Sustainability in volatility: The bankers’ challenge

By Cassandra Mascarenhas

The technical sessions of the Association of Professional Bankers’ 24th anniversary convention were held yesterday, bringing the APB’s flagship event to a close. Aptly themed ‘Sustainability in volatility: The bankers’ challenge,’ each technical session explored an area that could throw obstacles in the path of bankers and the line-up of speakers deliberated these and provided solutions via interactive sessions with the vast gathering.

APB Senior Vice President Aravinda Perera in his opening remarks noted that even during the 30 year period of internal war, the country’s economic activities continued and the economy kept growing, drawing from this that our economy, especially the private sector, has shown resilience and ability to grow during even very tight situations.  

“That gives us a lot of heart. Today, we are free of all of such situations and now that the war is over, the economy is showing significant growth. However, our good fortune surfaced when the economic world is in turmoil which is unfortunate as our new economic drive has somewhat been slowed down because of what is happening around us,” he stated.

Quoting from the Central Bank’s governor’s address at the inauguration, Perera observed that in the good old days, the time between two crises was long but that it is not the case now – we are now rapidly moving from one to another.

“This year’s theme reflects the fact that even during the war, the country showed its capability for economic growth. Significant economic growth will result in certain imbalances in the economy so there is volatility created by the growth itself. The present world economic situation has resulted in turbulence in our own economy. We want to discuss today how the country and individual organisations can sustain economic growth in the face of such volatility.”

Economic volatility and achieving sustainability

The presenter at the first technical session was Frontier Research CEO Amal Sanderatne who spoke on the topic ‘Economic volatility and achieving sustainability: The way forward,’ chaired by University of Colombo Department of Economics Prof. Srimal Abeyratne.

He commenced by stating that volatility is a major part of the environment bankers work in, noting that volatility is sometimes referred to in the instances of a crash after a period of growth that is not sustained, something which takes a long time to recover from.

“For instance, Malaysia which had very high growth went through the Asian financial crisis after which their seven to eight per cent growth rates fell to four to five per cent and this is what people expect will happen in the European countries. The US housing market did very well, then crashed but it may stabilise but no one is expecting that bubble again,” he observed.

“Even countries that experienced massive growth – some of the countries we aspire to be – saw period of significant volatility and setbacks during their period of rapid growth and these include Singapore, China and Malaysia to name a few.”

He then proceeded to draw lessons from these countries, starting with Malaysia. The interesting thing is that Malaysia did obviously have much better growth than Sri Lanka in the 70s, 80s and early 90s but within that there were severe economic crises, much worse than what we have seen in Sri Lanka. The same applies to the Malaysian stock market. While we have faced a lot of issues with our own stock market falling 30 to 40 per cent, it’s nothing compared to what Malaysia faced, Sanderatne stated.

They experienced very strong growth rates from the 70s to the 90s – this period was a comparable period to Sri Lanka. However, each decade had a crisis, culminated by the Asian financial crisis in the 90s. In fact, Malaysia experienced a 0.8 per cent growth rate at a point in the 70s and a minus 1.12 per cent growth rate in the 80s.

The four economic crises in Malaysia were due to oil shocks, commodity downturns, the 1985 recession and finally the Asian crisis.

“It is interesting to see some of the causes attributed to this. Malaysia in the 80s went through a massive period of investment where the budget deficit was almost 14 per cent and that was obviously not sustainable with economic shocks in the system. Furthermore, every time they had a crisis, they messed around with markets to control the volatility. There was a lot of volatility in the Malaysian financial markets during that period,” he said.

Sanderatne then moved onto the new growth star, China, a country where volatility is not immediately noticeable when looking at their economic numbers.

“Volatility can mean very different things. For example, if you’ve gotten used to 14 per cent growth which suddenly drops to eight per cent, a country can feel it although it is not so bad. Basically the problem in China is that it is still a centrally communist country and at a bottom up level, there is an inherent need to push up figures due to internal politics but this eventually evens out but results in debatable data.”

That may be one reason for the GDP numbers not showing volatility, he pointed out, but a look at China’s financial markets shows volatility. In 2006, the market went up 163 per cent. In three years, it went up almost 400 per cent then almost lost all of it, then went up 100 per cent and went down again – the stock market is all about volatility and Sri Lanka’s volatility is not so bad in comparison to other countries.

