Bank consolidation will aid economic growth

By G. De Silva

The Annual Report of the Central Bank for 2022 shows that the economy contracted by 7.8% in 2022. Interest rates are a key factor that influences economic growth. The report also states that outstanding credit to the private sector by commercial banks continued to contract for the ninth consecutive month in February 2023. This is a reflection of high interest rates that discouraged business expansion.

Central Bank statistics show that Licensed Commercial Banks (LCBs) kept a net interest margin of 38% in 2022. Banks were compelled to keep these margins due to the high cost of funds, provisions for impairment of loans and operating costs. Only 7% of the total income earned by LCBs went in for organic growth. When the dividend paid to shareholders is factored in it becomes less than 7%.

If our economy is to achieve any positive growth in the near future it is vital that bank interest rates be brought down. One strategy that can be adopted for this purpose is bank consolidation that can address both the high cost of funds as well as reduction of overheads.

Cost of funds

The main reason for the high cost of funds is the high interest rate offered by LCBS for deposits. Banks rely heavily on deposit mobilisation to fund operations. The Central Bank in its Annual Report for 2022 states that, “Deposits continued to be the main source of funding and represented 78.8 per cent of total liabilities.” Due to the liquidity constraints faced by smaller banks, deposit interest rates witnessed an unprecedented increase in 2022. This translated to very high lending rates which saw the AWPLR (Average Weighted Prime Lending Rate) rising to 29.67% by end November 2022.

The IMF Staff Report released in March 2023 issued prior to the approval of the IMF Extended Fund Facility states that, “the cost of rupee funding remains well above CBSL policy rates (average rates on new deposits reached 23 percent in December) and some banks have seen periods of rupee liquidity stress. With banks’ seeking to conserve capital in anticipation of future losses, credit growth has turned negative.”

Larger LCBs with stronger balance sheets will not be in this situation due to better ratings and the perception amongst depositors and other stakeholders about the stability of these banks. As such larger banks will have the ability to raise lower cost funds as share capital, deposits and other borrowings. Larger banks will also have a higher Current Account and Savings Account (CASA) ratio that will lower its cost of funds. This will enable these banks to lend at much lower interest rates without compromising on profitability.

Cost income ratios

Of the 10 listed Licensed Commercial Banks (LCBs), 3 Domestic Systemically Important Banks (DSIBs) with the highest asset size have an average cost income ratio of 24.53% whilst the 7 smaller banks had an average cost income ratio of 37.03%.

These ratios clearly show a relationship between asset size and cost income ratios. The larger the bank the lower the cost income ratio. Economies of scale, operational efficiency gains by avoiding duplication and branch rationalisation will lower cost income ratios when smaller banks are merged with larger banks. In addition to this, consolidation will help unlock synergies where the more efficient resources of smaller banks could be utilised to a maximum when they are put to use within the surviving entity.

Larger banks created through amalgamations will have high levels of capital funds that will enable the granting of much larger facilities without violating single borrower limits set by the Central Bank. The possibility of increasing geographical reach both within and outside Sri Lanka will also be much higher.

Duplication of infrastructure required for compliance, risk management, accounting and back office operations can be avoided through mergers supported by information technology. These functions can be administered efficiently by the surviving entity in an amalgamation. This would result in better risk management, cost effective administration and prudent tax management. Central Bank statistics show that 26% of the 6718 bank branches and outlets are located in the Western Province. Digitalisation of transactions enables a significant increase in the number of customers that can be served by a branch. As such the high concentration of branches in the Western Province cannot be justified by the population density in the Western Province.

An analysis of branch concentration per square kilo meter by province shows that the highest concentration of branches is in the Western Province. Bank consolidation will lead to a significant reduction in branch concentration per square kilometre. Premises and establishment costs form a significant part of the operating expenses of LCBs. As such a consequence of branch rationalisation would be a significant reduction in the cost income ratio since fewer branches will serve the same customers.

Despite announcements made by the Central Bank, the cost of rupee funding remains well above CBSL policy rates. The AWPLR has reduced by only 1.06% from end March 2023 (21.40%) to now (20.34%). In such circumstances, is it not time for the Central Bank to prepare a plan for bank consolidation that will bring down bank interest rates and re-establish the demand for credit in the private manufacturing and service sectors to enable economic growth targets to be met.