Banking sector exposed

By Chanaka Wickremasuriya of NDBS Research

The brokerage meas ures the level of fi nancial intermediation for a number of developing and developed countries using two ratios.

a) The level of Currency as a proportion of M1 (Currency + Demand Deposits) - the higher the ratio, the lower the level of financial intermediation. In countries where the level of financial intermediation and sophistication of financial transacting is high, the proportion of currency in circulation with respect to Demand deposits will be low.

b) The proportion of M2 ( M1 + Time and Savings Deposits ) against GDP. Generally, the higher the level of financial intermediation, the higher the level of M2 as a % of GDP. Note that in some developed nations, where the level of financial disintermediation is high (i.e.: where there exist developed capital and debt markets) this ratio may underrepresent the level of financial industry sophistication as a large proportion of domestic savings are channeled into debt and equity markets.

c) Finally, the second ratio is divided by the first (ie:M2/GDP) by the first (ie:Currency/M1). The higher the resulting ratio, the higher the level of overall financial intermediation.

Sri Lanka ranks very low in the level of financial intermediation, only above a few Latin American nations. It must be noted that countries like the United Sates, the United Kingdom, Germany and Japan have a high level of financial disintermediation, and hence a large amount of savings are invested in bonds and equity instruments rather than bank deposits. South East Asian countries also show a high level of intermediation due to a large % of M2 over GDP. This is because of the high level of international short-term debt held by these countries even at the end of 1997. An NDBS Stock Brokers report on Commercial Banking sector says that Sri Lanka has some way to go in improving its level of financial intermediation, and commercial banks have an important role to play in this regard. While it can be argued that this will necessitate the liberalization of capital account transactions given the country's low savings rate, the first ratio (i.e. : currency/M1) is still indicative of the low level of sophistication in the overall financial transacting process.

Performance of Sri Lanka's Banks in the International Context

NDBS modified version of the Dupont Analysis presents a breakdown of a banks income and costs as a percentage of average assets. ROEs for a number of local and foreign banks are calculated based on their latest available annual or quarterly reports. We first present the averages obtained from five (5) local commercial banks and six international banks listed in order to observe and analyse some of the differences between Sri Lanka's commercial banking industry and international practices and norms.

The most glaring difference is in ROE. However Sri Lankan banks' ROE is in rupee terms, and given the average depreciation of the currency (against the US dollar) at around 10% pa and a theoretical risk premium of 2-3% for Sri Lanka, the ROE of 23% seems inadequate. (Note that the average ROE for international banks rises to 16% if Bank of Tokyo-Mitsubishi's ROE of negative 38% is disregarded). Hence from an international investors' risk-reward perspective, Sri Lankan banks are yet to provide attractive returns.

On the upside though, Sri Lankan banks are operating at much lower gearing levels than their international counterparts, and this presents the local banks with theoretically more room to lever themselves for greater asset growth and shareholder return. There are some issues with regard to this though:

All banks ( both local and foreign ) are required to adhere to Basle standards of capital adequacy. The required total capital ( tier I + tire II ) to risk weighted assets ratio is 8%, and Central Bank authorities are looking into the possibility of raising this to 10% for local banks.

Most international banks operate at much higher gearing levels since they carry a higher proportion of subordinate debt that qualifies as Tier II capital, a practice that local banks have now caught on to, though it is still a very small component of total capital and liabilities. Since most of the issued debentures / notes were taken up by state institutions like the EPF, ETF, NSB and the Insurance Corporation, and given that a persistent budget deficit continuously taps into their resources, and public appetite for such long term savings instruments is poor, it is doubtful that banks will be able to continue to use this method to pad up their tier II capital.

Yet another issue is the overall asset quality and level of provisioning by Sri Lankan banks. Local banks still do not write down loans under internationally excepted guidelines, and only provide for assets in arrears for 6 months or over, as opposed to international norms of providing after 3 months. There are also the issues of:

* Overall classification of loans - ex: restructuring payment schemes as of audit dates ,

* Monitoring and auditing standards - lack of expertise and experience by central bank supervisors and general audit staff - particularly with regard to identifying non-performing assets.

