Small is beautiful, but scale is necessary

Sri Lanka has a highly fragmented banking and non-bank finance sector, which at one point in the past may have served a specific purpose of providing geographical reach. But post COVID-19 pandemic, the new norm of how we live and do businesses is riddled with ambiguity. In this macroeconomic context there is a consensus that Sri Lanka’s financial sector needs consolidation to face the challenges the new norm presents

Yes, small is beautiful. But scale is necessary. This sums up the current status of Sri Lanka’s financial sector. 

Sri Lanka has a highly fragmented banking and non-bank finance sector, which at one point in the past may have served a specific purpose of providing geographical reach. But post COVID-19 pandemic, the new norm of how we live and do businesses is riddled with ambiguity. In this macroeconomic context there is a consensus that Sri Lanka’s financial sector needs consolidation to face the challenges the new norm presents. 

The Central Bank’s recently-announced ‘Road Map 2021: Monetary and Financial Sector Policies for 2021,’ clearly indicates authorities’ tilt towards a market-driven consolidation process in the country’s financial sector. 

In this article I intend to make an attempt to briefly present the case for financial sector consolidation in Sri Lanka based on two points—how consolidation will benefit the country’s banking and financial industry and how it could propel Sri Lanka’s economy to a higher growth trajectory. 

From an industry perspective 

Sri Lanka always had a stable financial system and continues to do so in the present. Except for some non-systemic failures, stability of Sri Lanka’s financial system was not even threatened by the Global Financial crisis in 2008. If that is the case, one could ask why intrude with a well-functioning system? Here is why.

The most recent attempt towards financial sector consolidation was made in 2013-2014 period. But with the change in government, the process failed to run its full course. But now with COVID-19, the need for consolidation has become ever more important. 

Apart from its health risks, coronavirus has presented unprecedented challenges to businesses, economies and governments all around the world. Sri Lanka is also experiencing the brunt of the virus. The economy is estimated to have recorded a negative growth in 2020 and the aggregate demand in the economy is yet to pick up. 

Governments all over the world, including that of Sri Lanka, have extended massive stimulus packages to support businesses and reignite the economy. Central banks have slashed interest rates to extraordinary levels. Banks have also been asked to extend moratorium on both capital and interest components of loans of those affected by the pandemic. 

The non-performing assets in Sri Lanka’s banking sector are forecasted to increase after the moratorium expires this March. As per latest available data, the banking sector asset quality, as measured by the Gross Non-Performing Loan Ratio, is estimated to have weakened to 5% at the end of 2020 from 4.7% at the end of 2019 and 3.4% at the end of 2018. In the case of non-bank sector, this ratio is estimated to have deteriorated to 12.7% as at end 2020 from 10.6% at the end of 2019 and 7.7% at the end of 2018.

However, as earlier mentioned, the real NPLs are likely to be seen towards the end of the second quarter of this year, when the moratorium expires by the end of first quarter. On top of the deteriorating asset quality, banks’ profitability is impacted with margins getting squeezed, and certain banks and several finance companies face challenges meeting the regulatory mandated capital requirements. Global rating agencies maintain a negative outlook on Sri Lanka’s banking sector, largely due to aforementioned reasons.

Meanwhile, COVID-19 has accelerated the pace of digitalisation in Sri Lanka’s finance sector. The need to avoid physical contacts has made a lot of people to sign in for digital banking services. As a result banks, which didn’t have advanced digital offerings, have been compelled to invest in such platforms, which do not come cheap.

Relatively, larger financial institutions with stronger balance sheets are better equipped to make such investments as they have the wherewithal. Digitalisation improves operational efficiencies of financial institutions enormously. 

Although digital banking is clearly the future, banks and finance companies still need to maintain branches and open new ones to onboard the under-banked population in the rural peripheries of the country. 

Maintaining braches and establishing new ones is a costly affair. Maintaining a bank branch on average costs Rs. 7 million a month, with the lion’s share amounting to staff related costs. Opening a new branch needs an average investment of Rs. 10 million. We often see branches of local banks located on the high street of a town side by side offering the more or less the same services. Consolidation could avoid this duplication, thereby reducing overall operational costs and partly passing this advantage to customers. 

Also, with consolidated balance sheets, Sri Lankan banks can look at expanding to regional countries, which is the organic next step for larger Lankan banks. The Central Bank has also signalled that necessary support will be provided to large commercial banks to expand their operations into regional markets.

Let me put things further into context. Sri Lanka has a population of little over 21 million. We have 24 licensed commercial banks, including 11 foreign banks, and six licensed specialised banks. In addition we have 41 licensed finance companies and three specialised leasing companies. 

In comparison, regional banking hub Singapore with a population of 5.7 million has five local banks, while having a large number of foreign and offshore banks that operate due to its position as a financial hub in the Asian region. While South Asia’s largest economy, India with a population that exceeds Sri Lanka by nearly 80-fold has 12 public sector and 22 private sector banks in operation. 

A strong financial system is the backbone of an economy. For it to thrive it needs scale. At the same time it needs a robust regulatory structure. A central bank or any other financial sector regulator would find it easier and more effective to supervise and regulate a few large banks and finance companies instead of a large number of banks and finance companies.

The bigger picture 

The bigger picture of financial sector consolidation lies with its ability to support the economic growth of a country. Banks are essentially in the business of capital formation. They encourage people to save by paying interest and then lend those moneys to businesses to expand their operations, thereby using those savings to generate wealth. A banking sector with scale can perform this task at a larger scale and absorb more risks such as lending to unrated businesses and entrepreneurs.

Further, international trade is often carried out on credit and banks play a major role in it. Banks provide guarantees, pledges and references of their customers, bridging a trust deficit. The bigger the financial institution, the higher its influence on international trade. 

As Sri Lanka is aspiring to become an industrialised export-based economy, international trade is of paramount importance. Having a strong banking and financial system is a prerequisite for realising this goal. Hence, consolidation in the country’s financial sector could become key in helping to unleash the country’s trade potential.

Main argument against consolidation 

Naysayers to consolidation argue that it will widen the gap between the banked and under-banked, especially in the rural peripheries of the island. But is that the case? With the emergence of online banking, financial services apps and affordability of smartphone, the need to maintain a physical bank is set to diminish. 

Living in the new norm it is easy to understand that minimising capital erosion and supporting capital formation is going to be key for the survival of the economy as businesses, particularly the SMEs that provide a large proportion of employment will need extensive support by the Government and the banking sector. 

But as said above can a thinly spread financial sector cope up with the expected surge in NPLs and economic volatility once the debt moratorium is over? Can the financial sector clear the hurdle without consolidation?

In the face of possible systemic risks, State backing goes to the biggest players. Hence the answer to the question appears simple. Consolidation makes the strong, stronger, to face the impeding impairment that would test Sri Lanka’s financial sector like never seen before.

But it is important for the consolidation process to be market-driven as much as possible, due to various non-financial sensitivities, which if not handled carefully, could derail the entire process. 

(The author is the Chief Executive Officer/General Manager of People’s Bank)