International acceptance of bank consolidation and its benefits

The merging of bank branches in areas where there is a high concentration of branches will increase profitability of these branches when 

supported by information technology that can enhance branch productivity

By G. De Silva

There is no dispute that strong stable banks with good credit ratings can raise lower cost funds, that branch rationalisation and expansion of geographic footprint can facilitate financial inclusion without increasing cost income ratios, that upscaling is a prerequisite to make investments required to enhance digital capabilities without increasing cost income ratios and that economies of scale can bring down cost income ratios. These possibilities have been very clearly articulated by individuals holding very responsible positions and monetary authorities in many large and advanced economies.

International acceptance

Announcing the first merger of 29 public sector Licensed Commercial Banks (LCBs) to 12 LCBs in August 2019, Nirmala Sitharaman the Finance Minister of India had this to say: “The large capacity of one bank, the technology driven capacity of another and the strong deposit franchise the third has, are all being brought together, so Punjab National Bank, Oriental Bank of Commerce and United National Bank will be brought together and they shall form the second largest public sector bank.”

She also stated that these mergers would give the combined entities a high CASA (Current Account Savings Account) and lending capacity, large cost reduction potential due to network overlaps and rationalisation, cost saving and income opportunities for the joint ventures and subsidiaries.

The following is stated in an IMF working paper prepared after a bottom-up analysis of 386 Italian banks at the end of the financial crisis in 2017. “…profitability is expected to improve as the economy gradually recovers, operational efficiency gains are nonetheless needed to restore large parts of the banking system to healthy profitability. Banking system consolidation can play a role in facilitating such efficiency gains.”

Fitch Ratings-Milan, London in a report issued on 18 February 2022 states, “The Italian banking sector has been reshaped by consolidation in recent years, particularly in the second-tier segment. Cost-cutting is a driver for inorganic growth, particularly given inflationary pressures. Mid-sized banks have limited scope to reduce costs by themselves, but consolidation with other banks can generate good opportunities to cut costs by rationalising internal functions and processes, reducing branches and office space, and accessing cheaper funding.”

A statement issued by the Bank Negara Malaysia towards the end of the Asian Financial crisis (in 1999) contained the following statements on bank consolidation. “…what the Government has done now is merely to accelerate the consolidation process to ensure that the banking system is well-positioned to meet the growing and changing demands of the economy. The rationale for doing it now is that the sooner the consolidation takes place, the better it is for the Malaysian banking system.”

“Although the merger process would result in some rationalisation of branches and staff relocations, the economy, over the longer run, would benefit from a re-energised, more competitive and efficient banking sector. The cost of banking services in Malaysia would also decrease significantly on the basis of economies of scale.”

The Monetary Authority of Singapore is of the view that the Singapore market is too small to support more than two major local banks, and that further consolidation and mergers will help banks to achieve economies of scale and compete internationally, or at least regionally.

The Hong Kong Monetary Authority is of the view that merger and acquisition, if properly executed, offers a potentially effective means of generating shareholder value through creating synergies that can increase revenue and reduce cost. 

The Financial Services Authority of Indonesia in its strategy document ‘Roadmap of Indonesian Banking Development 2020 – 2025’ has expressed its view on bank consolidation as follows: “Consolidation, either through fusion, merger or acquisition, can be one of the strategies adopted by banks to increase their capacity and competitiveness.” This strategy is presently being implemented.

When asked about the progress made by European banks to engage in consolidation in order to address low profitability, Andrea Enria Chair of the supervisory board of the European Central Bank stated, “We are also seeing an encouraging trend of banks engaging in consolidation. Not only can well-planned business combinations help banks become more cost-efficient, invest more in digital transformation and, ultimately, boost their profitability, they can also help to remove the excess capacity in the banking system that was generated in the run-up to the great financial crisis.”

A report from the Deloitte Center for Financial Services contains the following: “The ripple effects from a more fragile and fractious global economy will be felt disparately across the global banking industry. Large, well-capitalized, diversified banks should weather the storms reasonably well.”

Strong, stable banks can raise low cost funds

Large banks attract the attention of investors due to its greater stability and ability to give a better return on investment, embark on geographic expansion and product diversification and invest in more sophisticated risk management systems. To the extent that investors infuse equity and risk reduction improves a bank’s credit rating which in turn increases its ability to raise low cost funds, the cost of capital of such banks will reduce.

