Loan growth has been robust in recent years, reflecting strong real and nominal GDP growth, as well as the additional role of the State Banks in providing loans to the government and loss making corporations. Deposits have grown proportionately, providing most of the liquidity needed to support loan growth.
Meanwhile, capital adequacy and provisioning rules have been made increasingly stringent. While most, though not all banks have been able to comply, capital will certainly be a scarce resource for the future, if the industry is to achieve growth rates which support economic growth at 6 – 8% pa. However, the performance of the industry overall in the first quarter of 2008, showed a declining trend in key indicators for most banks. Thus, the rate of growth of both loans and deposits declined sharply, resulting in flat growth in nominal terms and in negative real growth. Interest margins came under pressure, while non-performing loans, overheads and taxation increased, with a resulting adverse impact on returns on equity.
The causes of this decline are likely to relate to broader economic factors, particularly the impact of rising inflation on demand and savings and slower GDP growth in particular sectors. It is unclear whether the downturn in banking indicators in the 1st quarter of 2008 will be sustained. If so, it will bring to the fore the structural issues of the industry, which received less prominence in less challenging times.

High costs and taxes, low returns and need for new capital
The present banking business model is based on high costs, partly as a result of the relatively small scale of operations in a fragmented industry, resulting in high margins as these costs are passed onto customers, and to low returns on shareholder funds after high taxation charges.
The present paradigm therefore results in dissatisfied stakeholders. Borrowers and depositors complain of high costs and low returns respectively, whereas the providers of capital receive substandard returns on their investments, making capital accumulation for future growth problematic.

Cost structure and interest margin
As shown in Table 3, Sri Lanka has probably the highest level of costs in the region, and is second only to Indonesia in terms of its interest margin. High costs are a necessary consequence of a small and fragmented industry. The capacity of relatively small banks to absorb the high fixed costs of distribution, technology and marketing, for example which are necessary to survive in a competitive market is low. The ability to attract and retain highly mobile skilled employees by paying compensation which is competitive in a globalised industry, is also limited by the level of profit generation.

Small banks in a small economy will find it difficult to compete efficiently, both at home and abroad, to provide affordable services to its customers or to attract capital for growth. These difficulties will be heightened in an environment of high inflation and reducing economic growth worldwide.

Taxation policy
Banks paid income tax on profits on the same basis as other business enterprises until 2003. In that year, based on fiscal needs and perceptions of excessive profit generation, the Financial Services VAT was introduced for banks and financial institutions alone. Based on the new interpretation of profits for the purpose of FSVAT introduced in 2008, banks will this year pay around 26% of banking profits on account of that tax, and a further 35% of income tax thereon. Assuming normal banking business activities, and no material adjustments for losses brought forward etc, banks will generally pay taxes aggregating over 60% of banking profits.

This rate of tax is among the highest in the world for the banking sector, and is directly co-related to falling returns on equity. This high level of taxation is probably based on three factors. The need to bridge budget revenue shortfalls, the erroneous perception of excessive profit generations by banks, which is critically reviewed here, and the inequitable distribution of the tax burden, with some of the cost of tax holidays and evasion being borne by a sector which reports an apparently high and extremely transparent level of nominal profits.

This level of taxation increases costs to customers and reduces the ability of banks to accumulate profits or to attract new capital, in order to meet the increasing prudential requirements of the central bank or to support loan growth, which is needed for economic development.

Policy makers face a stark dilemma, namely to continue to levy this onerous tax rate on banks for fiscal benefit, or to witness the progressive diminution of the capacity of banks to generate capital on which loan growth is based.

Capital and returns on capital
It is estimated that if the banking industry were to maintain its present capital ratio, and if loans were to grow at a modest level of 15% pa in 2008 (2007 -19%) incremental new capital of around Rs 26 billion will have to be found. On the optimistic assumptions that profit levels can be maintained this year despite the contrary trend of Q1 2008, and the compression of profits likely to result from higher inflation, lower demand, higher NPLs and taxation, and if dividend pay out ratios remain unchanged, then around Rs 16 billion of capital can be internally generated. A further Rs 10 billion will therefore have to be raised from the markets to maintain the present capital adequacy ratio.

Similar or larger sums will need to be raised annually, in order to support higher growth. In either instance i.e. profit retention or infusion of new capital, shareholder or investor approval is needed and will rationally be given based on returns expected to be earned on their funds. In short, Sri Lankan banks will have to compete for capital both in the local and global market place, where it is a scarce and highly prized and priced resource.

Return on capital is therefore of vital importance for banks, as they will not be able to attract or acquire needed capital, unless acceptable returns are provided to investors.

Are Lankan banks making super profits?
Return on equity (ROE) is normally compared against the risk free rate, the rate paid by the government on its own securities. Investors will naturally expect a premium over this rate. It is seen that the equity premium for the industry is negative, the worst in the region. Even the best performing private banks in Sri Lanka do not come close to matching the equity premium of regional competitors. The ability of Sri Lankan banks to attract global capital is obviously constrained, unless their returns improve greatly.

The trend of bank profits, return on equity and the risk free rate in Sri Lanka is seen in Table 6. It is clearly seen that while bottom line profits are growing, which feeds perceptions of excessive profit generation; ROEs are below the risk free rate.Ironically, the popular perception persists that banks are making unconscionable profits, based on headline bottom line profit numbers, which fail to make the obvious connection between profit earned and capital employed. Banks have paid heavily for their fame, as the industry has been singled out for heavy taxation, now exceeding 60% of banking profits, based on the incorrect perception of excessive profit generation.