* Accounting of government guaranteed loans - state guaranteed loans are rarely provided for while their risk weighting is zero, and repayments usually take the from of re-capitalising bonds

* Valuation of security - property is valued at "market prices", but illiquidity usually brings down prices at time of disposal

Hence, though local banks are operating at higher capital ratios (ie: lower gearing ) their actual level of outstanding capital is difficult to ascertain due to inadequate provisioning, and in all probability lower than stated. Possibly in recognition of this the Central Bank intends to bring in international guidelines for provisioning by 2000 or 2001, together with the higher Capital requirements.

Before dealing with the thorny issue of mar gins, some interesting 'experiments' are worth a mention on the above figures. Assuming the cost and income structures for local banks remain the same under all gearing levels (this is a plausible assumption even with regard to Net Interest Income margins which theoretically fluctuate with gearing, as Seylan, which operates at a similar gearing to international banks, still posted a NII margin of 4%), and we give local banks the same capital : assets ratio and effective tax rate of international banks, the ROE for local banks jumps to 31%. But there lies a snag : local banks post a high level of foreign exchange income. If we reduce this level to international norms, the ROE of 31% plummets to 18%. The reason we point this out is that Sri Lanka still functions under a closed capital account system. Though there are free current account transactions, conversion of large volumes to and from foreign currency is still strictly regulated, hence the heavy demand by the public for foreign currency has given the banks the ability to maintain large spreads between buying and selling rates, incurring good revenues with little to no cost. In fact if Seylan bank's forex income was eliminated, the bank would have actually posted a loss for 1998, and if we bring the level of forex income down to international norms on the previous table, the ROE for local banks would stand at a paltry 13%.

It is obvious that Sri Lankan banks benefit from much higher margins than international banks. Rather than deal with the ethics of this, look at it purely from a numbers point of view. It is clear that if foreign banks also operated under similar margin structures, their ROEs would go through the roof. Time and time again state banks have been criticised for their inefficient cost structures, non-performing loan portfolios and high margin environment that private banks have purportedly exploited, but a closer comparison reveals that even the private banks do not fare that much better.

While there could be debate that margins (as calculated as Net Interest Income / Total Assets) will decrease with increased gearing, the experience at Seylan proves otherwise. Banks should be criticised for maintaining anomalies at both ends of the spectrum.

While undoubtedly yields have been high due to the generally high interest rate structure, rates have been kept abnormally high in order to compensate for non performing portfolios and general inefficiency, while interest paid to depositors has also been skewed down with guilt edged instruments paying a higher rate than bank deposits.

The question is where do the benefits of these high margins end up. While part is reflected in the ROE, most of it is absorbed by high personnel costs and operating expenses. Hence shareholders do not benefit from the much-touted high margin structure, as it is lost in general inefficiency, both with regard to manpower use and overhead expenses. In fact, total expenses including salaries, other overheads and depreciation add up to a whopping 4.02% of total assets for local banks, as opposed to 2.18% for the six international banks. If local banks can better structure these non-interest costs, the difference of 1.84% can in theory be used to bring down lending rates, increase deposit rates or increase shareholder return, or all three. (Note that the 1.84% of assets can translate into an average 3.0% decrease in lending rates as leases, bills and loans are only around 60% of total assets !)

This does not at all bode well for the future the financial industry, or the general economy for that matter, as inefficiencies in the financial sector necessarily percolates down to remaining services and industries in the form of high financing costs and low savings rates. And if some state policy-makers' ambitions of making Sri Lanka into a regional financial center are to come true, these inefficiencies will be have to be done a way with - soon, and in our opinion nothing short of privatization of the state banks and further liberalization of foreign ownership of local financial institutions will suffice. (Note that by this year foreign banks operating in Colombo will be required to publicly disclose the performance of their branches, and it will be interesting to see the relative differences in operating efficiency vis-a-vis locally owned banks)

Next a look at individual banks in Sri Lanka and a comment on their existing cost-income structure and possible future outlook.

Some Notes on International Banks

Note that Bank of Tokyo-Mistubishi posts a negative ROE due to the unusually heavy provisioning incurred in 1998 and our averages include BTMs performance. Effective tax rates in developed countries is higher than in Sri Lanka, particularly in Germany. HSBC, Natwest and ANZ are three banks that generally concentrate on a higher level of funds based income and hence their margin structure is best representative of what is internationally accepted. Chase Manhattan closely resembles a merchant bank and has a high proportion of off balance sheet liabilities (and low gearing) and therefore a high level of fee income.

