Why is Central Bank dragging its feet on bank consolidation?

By G. De Silva

Bank consolidation is internationally accepted as a means to achieve economies of scale and thereby ensure sector stability whilst providing needed financial support to aid economic growth. Better ratings, lower funding costs, the capability to introduce technology-based products that require heavy set-up costs, the ability to lower cost-income ratios, and the benefits of advanced risk management systems are some of the advantages larger surviving entities would enjoy after consolidation. The social and economic benefits that will come about after bank consolidation are higher levels of financial inclusion, lower interest rates and more involvement of Licensed Commercial Banks (LCBs) in promoting the participation of the rural farming and SME sectors.

Despite bank consolidation being included in its Monetary and Financial Sector Policies for 2023 and beyond, the Central Bank takes the stance that it is waiting for voluntary consolidation to take place. The unprecedented economic crisis that Sri Lanka faced in the recent past, not yet completely a thing of the past, exposed the vulnerability of the LCB sector. LCBs were excluded from the Domestic Debt Restructuring (DDR) exercise due to this reason. Prior to the DDR proposal being announced, caution was expressed in many forums that stability of the financial sector must be given very high priority. Based on the lessons learned from this situation shouldn’t the Central Bank look at having larger banks that can withstand the consequences of contingencies that can arise in the future?

It is also a cause for concern that the Employers Provident Fund (EPF) managed by the Central Bank has an investment of Rs. 32.77 billion in Sri Lankan LCBs. When the value of this investment can be significantly increased and the risk associated with it can be reduced by consolidating and forming a few large banks, it is disappointing that the Central bank as the manager of this major shareholder of the Sri Lankan LCBs (the EPF) is not taking a more active role in convincing the Boards of these LCBs to consolidate. It should also be noted that other Government-controlled institutions such as the Sri Lanka Insurance Corporation and the Employees Trust Fund are among the top 20 shareholders of most LCBs.

The recent performance of a once respected development bank now converted to a mid-sized LCB raises the question as to why the Central Bank remains a passive observer whilst this bank continues its downward trajectory. The Net Asset Value (NAV) of this bank reduced by Rs. 15.34 in real terms over the last 10 years, whilst there was an increase of Rs. 20.00 to 39.00 in the real NAV of the larger banks during the same period. The annual Earnings per Share (EPS) of this bank when discounted for inflation, has been less than its 2011 EPS for most of the 10 years up to 2022.

From 2016 this bank changed its dividend policy from declaring a decent cash dividend to declaring a nominal cash dividend coupled with a scrip dividend. In 2022 it resorted to declaring only a nominal scrip dividend. The last two rights issues done by this bank were a failure. In the first instance, the rights issue was closed without being fully subscribed. Only 60% of the issue was subscribed. In the second instance, five of its major shareholders declined to subscribe to the rights issue.

The bank managed to get a foreign fund to take up the unsubscribed shares in the second rights issue by offering additional shares through a private placement at Rs. 82.50 per share when the last published NAV of this share as of 31 December 2020 was Rs. 192.49. The NAV of this bank’s share dropped to Rs. 161.48 immediately after the rights issue. The losers were the existing shareholders. Given this backdrop, it is highly unlikely that this bank could turn to any of its shareholders in a future rights issue.

With total assets of approximately half or less than that of its larger competitors, this bank is not in a position to enjoy the economies of scale enjoyed by its larger competitors. This bank presently has approximately half the number of branches of its larger competitors. 52 of its 113 branches are located in the western province where LCB branch concentration is the highest. Paying lip service to financial inclusion and boasting of a large and wide branch network while employing such a skewed branch concentration is questionable.