The average Return on Assets (ROA) of the bigger Sri Lankan LCBs quoted on the Colombo Stock Exchange (CSE) with assets over Rs. 1 trillion was 1.04 per cent in 2022. These banks had an average turnover of Rs. 238.47 trillion whilst the average ROA of quoted banks with assets less than rupees one trillion was 0.76 per cent. These banks had an average turnover of Rs. 64.85 trillion in 2022. This very clearly demonstrates the higher profit generating capacity of larger LCBs and the benefits that would accrue to smaller LCBs by looking for merger opportunities with larger LCBs.

The interest of investment funds and high net worth individuals can only be developed when the size of the investment meets their minimum investment criteria. According to Central Bank (CB) regulations, one party or parties acting in concert can own only up to 10% of a bank’s voting shares. This can be extended up to 15% with CB’s special approval. As such, the quantum of total voting shares of a bank plays a crucial role in attracting investment funds and high net worth individuals. Larger banks created through mergers will have a much bigger share capital than the small banks that are in existence today.

Only banks with the capacity to undertake large scale lending without breaching single borrower exposures, invest in wide geographic regions and offer diverse products to its customers can absorb large equity infusions that will increase shareholder funds and consequently the number of shares. The fastest and most efficient route to create such banks with considerable shareholder funds is through a process of consolidation. These consolidated banks can initially raise equity through the CSE. There will also be a strong possibility for continuing entities in a bank consolidation to obtain improved investment grade ratings and favourable reviews in the international press that will enable them to enter overseas capital markets to raise lower cost funds.

Besides increasing the capability to draw in low cost equity and access local and foreign bond markets with much lower premiums than is done at present, larger banks created through consolidation will have much higher CASA ratios due to the combined customer base and the additional current and savings accounts that can be canvassed due to the stability, geographic reach and other synergies that will flow from mergers. That larger Sri Lankan LCBs have better CASA ratios is demonstrated by the average CASA ratio of LCBs with over 1.0 trillion in assets being 32.7 per cent whilst the average CASA ratio of LCBs with less than 1.0 trillion in assets is 22.3 per cent as at 31 December 2022. Since funds in current accounts come at zero cost and funds in savings accounts come at very low cost a high CASA has a significant impact on the cost of funds.

Deposits are the main source of funds for Sri Lankan LCBs. Deposit mobilisation is restricted by capital adequacy ratios. Here again, large banks created through consolidation will be in a stronger position to increase its Tier 1 capital through capital markets and deliver higher levels of profitability. This would in turn increase their capacity to mobilise deposits. The stability arising from scale will enable deposits to be mobilised at lower interest rates. A review of the larger banks with assets over one trillion and the mid-sized to small banks with assets less than one trillion shows that interest rates offered by the smaller banks are around 1% more than the bigger banks. This too will have its effect on the cost of funds of these banks.

Branch rationalisation and expanding geographic footprint can increase profitability and facilitate financial inclusion

The merging of bank branches in areas where there is a high concentration of branches will increase profitability of these branches when supported by information technology that can enhance branch productivity. Digitalisation and automation of transactions and processes will enable significant increases in turnover per workstation.

The Western Province, with 26% of licensed commercial bank branches and 47 branches per 100 square kilometres has the highest concentration of LCB branches. The Uva, North Central and Northern Provinces with an average of 8% of LCB branches in each province and five branches per 100 square kilometres has the lowest branch concentration. In circumstances where Sri Lanka still has a rural population that relies on face to face interaction and brick-and-mortar branches to conduct their financial dealings, it is important that LCBs set up branches in rural areas at least for the medium term to help our rural population enter the formal financial sector. On the other hand, population density does not play a major role particularly in the Western Province where technology driven customer experience strategies can be implemented to market products offered by LCBs.  

Well distributed branch networks supported by personnel trained to market deposit products tailor made for targeted segments can enable low cost deposits to be mobilised by commercial banks, particularly in the lesser developed provinces and rural areas. Only large commercial banks will have the required resources for this purpose. Low cost deposits will help bring down the cost of funds that will enable these banks to lower interest rates whilst maintaining net interest margins.