Note that all banks, ex cept NDB, post NII margins of over 4%. Bank of Ceylon clearly defines the inefficiencies of the industry with a personnel cost ratio of 2.12%. This is a staggering figure considering the huge asset base of around Rs 153bn ( Approx. 30% of the total market share ). In general we would expect banks to reduce their personnel cost ratios as assets increase due to greater economies of scale, but this is clearly absent in the case of state banks. Note that the private banks, particularly Seylan, do not fare that much better and ratios are still much higher than international norms. Sampath posts the best personnel cost ratio out of the commercial banks while the most glaring inefficiency is in the area of other overheads.

This is true for all banks and we believe that this is due to both the poor (read inefficient) use of technology in the overall financial sector and high advertising costs in the face of stiff competition. While banks have been moving toward greater use of technology in the last few years, banks like HNB and Seylan will still find it difficult to optimize its use due to their already high level of gearing, staff and physical overheads. Banks like Commercial and Sampath are relatively better positioned to maximize the use of technology and still lever themselves toward greater asset growth over the medium to long term while keeping their cost structures under control. (Note that Sampath is yet to go the way of the other three listed banks and issue debentures to boost tier II capital, and management is more than likely to contemplate such a move). Of course whether the management of these companies are aware of these problems and are concentrating on such strategies is a moot point.

Note that while Sampath posts the best ROE, if we present Commercial Bank with the same gearing and existing cost and income ratios, it too would post a ROE of over 24% and we believe Comb has the best opportunity to maximize the use of technology in its future levered growth. HNB, though posting a high ROE, is constrained by its already high level of assets : capital and the previously mentioned high level of staff and overheads.

While we have not included NDB in our calculation of averages for the local industry, we have included it in the above table for the benefit of observing the different environment / cost structures under which the DFIs operate.

While yields are higher than average due to the long term nature of advances, interest costs are also high due to international commercial borrowings and rates fixed at high AWDRs, giving NDB the lowest margins, and note that this is at a very low gearing level and therefore actual spreads are substantially lower than that of commercial banks.

The DFI's also do not have the benefit of current account funds unlike commercial banks, putting them at a slight disadvantage (we say slight since a large proportion of C/A funds of commercial banks are offset by statutory reserves).

But more importantly, the DFIs have still to capitalize on their classification as 'licensed specialized banks' and move into aggressive deposit mobilization.

With the gradual drying up of international concessional lending (ie: ADB, WB ), the future for the DFIs most certainly lies in the direction of commercial banking operations. While NDB will be looking to lever itself on its high capital and bring its interest costs down via deposit mobilization, it will also necessarily incur higher personnel and overhead cost due to branch expansion and related expenses.

Its relative success therefore will depend entirely on how cost effective it will be (relative to commercial banks) and this would hinge upon a more efficient use of human and technological resources.

Ceybank Unit Trust re-structures portfolio

Ceybank Unit Trust will reconstitute their investment strategy to take advantage of the bearish market sentiments and to facilitate dynamic trading strategies to suit economic conditions, a top company official said.

The re-structuring would enable the Fund to maintain stable dividend policy in the future irrespective of the equity market movement.

The proposed investment strategy will require re-allocation of Ceybank Unit Trust's assets and restructuring its portfolio, to see rapid recovery of its unit prices in a market recovery to provide enhanced returns to its unit holders, CEO Unit Trust Management Co. (Pvt.) Ltd., Dheerendra Abeyratna said.

The Colombo equity market took a severe beating over the last four years due to turbulent conditions in the regional economies, lower economic growth in Sri Lanka and the negative sentiment of foreign fund managers towards the region.

The crisis has affected the fundamentals of some of the listed companies and their prices have fallen sharply with the heavy selling of both local and foreign investors.

With the negative sentiment towards the region, foreign investors continued to sell stocks even with strong fundamentals and the end result was the sharp decline in prices of large market capitalised, liquid stocks which has higher foreign holding.

"Therefore, it is necessary to reformulate the investment strategies of Ceybank Unit Trust to effectively exploit the depressed market condition to achieve medium term growth," he said.