His final example was Singapore with its miraculous economic progress but the volatility there was in some ways even worse, Sanderatne asserted. The country enjoyed fabulous growth at 13 per cent at times which would then plummet to three per cent. “Malaysia and Singapore have had a crisis in every decade in which they grew at a high rate.”

“India had a current account deficit funded by capital flows but is now facing a big problem managing the deficit. Ours is different because it’s a debt issue and not FDIs. When you rely on foreign capital, it can attack your currency. If we plug into the global economic grid, we will have to take the volatility that comes with it.

A country can grow rapidly this way but will have to face a lot of volatility with it. While it can be argued that Singapore wouldn’t have experienced such problems if they pursued the correct policies, even people who do it right could mess up the economy and sometimes being plugged into the global grid can mess up a country severely.

“Countries did have double digit growth at some point but achieving sustained double digit growth is uncommon even among growth stars – only Thailand hit 10 per cent growth on a continuous five year basis. In fact, eight per cent sustained is quite the achievement. The numbers we aspire to sometimes may not be backed up by what people have done on a sustained basis. If you don’t want volatility, don’t reach too high. Six to seven per cent sustained is very good in a context of sustained growth in emerging countries.”

Taking some questions from the audience, Sanderatne stated that volatility can be a stimulus fofr economic growth.

“Yes, it could be because I guess what the whole creative destruction is about – it’s a way of clearing out bad business models. Banks that cannot deal with volatility tend to disappear. It’s like an evolutionary process of sorts.”

In response to a question on interest rates, the exchange rate and the stock market, he estimated that there is a slightly greater chance that they will be lower than today’s level, maybe 100 basis points lower. However, there is a 20 per cent chance that it could really jump to 19 per cent or something.

“I’m a lot more bullish in terms of the exchange rate. I think there is a good 60 to 70 per cent chance that it will appreciate to the 126 level within the next six months. The stock market greater has a greater chance of going up. However, there is a 10 to 15 per cent chance that it could fall a lot.”

“On the question of governments causing volatility I completely agree as some of the huge problems occurred when governments tried to intervene when they should have let the private sector handle it but from a realistic point of view, what else do you expect governments to do – they will get involved and increase volatility and we need to get used to it.”

A catalyst for sustainable banking

The second technical session featured Citi Bank Sri Lanka’s former CEO Nihal Welikala as the presenter who spoke on ‘Risk management: A catalyst for sustainable banking,’ and was chaired by DFCC Bank Chief Risk Officer Trevin Fernandopulle.

The first issue he highlighted was the inherent fragility of banking systems. The sustainability of banking is of particular relevance today after the catastrophic banking collapse in the US in 2008, the financial and economic impacts of which reverberate globally even today. It has struck every country in every continent and has had a durable and last effect on all economies.

The second aspect is that they are no longer locally confined. The Mexican crisis in 1994 quickly spread to Latin American companies and there was a second wave emanating from Mexico into Asia as well. The real estate crisis in Japan and Scandinavia slowed growth in the European economies for many years after. The subprime crisis in the US is still ongoing as is the Eurozone crisis 2012 which has its roots in what happened in America in 2008 and one cannot be too positive about what’s going on there the resulting recession is being transmitted globally.

“Given the crisis that was caused by over borrowing, why is there preference for debt over equity? There are number of reasons, one is the tax subsidy, the government bears the risk on certain creditors, moral hazard expectations as governments are likely to bail creditors and bond holders but let shareholders sink. Equity issuance is more costly than debt. I think the most important reason is related to the ownership structures of banks and the governance that flows from this,” he explained.

How do we sort out the mess that has been created, he questioned. Regulators worldwide are working on two plans: Plan A is to increase capital and shift the risk of insolvency from the tax payer to shareholders. This is a moving target and will be relevant to even the better managed banks in Asia.

Plan B where shareholders are asking why they really need to invest in these complex banks as there are high regulatory and complex risks involved. With large volumes that banks deal with, things can slip between the cracks.

New regulations are going to make this a very costly business, Welikala added. Shareholders are demanding that banks be downsized to downsize or that they be broken up and sold piece by piece. Breaking up is hard to do. It is a long and complex process and meanwhile it is inevitable that regulations on capital inadequacies will continue to increase.

Turning to the financial sector in Sri Lanka, Welikala admitted that S&P’s ranking of Sri Lanka higher on the risk scale came as quite the surprise after the Central Bank’s annual report and proceeded to assess S&P’s methodology.