Large banks capable of expanding their footprint across all parts of Sri Lanka can also play a major role in offering financial services tailored to the unique needs of the population in those areas coupled with management guidance to the Small and Medium Enterprises (SMEs) and farming population in rural communities. Cost savings realised through rationalisation will enable the deployment of personnel required to adequately support the end to end service experience SME operators, farmers and the rural population in general will have during their early interactions with and induction to the formal financial sector. 

A well thought out post consolidation rationalisation and geographic expansion of the branch network will bring significant benefits to the merged LCBs as well as the Sri Lankan economy in general by facilitating the entry and integration of our rural population, which is 80% of the Sri Lankan population, with the formal financial sector.

Technology will be a key driver of consolidation

Banks the world over are getting into partnerships with financial technology (‘fintech’) companies. Fintech partnerships and acquisitions provide diversified revenue sources by expanding the range of products and services. Product diversification is known to be an effective strategy for business development and risk reduction.

“A number of the potential business options such as wealth management involve heavy set-up costs that need scale to justify them. Such new businesses are also more demanding in terms of managerial skills and smaller banks may find it difficult to attract the right talent.” Hong Kong Monetary Authority.

Antoinette Schoar a professor at the MIT Sloan School of Management says that “Right now, the majority of spending on what we call fintech activity is actually in big banks.” Bank consolidation is the quickest and most effective way of forming big banks that can afford and justify investments in fintech targets. 

Banking experts say that, mergers and acquisitions (M&A) in the banking industry are expected to remain high in the near future as the industry continues the digital transformation process. According to PWC Vietnam the financial services industry’s need for digital capabilities, means M&A will continue to be a driver for transformation.

When one looks at our Sri Lankan LCBs we see that there are mid-sized LCBs that have made significant investment in technology driven products. A merger of these banks with bigger LCBs that have a bigger customer base and branch network will create the potential for increasing profitability in the merged entity using the technology of the mid-sized bank and the scale of the bigger commercial bank. What we see at present are several banks investing in technology to develop the same product. Digital wallet features introduced by our LCBs is one such example. Some banks try to achieve scale through technology rather than using technology to capitalise on scale. When one looks at Sri Lanka’s overbanked scenario this is a significant waste of resources within the sector.

While technology increases choice and access to most consumers, it can exclude those who don’t know how to use the internet or devices like computers, smartphones and tablets. Many customers say that grappling with poorly designed mobile banking platforms motivate them to switch banks. If such experiences and situations are to be avoided, substantial investment would be required to build customer confidence and help customers migrate to electronic banking channels. Mergers provide the opportunity for banks to spread and absorb the sizable fixed cost that would be incurred to encourage customers to migrate to electronic banking channels. The consolidated banks will also find further new investments in fintech products to be feasible thereby enabling product diversification without much stress on profitability.  

Economies of scale can lower cost income ratios

Branch rationalisation, more productive utilisation of human resources and the amalgamation of central functions/support services such as finance, internal audit, information technology, risk management and compliance etc. will enable the continuing entity in a consolidation to lower its cost income ratio.

The Hong Kong Monetary Authority is of the view that “future profits may also benefit from cost reductions arising from economies of scale – that is, the ability to spread fixed costs, including particularly those which are technology-related, over a larger scale of operations. Cost economies can also be achieved by eliminating duplications in branch networks.” Quarterly

Bulletin 08/2001

Reduced need for office space due to lesser number of seats for the combined entity to perform central functions/support services will lower establishment costs. One off activities such as preparation of annual reports and the holding of AGMs, etc. will not have to be duplicated.

Cost income ratios of banks will also reduce due to the higher levels of income generated after consolidation. Corporate Banking revenues will be boosted by bigger single borrower limits and product diversification, retail banking will see revenue generated through financial inclusion and the introduction of new market oriented financial products.

What is expected of the Central Bank of Sri Lanka

It is understood that IMF guidelines call for weaker banks to be merged with stronger banks and that the Central Bank has been directed to develop a roadmap for financial sector restructuring and recapitalisation to address capital and liquidity shortfalls by next month. Senior officials of the Central Bank must surely be aware of the advantages presented in this article. It is hoped that the Central Bank will take a more active role in encouraging banks towards consolidation in order to achieve the strengths to be gained and the opportunities that would open up through bank consolidation in this roadmap for financial sector restructuring.