Bank consolidation: The way to go

By G.S. De Silva

The solutions to capital adequacy and liquidity shortfalls do not lie in the shortsighted measures taken by the small to midsize LCBs in Sri Lanka today. The solution lies in the creation of large banks capable of raising equity capital through our stock market and mobilising deposits more effectively. Due to the lower risk of investing in larger banks, such capital and funds will come at a lower cost thus reducing the cost of funds 

A report prepared by Acuite Ratings and Research, a leading credit rating and research agency in India, under the caption ‘Banking sector: next phase of consolidation likely over FY 22-24’, states that bank consolidation is imminent because “many small sized private banks continue to face chronic asset quality problems which constrain their capital availability. Hence there is uncertainty on their scalability and business sustainability over the short to medium term.” The Indian scenario referred to here, is also applicable to Sri Lankan banks and finance companies that have to function in the challenging operating environment that exists in Sri Lanka today.

The aftermath of the Easter Sunday bombings and COVID-19 pandemic followed by the economic crisis increased stress on the banking sector by lowering asset quality and causing shortfalls in day-to-day liquidity. The debt restructuring that is yet to be finalised is likely to aggravate the situation if adequate provisions have not been made. There could be an erosion of equity capital, which could lead to a violation of the Basel III capital requirements.

The foregoing has led smaller local banks to resort to measures that adversely impact two of its key stakeholders, the shareholders and customers. The repercussions will adversely affect these banks and the economy.

The response of shareholders to the rights issue of a midsized Licensed Commercial Bank (LCB) last year is an indication of how successful LCBs would be, in raising capital through the stock market. This attempt to increase the Tier 1 capital of the bank fell short of their target by Rs. 574 million.

In this background some banks have resorted to offering a scrip dividend instead of a cash dividend thus depriving shareholders of the accustomed dividend cash flows and offering shares in lieu. This will only worsen the situation when these LCBs seek to raise equity through rights issues in future.

In a scenario where raising capital funds through rights issues is highly unlikely, banks have also resorted to raising funds through Basel compliant convertible debentures offering very high rates. A recent issue of such convertible debentures by an LCB was done at a rate of 28% per annum for five years.

The main source of funding for commercial banks is deposits. Smaller banks rely heavily on this source of funds. Due to liquidity constraints, smaller banks are offering very high interest rates to attract deposits. As a result, larger commercial banks are pressured to maintain high deposit rates in order to compete with smaller banks for deposits.

Issuing debentures at very high rates and offering very high interest rates for fixed deposits increases the cost of funds in banks which in turn would be passed on to its customers by offering facilities at very high rates. This would deter customers from obtaining loans which cannot be justified to finance any business venture. The small and medium sized enterprises which form the backbone of our economy are the most affected under these conditions.

In its recently released Annual Report for 2022 the Central Bank reported a deceleration of 6.2% in credit extended to the private sector by LCBs. This was due to the high interest rates that prevailed in the banking system. The effect of this is reflected in the 7.8% contraction of the economy in 2022, reported in this Annual Report. The Central Bank expects a positive growth of 3.3% in 2024. Can there be an expansion of the economy as anticipated by the Central Bank if LCBs continue to adopt high cost funding strategies to maintain capital adequacy and liquidity?

The solutions to capital adequacy and liquidity shortfalls do not lie in the shortsighted measures taken by the small to midsize LCBs in Sri Lanka today. The solution lies in the creation of large banks capable of raising equity capital through our stock market and mobilising deposits more effectively. Due to the lower risk of investing in larger banks, such capital and funds will come at a lower cost thus reducing the cost of funds.

A number of factors make the raising of equity capital much easier for larger banks. These include the lower risk of investment due to size, better earnings per share due to economies of scale, improved cost income ratios, capability of offering more sophisticated financial products on a much larger scale, etc. These factors will also increase foreign investor confidence that will create more avenues for increasing capital funds.

As a result of the low cost of funds, larger LCBs will be better positioned to offer loans and other financial products at much lower cost to its customers. This will definitely be a huge boost to economic growth. Sustainability and expansion will be feasible when businesses are financed with low cost funds. The foregoing has been the experience of countries that have gone through bank merger programs. Economic growth and financial sector stability can both be achieved through bank consolidation accompanied by an effective monitoring mechanism administered through the Central Bank.

Many countries have resorted to bank consolidation in combination with other measures to bring stability to the banking sector. Banking sector consolidation was necessary to overcome the capital erosion caused by high non-performing loans (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 €5.9bn were heavily subscribed.”

The Asian Financial crisis triggered a wave of consolidations in the Indonesian banking sector. Its success has prompted the Financial Services Authority of Indonesian to include the following in its ‘Roadmap of Indonesian Banking Development 2020 – 2025’. “Bank consolidation is one of the efforts to strengthen the structure, resilience and competitiveness of the national banking industry in order to contribute significantly to the national economy.” 

The bold step taken by the Indian Finance Minister Nirmala Sitharaman in August 2019 to amalgamate 10 public sector banks to 4 big banks resulted in 27 public sector banks that were in India in 2017 being brought down to 12 banks. Despite critics raising a number of issues related to integrating human resources, compatibility of information technology architecture and blending of cultures, the consolidation exercise was completed by 1 April 2020.

The conclusion in a research paper titled ‘Do Bank Mergers Improve Efficiency? The Indian Experience’ prepared by Snehal S. Herwadkar Research Director of the Department of Economics in the Reserve Bank of India confirms the success of this decision. “The findings of the paper confirm that banking mergers in India have been, on an average, beneficial to the banking sector as the financial performance and efficiency of acquirers improved post-merger. These findings also hold true for the recent bank mergers during 2019-2020.” 

The IMF has consistently emphasised on the need for financial sector consolidation in Sri Lanka. A press release issued by the Central Bank on 1 August 2014 states that, The International Monetary Fund in its recently concluded Article IV Mission Report has expressed positive sentiment regarding the ongoing financial sector consolidation, highlighting that the program offers a potential opportunity to increase the resilience of the system and contribute to more effective oversight. I believe the contents of this press release are still relevant.

Total assets of Sri Lankan financial institutions amounted to 141% of GDP by the end of 2021. LCBs had 62% of the total assets of financial institutions as at end 2022.

Whilst the timely and appropriate measure taken by the Central Bank of Sri Lanka to implement the Master Plan for Consolidation of Non-Bank Financial Institutions is commended, it would be in the interest the national economy for the Central Bank to take the next step to enhance financial system stability by implementing a consolidation plan for LCBs. After all, the health of the Sri Lankan financial system depends to a large extent on the stability and efficiency of the LCBs.