This bank has made heavy investments in digitalisation. Its investment in “Digital Capital” is Rs. 5 billion. It is not possible for a mid-sized LCB with a relatively small customer base to realise the full benefits of digitalisation and reduce its cost-income ratio due to the absence of scale. Increasing the customer base through amalgamation will bring significant benefits to the surviving entity and the economy as a whole. In this regard, a perspective expressed by Deloitte a leading international consulting firm is relevant. It states that one of three core drivers of bank consolidation is the hunt for digital capabilities. In such situations, it makes a lot of sense for larger Sri Lankan LCBs to merge with mid-sized LCBs such as this, rather than hunting for digital solutions. The resulting synergies will make the combined entity a much stronger one.

The contribution that capital markets can make to the economy through LCBs, the facilitation that LCBs can do to develop a vibrant SME sector, and the boost that LCBs can give to economic growth by financing large business ventures are all lost due to banks such as this trying to rely on organic growth to increase scale. The potential significant risk it poses to the broader LCB sector in the meantime is also high. The absence of interest shown by the Board of Directors and management of this bank to look for banks that it could merge with shows that waiting for voluntary consolidation is not going to make consolidation a reality.

Another development finance institution also converted to a mid-sized LCB by merging with a very small commercial bank incorporated by it, clearly shows how a mere conversion of a development finance institution to an LCB by merging with a small commercial bank cannot achieve the results that a large commercial Bank can achieve. The merger and conversion of this development finance institution to a commercial bank took place in 2015. The merged entity has yet to show that it has realised any tangible scale benefits. This bank switched to declaring a scrip dividend instead of a cash dividend from 2020 following a failed rights issue in 2019. Its second rights issue in 2022 also failed in a background where the bank continued to declare scrip dividends instead of cash dividends. The two failures to raise funds from the market demonstrate its inability to lower its cost of funds through the infusion of equity. This ultimately results in higher lending rates in order to maintain net interest margins.

The alternate strategy adopted by this bank was to resort to Basel 111-compliant debenture issues to ensure its capital adequacy ratios are met. At a time its 2019 rights issue was to be undersubscribed, the bank commenced a listed debenture issue, for which it offered rates that were 2.4 to 2.8% higher than the Average Weighted Fixed Deposit Rate (AWFDR) published by the Central Bank. Through this debenture issue, the bank locked itself to these rates for a period of five to 10 years. A subsequent debenture issue done by this bank fell short of expectations despite rates above the prevailing AWFDR being offered. The ultimate result of these actions is an increase in the cost of funds of this bank, which of course will be passed on to its customers, impact their enterprises and ultimately the broader Sri Lankan economy. 

The absence of scale definitely affects the ability of this bank to maintain net interest margins and lower its cost income ratio. The total assets of this bank are one-third or less than that of its larger competitors. Single borrower limits, constraints to increasing geographic reach, inability to reach out to a wider segment of our population and offer a more diversified portfolio of products and inability to carry out branch rationalisation have had an impact on this bank’s cost-income ratio. The cost income ratio of this bank in 2022 is 25% or more than the cost income ratios of its larger competitors.

The real Earnings per Share (EPS) of this bank in 2022 when compared to the EPS in 2012 shows a negative growth. Similarly, the Net Asset Value (NAV) per share also declined in real terms over the past 10 years. In a situation such as this, it would be near impossible for this bank to raise additional capital through its present shareholders unless new investors are brought in by offering attractive terms. The affected parties in such a situation will be its existing shareholders which include the Employees Provident Fund and the Employees Trust Fund.

At one time this bank played a major role in the economy as a development finance institution. Today the constraints faced by this bank due to lack of scale contribute adversely and in some measure hinder the revival and growth of our economy. In this backdrop, a question that begs to be answered is, why the Central Bank is taking a backseat in following through on bank consolidation as announced in its Monetary and Financial Sector Policies for 2023.

What is presented here are only two banks that could be candidates for consolidation. There are many more small LCBs and other mid-sized LCBs that can greatly benefit from consolidation and thereby pave the way for a more stable financial sector if only the Boards of these banks take a genuine interest in doing so. Being key drivers of the economy, more stable, efficient and larger LCBs will be positioned to play a major role in rebuilding Sri Lanka’s economy at a time when its assistance is needed the most.