##ated structural implications which may have gradually affected the efficiency of the financial markets since their outset. • first, credit derivatives and, more generally, structured credit markets have affected banks ’ perceptions of risk and propensities to lend when granting credit. however, it is not enough to consider in this regard the enhanced potential to clearly separate credit and liquidity risks and thus to enhance specialisation. as we have clearly witnessed over the last couple of years, by apparently transferring the credit risk associated with the issuance of credit, some banks may have eroded issuing criteria and thus contributed to an overvaluation of assets. • second, credit derivatives and structured credit markets have transformed the way banks operated. innovations in credit portfolio management practices have had profound implications for the banking business model. many banks have moved from the “ buy - and - hold ” model to the “ originate - and - distribute ” model, whereby they distribute credit risks they originated to other market participants. in this respect, banks have increasingly performed the role of active portfolio credit risk manager in addition to credit provider. in particular, they have increasingly found structured credit products an attractive mechanism for reducing exposure concentrations in their loan books, while also allowing them to meet the needs of their corporate customers. these evident advantages of the new way of operating, together with the possibilities offered for capital regulatory arbitrage, seem to have overshadowed the disadvantages, such as the excessive focus on returns and short - termism. • third, credit derivatives and structured credit markets have transformed the financial system at large, whereby the risk re - allocation activity may have become just as important as – and in some cases a full substitute for - the more traditional capital allocation. whilst the aggregation and structuring of credit risks and their subsequent transfer to market participants with different investment horizons, asset / liability structures and risk appetites made evident the virtues of the model, it downplayed the now evident fact that the recipients of the risks were often vulnerable in terms of managing liquidity, interest rate and systemic credit risks. overall, these three structural implications of credit derivatives and structured credit markets may in a normally functioning financial system bring about increased opportunities and productivity in the banking intermediation business. whether this partially explained the fast growth of bank credit in the euro area during the years before the crisis, possibly above the level that can be explained on the basis of its traditional determinants, is a conjecture that remains to be substantiated. what is clear is that, going forward,

to productivity gains. attempts are made to minimize income expenditure gaps and avoid deficit financing from inflationary sources such as bank financing, in particular, borrowing from cbsl. govt. ’ s medium term strategy rests largely on public investments in key sectors and infrastructure that supports growth. it is important that these investments are financed in such way that it would not place excess burden on the budget. in this regard, it is encouraging to note that the govt. has committed to commence operations of infrastructure projects such as the south harbour development, weerawila airport and other highways within the framework of public private partnership, which will provide an opportunity to the private sector to take part in such projects. reducing vulnerability to rising import prices in view of the significant volatility in oil prices in international markets, cpc has taken measures to hedge oil imports so that the price fluctuations do not adversely affect domestic prices. it may be worth exploring the possibility of introducing hedging to other critical imports such as gas, fertilizer to mitigate impacts of adverse price fluctuations in the domestic market. 3. banks and financial institutions banks and financial institutions are expected to provide finances for economic activity. some banks and financial institutions provide credit to government as well as the private sector, while others serve only the private sector. the continuing high growth in private sector credit could cause a threat to price stability as well as the financial system stability. high credit growth could deteriorate the quality of assets of commercial banks and increase the level of non - performing loans. in inflationary situations, lenders should be cautious not to fuel inflation further, but to direct investment towards productive activities. banks and financial institutions continue to enjoy short term profits from lending at high rates to their customers and living on interest income. but the real value of their assets and profits continue to erode in an inflationary environment. for example, the real growth of assets in the banking system in 2006, was 5 % as compared to a nominal growth of 19 %. similarly, the real growth of profits of the banking sector in 2006 was 12 % compared to a nominal growth of 26 %. in essence, the real value of short term profits recorded by the banking sector is only half of the nominal growth. eventually, there will be pressures for higher wages which will, together with rising non - performing loans, erode profits and threaten the stability of the banking system. banks and financial institutions should therefore take a longer term view and be more cautious in expanding their loan portfolios