Way forward: Industry consolidation
If the banking industry is to build scale, in order to reduce costs, increase capital and to compete against foreign banks at home and regionally, consolidation of the industry is needed.
Although there is broad agreement from stakeholders that consolidation is desirable, three broad areas of difficulty stand in the way of deals being done.

Ownership
The Central Bank has established the principle of broad based ownership of banks, limiting single ownership to 10% of issued shares or to a maximum of 15%, with Monetary Board approval.
The state banks have been exempted from this ownership limit as a matter of policy, although the argument in favour of broad based ownership should in principle apply equally to both public and private bank.

There are two main justifications for the restriction of ownership of banks, both of which were highlighted during the Asian banking crisis -- (i) that ownership concentration, especially by an individual or family, limits access to capital during times of crisis or systemic need, and (ii) that the model of concentrated ownership is more vulnerable to abuse of the principles of good governance e.g. it increases the risks of interference by owners in management, leading to conflicts of interest and dilution of the independence of professional management.

The governance argument in (ii) above, while still valid, is of lesser importance today with the enactment of a plethora of laws, regulations, disclosure rules accounting standards and a Code of Governance, designed to promote transparency and to control abuse of powers and conflicts of interest.

However, the argument that shareholders should have sufficiently deep pockets to inject capital when needed, and that dominant ownership by individuals or families is less likely to result in capital infusion under circumstances of stress is an important one, as exemplified in situations of crisis elsewhere.
On the other hand, it is argued that limits on ownership are difficult to monitor and enforce in practice, and that they restrict banking consolidation, which is essential in order to raise new capital for growth, to reduce costs, and to meet the challenge of foreign competition.

Given the need for banking industry consolidation in Sri Lanka, how can this objective be legally facilitated and within what ownership structure?Consolidation can occur broadly in two ways, namely through mergers or acquisitions.

Mergers
In this situation, Bank A acquires the assets and liabilities of Bank B, and the latter is liquidated. Alternatively, a new Bank C acquires the assets and liabilities of both A and B, both of which are subsequently liquidated.

Mergers (and acquisitions) are an area of legal complexity. It is therefore desirable that regulators review the rules, clarify the processes and plug any gaps if necessary before any transactions occur. Having to change rules or meet legal challenges during the course of a live deal, clearly will negate the chances of its successful completion.
In theory, a merger could occur, within the present ownership limits, with the owners of the new bank conforming to the 10 or 15% restriction.

In practice, while this may be an achievable long term goal, there is a transitional problem, i.e. many local banks who may want to participate in a merger, have shareholders who own considerably higher percentages, which they have been permitted to hold for transitional periods of upto five years.
These dominant shareholders are unlikely to want to dilute their ownership in a merged entity, even for this transitional period.

A policy decision therefore needs to be taken whether the consolidation process should effectively be postponed until the five year transitional period expires, or whether some pragmatic compromise should be made in the interests of banking industry development and stability. One possible compromise may be to allow a larger percentage holding than 10 or 15% in the merged bank, but only for existing shareholders and only for the unexpired period permitted under transitional arrangements.
The percentage could also be capped at some amount to be decided at a policy level, but if investors are to be encouraged to merge, they would need to hold 20% of shares at a minimum, the percentage at which equity accounting is permitted under present accounting standards.

Acquisitions
The present ownership limits based on the principle of broad based ownership do not facilitate investment in banks by strategic investors i.e. those entities whether local or international, which have both the management and technical skills and the financial resources, to add value to the development of the Bank over a long time scale. As local banks increasingly meet fierce competition from overseas, they would surely benefit from both the skills and the capital of a powerful financial institutional partner who would typically want to own upto say 30% of the shares of a bank, in order to justify the investment of time and money. Although the qualifying conditions for strategic ownership would have to be defined tightly and upfront, and the criteria applied uniformly, there is little doubt that many local banks would benefit from ownership by a reputable, financially strong institution, with appropriate technical skills on which it could draw when needed. Ownership rules would need to be amended accordingly.

Policy clarifications: Consolidation
If bank consolidation is to happen, a clear supportive policy statement by the Central Bank detailing parameters is a precondition.

This will resolve contradictions between ownership restrictions and the goal of consolidation. It will also provide direction to shareholders and management in formulating their own objectives. To be effective, such a statement should be supplemented by a review of applicable laws and regulations with changes if any, being effected without delay. In the absence of policy emphasis and clarity and overt regulatory support, consolidation is unlikely to happen in practice.

Taxation policy
It is clear that a policy contradiction exists at present between the need for fiscal revenue maximization, and the prudential requirement for banks to accumulate capital.

There is no question that a tax rate of 60% on banking revenues if sustained, will jeopardize the prudential objective. In resolving this contradiction however, policy makers must ensure that they look not at nominal, bottom line profits, but on comparative returns after tax on shareholder funds, the determinant of capital growth.

Consolidation will bring big changes to boards and employees, senior management, as well as to shareholders. Resistance to organizational and behavioural changes is understandable and is to be expected. However, all stakeholders will need to understand that banks must change in order to survive, and that survival requires cultural change, sooner rather than later.

Summary
Banks in Sri Lanka will need to raise significant amounts of capital locally and globally to support future growth. If investors are to inject new capital, they will need assurance that returns on their funds are internationally competitive. Banks will therefore need to increase returns, at a time when margins are being compressed by competition, rising overheads and investment in fixed costs, particularly in technology, branches and skills.

If this is to be done two structural issues need to be addressed, namely the lack of scale of local banks, which contributes to their comparatively high level of fixed costs, and the rate of taxation of over 60% of banking profits. Banks and policy makers need to face these realities together, if the growth of the banking sector, on which economic growth relies, is to be sustained.