Bank consolidation an alternative to parate execution to ensure stability

By G De Silva

 Much is being spoken of in recent days about parate execution and its adverse effects on the wider economy as a result of the destruction caused to SMEs. Proponents of parate execution including the Central Bank Governor argue the need to continue parate execution in order to maintain banking sector stability. While both parties may have a strong rationale for their respective points of view, one should also look at alternative courses of action that would end up in a win win situation for both parties. In such a scenario one should actively and urgently consider bank consolidation to create large banks that would establish banking sector stability and in turn facilitate a more lenient enforcement of parate execution.

Large banks, with a far superior ability to access capital markets to raise Tier 1 capital and the ability to achieve high levels of profitability are just two benefits that would arise from bank consolidation that would establish banking sector stability. It is an undisputed fact, recognised the world over, that large banks are more stable and are in a better position to withstand stress caused due to economic calamities. Smaller banks are more vulnerable to organic growth being hampered by Non-Performing-Loans (NPLs).

Larger banks raise funds on larger scale

Capital adequacy can be improved and cost of funds lowered due to larger banks having the capability to raise funds on a much larger scale through capital markets than its smaller counterparts. Limitations caused by restrictions imposed by the Central Bank on ownership of issued capital carrying voting rights can be eased when there is a significant quantum of issued capital. Local and foreign funds including funds from institutions created by the World Bank such as the International Finance Corporation and high net worth individuals can be attracted due to large banks having the ability to offer investments that are large enough to meet their minimum investment criteria.

Large banks are very rightly considered to be more stable and capable of sustaining earnings per share that investors would expect. This would in turn result in these banks having better ratings than small banks. In the light of the foregoing large banks can have successful rights issues at lower premiums and offer Basel compliant debentures at lower interest rates than smaller banks.

Banking sector consolidation in Greece

Banking sector consolidation was necessary to overcome the capital erosion caused by high NPLs during the financial crisis in Greece. A successful bank recapitalisation exercise supported by private sector participation took place in Greece after its banking sector completed a consolidation exercise that reduced 18 commercial banks to 4 large banks. At the time, Greece’s Central Bank governor Provopoulos noted that “the reception by markets of our stress test results was extremely positive, with both Moody’s and Fitch releasing statements that their assessments were similar to ours.” “The reception has set off a chain reaction with three of the systemic banks re-entering the markets with highly successful capital increases. The fourth systemic bank has also launched a capital increase which I expect to be successful. Last month’s rights issues by three systemic banks, Piraeus, Alpha, and Eurobank, for a total of €5.9 billion were heavily subscribed.”

The ability to raise funds at a much lower cost than smaller banks would positively impact Net Interest Margins (NIMs) of the larger banks. The much bigger customer base that larger banks possess results in much higher Current Account and Savings Account (CASA) ratios. NIMs will be further boosted due to the higher CASA ratios enjoyed by these large banks.

By parate execution, banks try to avoid the adverse impact on NIMs as a result of having to suspend recognising interest on their NPLs. The positive impact on NIMs that large consolidated banks would enjoy as a result of raising low cost funds and the very low cost funds available to the larger banks as a result of high CASA balances, place these banks in a position to absorb the effect of having to suspend interest on NPLs. In such a scenario differing parate executions can be justified.

Bank consolidation increases profitability, lowers risk  

Several factors can positively influence the profitability of larger banks that are created through bank consolidation. Large banks can utilise its bigger loan portfolios and depositor bases to have stronger loan growth and deposit mobilisation. Attractive interest rates that can be offered to borrowers by larger banks would lead to credit expansion and customer accumulation with minimal credit risk. 

This, together with high deposit inflows will contribute towards lower liquidity risk in these banks. 

There may even be a reduction in NPLs if these banks offer attractive interest rates and repayment schedules. It goes without saying that all this would invariably lead to high levels of profitability in the banking sector. Due to the scale of resources available to them, larger banks will be capable of increasing profitability while lowering risk, by refining its credit evaluation systems to improve accuracy and implementing efficient compliance and risk management systems and processes to support its capacity to operate on a much larger scale.

Of the 10 listed Licensed Commercial Banks (LCBs) operating in Sri Lanka, three Domestic Systemically Important Banks (DSIBs) with the highest asset size had an average cost income ratio which is 12.5% lower than the smaller banks. This clearly shows that size plays an important role in profitability.

Larger banks created through amalgamations would have high levels of capital funds that would enable the granting of much larger facilities without violating single borrower limits set by the Central Bank. The resulting economies of scale will bring down cost income ratios.

The cities and towns in Sri Lanka have a high concentration of bank branches, in most cases within less than a kilometer of each other. Premises and establishment costs form a significant part of the operating expenses of an LCB. Bank consolidation will open the door to branch rationalisation that would result in significant reductions in cost income ratios since fewer branches will serve the same customers. Enhanced digitalisation will further augment such an initiative.

Bank consolidation will also create opportunities for operations rationalisation backed by digitalisation. Infrastructure for branch administration, compliance, risk management, accounting and back office operations will only be required for the surviving entity that will have the resources to invest in digitalisation to increase productivity. This will lead to a significant reduction in operating costs and an appreciable increase in net operating incomes.

Cost reduction

The possibilities of cost reduction due to bank consolidation was emphasised by the Finance Minister of India Nirmala Sitharaman when she repeatedly spoke of “large cost reduction potential due to network overlaps” during the press conference to announce the first round of the recent Indian bank consolidation program.

This clearly shows how objectives of maintaining capital adequacy and profitability could be achieved through bank consolidation. 

Thus there will be no urgency to resort to draconian measures such as parate execution to lower NPLs and preserve capital of banks if a bank consolidation program is commenced without any further delay. 

In the light of the foregoing, it is surprising that the CBSL does not see the urgency for bank consolidation in order to stop the serious damage to the already battered SMEs that form the backbone of our economy.