Financial Times

Recent trends in banking and financial services
By Nihal Welikala, General Manager, NDB
(These are excerpts of a presentation made at the APB's anniversary convention in Colombo last week)
Traditionally, banks play an intermediary role between the providers of capital and its users, between depositors and borrowers. The vital liquidity and payment services provided by banks for its customers are a corollary of this primary function.
Why should banks exist at all? Why not eliminate the expense of intermediation, and allow the bond and equity markets to replace banks?

This has occurred to a great extent in the OECD markets, but not significantly in developing countries including Sri Lanka. There are many reasons why not, including the distortions caused by large fiscal deficits, but I would like to emphasize one set of reasons in particular, namely the below acceptable quality of information provided by many borrowers, poor corporate governance, and the deficiencies and delays embedded in many third world legal systems in enforcing rights of creditors.

Banks, rather than the capital markets are best positioned to deal with the problems of opaque accounting, or even the multiple sets of books which with we are all too familiar. Bank debt is therefore the preferred component of the capital structure of firms in developing economies. But leverage carries with it another problem, namely that of moral hazard. For a borrower, the most that he can lose is the amount of his loan. In theory, because his losses are capped to the extent of his equity, he is encouraged to take bigger risks with his investment than he would if he was using his own money.

Banks have the special skills needed both to manage and to price the risks of asymmetric information, adverse selection and moral hazard, and to deal with the legal consequences of failure of borrowers. Where these risks are high in any economy, bond and equity markets typically will take root and develop only slowly, and lending rates will reflect the high intermediation costs of risk management, which contribute to keeping the cost of lending stubbornly high.

The dominance of bank lending in an economy carries with it attendant risks, including that of over leveraging by firms, and over reliance by banks on security as opposed to cashflow lending. It is therefore desirable at a policy level, to keep raising the bar on accounting standards and disclosure at all levels, and to facilitate the widening and deepening of the capital markets, a trend, which is starting to occur in Sri Lanka. However, for the present, nobody loves banks, but everyone needs them!

"It is worth emphasizing that banks are highly leveraged institutions. Shareholders typically have 10% at stake in a bank, whereas depositors and lenders have 90%. But the consequences of failure of financial institutions can be brutal, and reach far beyond the interests of stakeholders. Bank failure is often contagious, and can cascade across whole societies and economies. "

"Banks are coming under fire today, as never before. Borrowers question why interest rates are high, while depositors bemoan their declining incomes. Banks are criticized both for their high level of non-performing assets, and for not taking sufficient risks. They are berated for earning excessive profits on the one hand, and also for not building up their capital on the other. Where does the truth lie? How efficient are our banks, and how profitable and well capitalised, in comparison with our regional counterparts?

Let me at the outset, distinguish between interest rates, and interest rate spreads, a distinction which is often overlooked by critics of banks. If we want lending rates to decrease to low single digits, macro-economic policies should be in place which lead to low fiscal deficits and inflation, and reduced cost of compliance with prudential requirements. A further point worth making is that low interest rates alone do not drive economic growth, as shown by the example of Japan, over the last decade.

Should the benefits of lower interest rates be passed on to borrowers or to depositors? The case for reducing the burden on borrowers, based as it is on the need to spur economic activity, is both merited and vocally made. However, it is simplistic to ignore the interests of the silent majority of depositors, especially in the context of the economic need for increased savings. Savings and investment are two sides of the same coin of economic growth, and a balance needs to be struck between them.

Perhaps the answer then is to keep everyone happy, apart from the bankers, by reducing the interest rate spreads of banks. This would certainly be a popular panacea, but how feasible is it in practice? The answer to this question lies in the arithmetic of the revenue and cost structures of banks.

For 2002, based on published data for the six largest public and privately owned commercial banks, rupee spreads approximate to around 5 - 6%. In comparison, spreads in India average around 2 - 3%. We therefore face the question whether bank spreads can in practice be reduced by say 2%. If this is to be done, then logically, banks must be able to reduce their costs, or their profitability must decline accordingly. Two factors therefore need to be examined, namely whether the costs of banks can be restructured without affecting their profits, and whether banks are making excessive profits, which can be reduced and passed on to their customers, without affecting their own viability.