The proposed strategy will envisage the following:

The Fund will reduce the number of equity holdings by divesting stocks with very low market liquidity and have shown deterioration in their economic fundamentals.

The equity portfolio on stocks will be re-focused, to ensure they have a high market capitalisation and high market liquidity with sound economic fundamentals to achieve rapid earnings in a market upturn.

Provide for diminution in value of its equity holdings, which resulted due to the sluggish domestic and global economic situations.

Increase the allocation in the fixed income securities with the view to enhancing and stabilising the annual dividend distribution to the unit holders.

"The above strategy would not affect the net asset value of the Fund and the realisable value for the unit holders as the present net asset value reflects the market value of all equity holding net of the portfolio depreciation," Mr. Abeyratna said.

The fund manager believes that the successful implementation of the asset re-allocation strategy and re-structuring of the portfolio will lead to the rapid recovery of the unit prices in a favourable market movement.

This strategy will increase the Fund's allocation in fixed income securities within the parameters of the Unit Trust Code with the objective of enhancing the dividend distribution to the unit holders.

The managers have commenced the implementation of the above strategy since end 1998 and it will be reflected in the financial statement for the year 1998/99.

This exercise will be carried out gradually over a twelve-month period to maximise the divestiture proceeds while making minimum impact on the market.

The income of Rs. 16.7 mn brought forward from the previous year and the net interest and dividend income of Rs. 35.8 mn as at February 28,1999, is retained, pending the full implementation of the above strategy in order to absorb a portion of the provisioning.

Hence, the Fund did not declare a dividend as at March 31,1999.

The provisioning for the diminution in value of equity holding will enhance the future income of the Fund as that will enable the fund managers to exploit trading opportunities by rapidly moving between stocks, thereby realising capital gains.

The Fund awaits the approval of the Securities and Exchange Commission (SEC) for its provisioning policy and the policy on future income distributions.

The SEC has appointed a sub-committee to examine the matter and recommend the best course of action suitable considering the unique nature of the industry.

Ceybank Unit Trust was launched on March 25, 1992 with the view to providing a reasonable return by way of capital appreciation and income by investing in the equity market.

The recent performance was hampered due to the sharp fall of blue chip stock prices. Ceybank Unit Trust has 72 per cent exposure in the equity market and the balance of approximately Rs. 217 mn is invested in liquid fixed income securities providing stable returns.

The Fund has distributed a total of Rs. 581.7 mn over the last six years, which accounts for Rs. 5.15 per unit held by the investor.

Easy NDB loans for micro finance

By Shevan de Simon

National Development Bank (NDB) has come up with a scheme to arrange loans for micro enterprises and self employment projects, through the NDB branch network and Sarvodaya.

"The implementation of the scheme was initiated last week," Senior Manager, Re-finance Operations, R.D. Gunapala told The Sunday Times Business. The bank has already approved two self employment projects, a manufacture project and a transport project. "Sarvodaya which has signed an agreement with us is also coming up with a few projects," Mr.Gunapala said.

"Any economic scheme with fixed value assets not exceeding Rs.2 Mn is eligible and is open to all sectors," he said. Sarvodaya a non-profit organisation has been engaged with these type of schemes implemented through co-orperative projects.

The maximum loan for the scheme is Rs. 250,000 per enterprise. The loan will be given for a 5 year period with a grace period of one year at concessionary interest rates.

The applications made through Sarvodaya and NDB branch network will be given to the NDB finance operations department for approval. NDB will also play the role of the apex institution to administer the funds of the credit line.

Payphone operators in the net

Telecommunication Regulatory Commission (TRC) is to bring payphone operators within the TRC law by making them re-sellers of telecommunications services, The Sunday Times Business learns.

Payphone operators who previously had no status with the telecom regulatory law, are now considered to be re-sellers of telecom services under an amendment to the TRC Act.

The amended TRC Act of 1996 (section 18a) makes it an offence to re-sell telecommunication services without the TRC's permission.

This rule applies to payphone operators as well as communication bureaus scattered islandwide, Director Economic TRC, Palitha Gunawardena said.

However, the rule does not affect two operators, The Payphone Company Ltd. and TSG (owned by IWS Holdings) who have obtained direct licences from the TRC.

