.8 mn + 3.0mn = Rs. 8.6
  mn

2. 40% of total outstanding accommodations as shown in the latest audited
   financials:

• 40% of Rs 1,000 mn = Rs 400 mn
  Compliance Check:
• Total "large" accommodations= Rs 8.6 mn
• 8.6mn < 400mn---+ Within the 40% threshold for aggregate of accommodations