An analysis of the profit structure of banks reveals that generally, their spreads are sufficient only to meet their costs, and that profit is generated by the magical "fee revenues and other incomes", the holy grail now being pursued by all banks. Within this structure, can interest spreads be reduced? There is no easy answer to this question. An across the board, immediate, general reduction of rates by 1% on the performing loan portfolios of the eight largest commercial banks and DFIs, would cost Rs. 6.3 Bn, which compares with their total profit before tax of Rs. 7.9 Bn. A 2% reduction across the board would cause red ink to flow across the industry. However, it must be possible to reduce spreads progressively, provided the issue of the high cost bases of banks is addressed.

Credit costs arise from revenues foregone on non-performing loans, and from provisions against doubtful debts. NPLs for the industry are estimated by the Central Bank at 15.3% which translates to around Rs. 90 Bn for 2002. On a simplistic calculation, the cost of funding these loans at say 8% p.a. is over Rs. 7 Bn, which roughly equals the profit before tax for the large local banks. Provisions made by the largest eight banks totalled Rs. 7.5 Bn for the same year. Together these add an estimated 150 to 200 basis points to lending rates. In other words, the cost of credit is high, and is likely to mount in the short term, as prudential regulations relating to NPL recognition and asset valuations, become more stringent. In the medium term, as risk processes and profiles improve, these costs should reduce. Reforms such as the proposed formation of an Asset Management Company, which will focus on recovery of stressed assets, will speed the process.

Overhead costs are also high and reduce spreads on average by a further 4%. The cost to income ratios in Sri Lanka average around 65% in comparison with 50% and less in India, and below 40% in Malaysia for example. There are two reasons for this. The first is internal to banks, and revolves around management determination to contain and reduce costs. Tough decisions need to be taken to drive down overheads. Business processes will need to be reengineered. Innovative and less costly delivery mechanisms will have to be devised. More specifically, banks will need to identify and exit from unprofitable products, relationships, assets and markets, if costs are to come down.

The legal and regulatory framework will need to help not hinder this process, if the end result of lower interest spreads is to become a reality. The second reason for high costs is structural. It relates both to the comparative lack of critical mass in the industry, and to its architecture. Net banking revenues in India for example, amount to $ 14 Bn, compared with $ 0.5 Bn in Sri Lanka. Fixed costs are therefore incurred by numerous banks individually in this country, but fragmented revenues are insufficient to support these costs for all banks. In other words, size matters in reducing costs, and this is an issue, which is related to the architecture of the banking industry.

How profitable are banks? Can reduced spreads effectively be passed on to their shareholders? The recent spate of good results by banks has aroused criticism of excessive profit making. This criticism is ill founded. Firstly, banks need to build capital to meet new regulatory requirements, and more stringent provisioning policies. Secondly, profits are only meaningful and must be judged, not in absolute rupee terms, but in relation to value added to shareholder funds, namely the premium earned over the risk free rate. In 2002, a stellar year for banks, the premium averaged around 4%, which contrasts with negative premiums in the previous two years, and a modest 2% in 1999. Premiums in the lower interest rate environments of Singapore and India, were much higher at 8 - 9%. If banks are to attract new equity capital for expansion, as they must, to meet the increased demands of regulators and a burgeoning economy, risk premiums need to increase to attract international investors.

In summary, the challenge for banks is to achieve an acceptable balance, building profits and capital, while also ensuring that its customers are well served, thereby fuelling economic growth. " FIs in Sri Lanka, of necessity paint their visions on a small canvas, an economy of some $ 15 billion. As an aside, scale is the imperative, which will drive banks to seek opportunities outside our shores, perhaps following the currents of trade and cashflows.

