Depositors have no voice in bank operations

Firstly, banks are largely funded by thousands of depositors, who have no knowledge of, or voice in, how the bank is being run. Board, management and regulators therefore act as trustees for depositors. Maintaining sufficient capital to mitigate the risks that banks take is a powerful tool in discharging their fiduciary responsibilities. Secondly, as was demonstrated during the Asian banking crisis, the systemic and economic impact of bank failure is very high. Banks therefore need to be managed, regulated and capitalized, differently from other companies.

NDB CEO Nihal Welikala, in an interview with The Sunday Times FT responded to a series of questions on the progress of the Bank after its merger, provisions of the Banking Act relating to shareholding restrictions and proposals contained in the budget. Excerpts

It is over a year since the merger between NDB and NDB Bank. How successful have you been in the merger?
NDB is a bank which has repositioned itself from being a state owned development bank, funded by multilateral agencies, to a privately owned universal bank with independent funding. Our strategy and its implementation fall into two phases. Phase 1 built solid foundations for change. This included the agreement of a long term business strategy, legislative change which resulted in NDB acquiring a commercial banking licence last August, the acquisition of ABN Amro Colombo and its subsequent merger with NDB, the rationalisation of subsidiaries and associates, introduction of an array of new banking products to supplement project finance, together with supporting systems and processes, major changes in human resource management to deal with the new challenges of scale and complexity, a substantial reduction in the cost of credit, with a non performing loan (NPL) ratio which is among the best in the country, and strong profits and capital. Although work under Phase I is a continuing journey, we are sufficiently confident of the solid nature of our foundations to launch into Phase 2, to expand the scope of our business and to build scale.

What are your aspirations now – post merger?
Our aspiration is to become a “World Class Sri Lankan”. This is not just a catchy slogan, but is reflected in our positioning and strategies. There are three aspects to our strategies.

Firstly, we need to cater to the needs of businesses, ranging from SMEs to the largest corporations. Secondly, as a country’s per capita income grows, the aspirations of individuals also increase. Aggressive multinational banks are rushing to fill the consumer financing space, based on global products, brands and systems. We believe that there is no reason why local banks cannot build their competencies to match them. NDB will systematically reposition itself from being a niche player, to reach the mass market, using innovate strategies on distribution, technology and products, while building our brand. We need to invest consistently for this purpose over the medium term. The benefits for the bank will include building a stable deposit base, and diversification of revenue streams and risks.

Thirdly, we are already market leaders in the capital markets area, in debt and equity issues, through our subsidiary NDB Investment Bank. We also have a strong partnership with our associate company Eagle Insurance and Aviva of UK. This is more than just a profitable investment. It enables banking and insurance products to be synergised through bancassurance.
To make this happen, you need among other things, excellent systems of measurement, and to link individual rewards to corporate goals. We have come some way along this road. It is important that we complete the journey quickly.

What are the challenges facing the banking industry today?
Capital, profit compression and competition. Policies relating to ownership and governance will also affect the future of banks. Prudential capital requirements have been increasing globally and in Sri Lanka, and this is a continuing trend. This tightening recognises the fact that banks are different from other commercial entities in at least two respects. Firstly, banks are largely funded by thousands of depositors, who have no knowledge of, or voice in, how the bank is being run. Board, management and regulators therefore act as trustees for depositors. Maintaining sufficient capital to mitigate the risks that banks take is a powerful tool in discharging their fiduciary responsibilities. Secondly, as was demonstrated during the Asian banking crisis, the systemic and economic impact of bank failure is very high.

Banks therefore need to be managed, regulated and capitalized, differently from other companies.

The Tier 1 and 2 capital requirement has effectively been increased to over 10 percent with the recent change by the Central Bank in asset risk weightings. Basle 2 will also increase the need for capital in about one year’s time.

New capital will have to be raised if banks are to grow. An important source of capital growth is profit retention. However, profits are being compressed, not just by competition, but by fiscal and policy actions.

The new requirement to create a general provision of one percent against performing loans will reduce profits after tax for the industry by around Rs. 10 billion over two and a half years.

Further, the effective tax rates on banking income have progressively been increased to around 60 percent.

The cost of credit includes both provisions for doubtful debts as well as the interest carrying cost of these loans, as NPLs produce no income, but need to be funded.

Additionally, the overheads of the industry as measured by a cost to income ratio of around 60 percent, is also not competitive with the best banks in the region.

This is partly due to the fragmented nature of the industry.

Consolidation of banks will enable larger entities to absorb better the fixed costs of technology and distribution, for example. The fragmented, high cost paradigm of local banks allows foreign banks easy market penetration, as seems to be happening in consumer banking.

Where is NDB in terms of the one percent requirement?
NDB is in a relatively strong position, as it has already created a general provision of over Rs. 200 million.

What are your thoughts on consolidation in the local banking industry?
Consolidation is desirable, but unlikely to happen in my view, until the architecture of the banking system, including ownership and governance is redefined at a policy level. Mergers also pose complex challenges to management, which we need to plan for now, if we are serious about consolidation.

The Sri Lankan banking industry needs to consolidate if it is to be competitive.

However, I would like to emphasise that consolidation does not mean the consolidation of ownership which results in the creation of difficult issues of governance and monopoly, but consolidation of the operations of banks, in order to optimise cost efficiencies and capital usage.