Water protests seen growing in Sri Lanka

By Feizal Samath

Some years back, angry rice farmers forced open the sluice gates of a large reservoir in Sri Lanka and directed water to their fields when irrigation officials said the water was only for domestic consumers. Last month, a group of domestic consumers took out a small street protest in Borella demanding that their water supply be increased from the few hours they receive now. In the south at Hikkaduwa, a similar protest took place by consumers, urging water cuts to be abandoned.

Households in Anuradhapura have been getting just two hours of water a day for the past decade and consumer protests have been of no avail.

The battle for water in Sri Lanka is growing and experts say the water protests are similar to water problems seen in India, where the tussle for water is between farmers, industry and domestic consumers.

"The situation of water protests in India is slowly coming to Sri Lanka," believes M. Wickremage, director of the state-run Water Resources Secretariat.

Economic development, population pressures and growing demands for food production, electric power, and adequate water for domestic and industrial users and sanitation services are placing increasing pressure on the country's water resources.

And with industry expanding much faster than neglected farmlands, pressure is also building up on the need to provide more water resources to industry than to farmers. Irrigated agriculture consumes 70-80 percent of Sri Lanka's water resources while domestic users take about 8 to 9 percent. The rest is used by industry and smaller users.

In Sri Lanka, all the river basins in the dry zone are facing a serious water scarcity. In future irrigated agriculture would have to be a lot more efficient and in many cases may have to be reduced to meet other demands for water, says Douglas J. Merrey, Deputy Director-General of the Irrigation Water Management Institute (IWMI).

"Two years ago in Anuradhapura, I saw this big demonstration by farmers who were not allowed to grow rice using water from tanks which were reserved for city use. In the city itself there are water restrictions," he said, adding that competition was growing for water use between irrigated paddy and domestic use. "This situation is going to get worse," he warned.

Experts say that irregular rainfall and the loss of retention capacity of the natural water system is causing some of the problems of depleting water resources. Rain provides the bulk of Sri Lanka's water requirements with little coming from groundwater.

Sri Lanka has 103 river basins and annual rainfall amounts to an average of 127 to 132 billion cubic metres of water, according to official figures.

A government document says that though Sri Lanka has an overall average precipitation of more than 2,000 mm per year, the monsoon climate and national geography "create substantial variability in the amount of water that is available both locally and temporally."

It noted that projections for the year 2000 show that expected demand for water far outstrips supply, particularly in the country's dry zone where most of the irrigation schemes are located and "the estimated future annual water deficit is estimated as 2,500 million cubic metres."

Other studies reveal that at the current rate of irrigation efficiency in Sri Lanka, several local rice-growing districts would face water shortages in the future. "Some of these districts will be in serious water scarcity conditions that the available water resources may not even be adequate to meet their projected demand," an IWMI study said.

IWMI, established in 1984, has been undertaking global programmes to improve food security and the lives of poor people through fostering sustainable increases in the productivity of water used in agriculture through better management of irrigation and water basis systems.

Headquartered in Colombo, the institute has country programmes in Burkino Faso, Pakistan and Sri Lanka and project offices in Mexico and Turkey. IWMI is supported by over 20 governments and donor agencies including the Asian Development Bank and the Food and Agriculture Organisation.

Nanda Abeywickrema, a Sri Lankan water specialist, told a recent discussion on integrated water resources management that the public sector may soon lose the control that it has on water resources to the private sector.

"The private sector is the engine of growth in Sri Lanka and the time will come when they would have a bigger say in the use of water resources," he told the meeting organised by the South Asian Technical Advisory group of the Global Water Partnership (GWP-SASTAC).

Mr. Abeywickrema, a member of GWP-SASTAC, said that the group was planning another consultation next month to discuss the formulation of a "vision" of Sri Lanka's water needs into the new millennium.

There has been no national policy for the allocation of water for diverse uses so far, but a proposed National Water Resources Policy prepared by the Water Resources Secretariat - currently being studied by the government - may provide some relief to water users. The plan, presented at the GWP-SASTAC meeting, lists out water rights and allocations and says that the right to use water would be granted through a process of water entitlements.

It also has provision for the voluntary transfer of water entitlements between entitlement holders; the development of river basins; a water management cost sharing basis and the development of groundwater resources.

Another important segment in the proposed policy is the setting up of a water tribunal, which as an independent body to resolve disputes over the use of water.

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