Two banks at present own over half of loan assets, and the big six dominate commercial banking by any measure. If you widen the definition to include the entire financial sector, eleven FIs, including the two DFIs, the NSB and the two state provident funds, out of 158 institutions enjoy the lion's share of the market. The first question that arises then, is on the future of this plethora of financial institutions.

Do they all have the scale of business and capital needed to take on the risks which they need to do, or should some consolidation take place? Do regulators have the wingspan, to encompass the activities of a multiplicity of complex entities, to ensure that minimum safety standards are in place? While there is undoubtedly a need both for competition, and for specialists, industry consolidation seems inevitable by the yardstick of institutional safety and viability, and in keeping with regional trends after the Asian crisis."

"The second question relates to the validity of the present assumption on the need for specialised banks. Should specialist institutions be permitted to expand into commercial banking, and conversely should commercial banks be allowed to take on the wider financial services presently reserved for the specialists? The question to be answered for specialised institutions, is whether the product focus that they bring, sufficiently compensates for the necessarily limited scale of their operations, and the concentrated nature of the risks that they assume. Let me answer this in relation to the changing role of the development finance institutions.

The DFIs were set up globally in the twenty years or so after World War II, in order to finance reconstruction and industrialization. They were without exception, owned by the Government and funded by multilateral agencies, who provided subsidized long term credit.

This model is long since defunct. Multilateral funding for DFIs has stopped as a matter of global policy, and whatever funds are available, are provided to all qualifying banks, including commercial banks. In fact, concessionary loans made to DFIs in the past, are now maturing, and are being repaid and replaced at higher cost and shorter tenors, on the local markets. Additionally, ownership of DFIs has largely been transferred to private shareholders, who rightly demand an adequate return on their investment. The principal competitors of the DFIs are now the commercial banks who have the tools, including current accounts, to monitor their loans more effectively, and the range of products, which the DFIs presently lack, to cross subsidize interest earnings.

It is a paradox worth noting, that the interest spreads of DFIs are on average 2 - 3% lower than those of commercial banks, despite the higher risks that they assume. In response to these problems, DFIs globally, have either transformed themselves into vibrant, market-based organisations, operating on a level playing field with commercial banks, or have perished.

DFIs therefore have no option but to seek a new role, which will ensure the continuing viability of the project lending business, by supplementing it with new banking products. I would stress that this expansion into commercial banking, is the only way, that the crucial project lending skills of DFIs can be kept alive . The need for change is not a matter of philosophy or choice, but of arithmetic and survival. " I would like to draw a distinction between consolidation of the industry, and consolidation of ownership, two concepts which are sometimes dangerously confused.

The first is inevitable in my view and healthy, if properly managed. The second is fraught with many difficult issues. A fundamental question that needs to be asked is whether Government dominance of ownership of the financial sector is desirable. It can be argued that public ownership ensures that socially essential, but commercially unviable, lending and distribution objectives, can be achieved. The argument has validity in a developing country, provided it is done in a transparent and measured manner.

The issue is one of degree - whether the Government needs to dominate the sector to the extent that it does, for such ownership carries with it certain drawbacks. These include the moral hazards arising from implicit or explicit guarantees of deposits, and the resulting impairment of the force of private sector competition.

Another fundamental question relates to the ownership of private banks. Should ownership be broad based or should business conglomerates or families be allowed to dominate despite highly adverse consequences of oligopoly in a small economy? Both models have been used in developing economies, but the East Asian crisis of 1997 highlighted certain structural weaknesses of the second. The highly leveraged capital structure of banks, casts heavy fiduciary responsibilities upon boards and management. This trustee role it was found, is not best discharged by a single dominant owner, leading as it did to issues relating to transparency, connected party lending and minority rights.

It was also found that single owners did not have the capacity or willingness to inject new capital at the time of need. As a result, many countries have taken measures both to broad base ownership, and to strengthen corporate governance, by providing a rule based framework to answer two crucial questions. Who runs banks, and for what purpose?

Back to Business