Your comments on the new rules on dividend payments:
The new rules on minimum dividend payment will also add pressure on capital. Capital accumulation through profit retention is therefore becoming more difficult in these circumstances. On the other hand, if fresh equity is to be raised, investors will look not just at the bottom line profit. It is the percentage return on funds invested that matters. Investors compare the after tax return on shareholder funds, with the risk free rate in this country, and against similar opportunities globally. Sri Lanka is in competition for global capital if banks are to grow, and we need to recognize this, both at bank and policy levels.
Improving profitability is not merely a matter of taxation. The efficiency of banks needs to improve, if we are to be competitive against multinational or regional banks. The industry level of nonperforming loans has reduced from 14 percent to eight percent, but it is still too high compared with our regional competitors.

What are the ownership and governance issues which face banks today?
Banks are funded largely by depositors, who have no voice in how banks are run. Regulators therefore need to ensure that the fiduciary responsibility owed to depositors, is efficiently discharged.

Broad based ownership is one tool which is used to ensure that no single owner can use his position to use depositors’ funds improperly. In the larger markets, broad based ownership results in practice from the enormous market capitalisation of banks. It is beyond the reach of any single individual however rich, to buy control of Citigroup or NatWest Bank. In thinly capitalised markets like Sri Lanka, this does not hold true.

It is affordable for a small group or even a single investor, to take dominant control of a bank. Single ownership is therefore limited by legislation to 10 percent, unless Monetary Board approval is obtained to exceed this limit.

How do you view this rule?
The problem lies in the implementation. The burden is cast on the bank to ensure that no single entity, either singly or through nominees or acting in concert, owns more than 10 percent of capital.

To discharge this burden, the bank is therefore required to know the beneficial owners behind its shareholders, and whether they are acting in concert.

This is an onerous responsibility, especially if shareholders chose to hide their identity behind a veil of corporate secrecy in some far away tax haven, or to act in concert. In my view banks should not take on this burden alone. It should at the least, be shared by the bank and regulators, with both entities of course being held accountable through the judicial process.
Depositors should also be protected in my view, by a mandatory governance code for banks.

The three vital questions of governance - who should own banks, who should run banks and for what purpose need to be clearly answered as a matter of public policy. The dividing line of rights and responsibilities, between shareholders, boards and management, should be precisely defined, and rigorously implemented in practice.

Mandatory ownership limits will matter less, if mandatory governance rules ensure independence of boards and management, while defining their responsibilities and ensuring accountability. Relaxing ownership limits either in theory or in practice, without enforceable governance, is a high risk strategy.

What are the ownership issues faced by NDB?
In the case of NDB, where we have been unable to satisfy ourselves that the Banking Act rules on ownership have been complied with, we have not registered the shares in question, in accordance with the law and our own Articles of Association. We have requested the owners of these shares either to comply with the law or obtain Monetary Board approval for the exception. Where these shareholders want to exit, the matter is more complicated than a normal sale, for example because of the existence of unregistered bonus shares. We have worked with our lawyers to arrive at a legal process to validate and facilitate such sales, and this is being discussed with the parties concerned.

What is the impact of the changes in the budget?
There were three changes relating to banks which were introduced in the recent budget. However, the real issue for banks relates to earlier increases in income tax and financial services VAT, which resulted in banking income being subjected to an effective tax rate of nearly 60 percent and the effect of the VAT charge is to increase the costs of every bank employee by 20 percent. This tax rate needs urgent review, in my view.

In the deemed dividend tax, any bank with a dividend payment of less than 1/3rd of distributable profits will be taxed at the rate of 15 percent on the difference between the 1/3rd and the amount distributed. NDB’s payment ratio has historically been higher than this level, so it does not directly affect us.

Dividend policy and capital structure are complicated issues, on which the standard theoretical framework was laid down many years ago by Modigliani and Miller, and developed subsequently. If we recognize the existence of these complications, but set them aside for the moment, two issues need to be addressed. Firstly, should a firm make a minimum dividend payment each year, to benefit minority shareholders at the least, and secondly if it does not, should it be taxed to encourage it to do so?

Whether a dividend should be paid and to what extent, depends largely on the availability of free cash flow i.e. cash flow after proposed capital investments. This in turn depends on whether the firm is in a growth or mature cycle. If the former, and if growth results in higher returns for shareholders, then it is better to invest than to pay out.

However, the problem arises, if a slow growth company with a low rate of return on shareholder funds pays low dividends, and uses retained profits as zero cost funding to the detriment of minority shareholders. If taxation is to be used to encourage dividend payment, care must be taken to ensure that residual cash flow after investment is the basis for applying the tax.

My view is that a simple tax formula may be too broad an instrument to use to shape dividend policies of firms with very different investment needs. Tax policy may not be the right instrument to protect the rights of minority shareholders.

In the doubtful debts policy, the maximum deduction from profits for tax purposes is to be limited to one percent of loan balances. The limit is set high and therefore should not impact most banks in practice. However, at a time when banks are being encouraged to increase this cover for doubtful debts, it is not easy to understand the principle behind the ruling.

The VAT input credits may have a significant impact on the leasing industry, and I believe the issues are now being studied.