“Firstly, the economy and banking sectors are assessed together under a single measure.  This reflects the reality that bank performance and economic policies and cycles are closely linked.  Banks performance is pro-cyclical and rides the economic waves.  There is however a time lag between cause and effect, reflected in the old banking maxim that good loans are made in bad times, and bad loans in good times,” he noted.

For risk managers, it emphasises the point that credit decisions cannot be taken at the level of individual borrowers alone, but should be viewed in the context of economic and portfolio risks, and that the quality of loans can only be assessed over time and economic cycles.

Other risk factors considered by them include the range and stability of funding options available banks.  They also reviewed the supervision of finance companies. The hard lessons of contagion have been well learned in the recent global crises as well as recently in Sri Lanka.

They also assessed the relative competitiveness of the banking industry, but state that individual bank risk ratings will included assessment of factors such as business positioning, capital and returns, risk strategy, funding and liquidity.  

“A specific point they considered was the potential for conflict of interest arising out of the investments by the EPF in commercial banks, highlighting the dual role of the Central Bank as regulator of banks and supervisor of a major investor in banks. While they acknowledge that the Central Bank has mechanisms to manage the risk, they state that ‘we assess systems without such potential conflicts as relatively less risky than those with.’”  

Some lessons for banks that he listed out were that they should be encouraging savings including foreign remittances, looking at project financing to drive the economy, have more medium to long term lending and move out of consumption lending into investment lending.

There have been two successive years of rapid loan growth but the growing pains are starting to show on liquidity and net interest margins are under pressure in most banks. The costs of investments are starting to rise.

“Can the existing banking paradigm deliver new goals? The four universal challenges are the need for new capital and ROE and everywhere, banks are have to do less, managing complexity and fixed costs. If you look at this target of doubling assets, you see a number of challenges. We need to raise tier one and tier two investments of around 400 million rupees and also need to raise new deposits of three trillion rupees. A lot of banks need to spend time choosing what track to follow. Funding risks are clearly increasing, there more borrowings abroad than there used to be and management of currency risk is also changing,” he listed out.

Some strategic options that he offered was for banks to grow their assets which Welikala  felt was a necessary option for Sri Lankan banks coming from a low base but this needs to be directed from a policy point of view and be directed into project and infrastructure finance. Diversify incomes through capital markets, insurance and overseas expansion and cut costs through measures such as using mobile phones as a transformational technology for banks were some other recommendations made.

Executive salaries and pay caps

Commercial Bank PLC Chairman Dinesh Weerakkody presented at the third technical session and it was chaired by University of Sri Jayawardanepura Department of Human Resources Head Prof. Henarath Opatha.

Executive salaries are set according to a unique blend of external market competitiveness and internal equity considerations. Every organisation has its own way of paying people and use many variables to determine the mix and quantum, such as revenue size, number of employees, type of people they wish to attract, profitability, pre-established pay history, corporate culture, geographic location, talent depth, benefits and perks, and ease of commute.

“Every enterprise has to compete in an open market to attract and retain talent; those who pay too low fail to attract or retain good employees and must either raise their entry salary or do without good hires. Those who pay too high will have long lines of applicants for every opening, but they need to be much more profitable or more efficient than their competition or they may spend themselves out of business, or in a down turn they would need a pot of money to fund severance programs to lay off excess staff,” he said.

Despite many companies saying that they pay according to what the market requires, no two entities pay exactly the same. Beyond the minimum starting range, employers all vary in their practices, even for similar organisations of the same size within the same city and in the same industry. No two organisations will agree on exactly what their ‘competitive market’ is for all jobs, how it is structured or what their target pay should be.

 “Often experience at the company where you currently work generally trumps experience elsewhere, if someone was new in a position, companies would pay near the bottom of the scale. On the other hand if a company is hiring seasoned talent - people who can hit the ground running, they will warrant a salary that exceeds the entry rate,” he explained.

The role that qualifications and specialised training plays in determining a salary depends on the nature of the job and the relevance of the education and skill for the role. More formal education or advanced credentials in the specific field of work or occupational area will carry a lot of weight when determining salary offers.

To discourage excessive risk taking companies have often used pay caps. However, companies that used pay caps have failed for several reasons. Vast majority of companies in most industries have incentive schemes that are sensible and as generous as they can afford to be.  

When a blanket approach is used for all staff, it can become expensive and unhelpful, because a company can end up losing the key talent in the business to competitors as the salaries will not track at all with the amount of increases in pay that their counterparts enjoy outside the organisation. Money is generally a crude motivational instrument.

“In the final analysis, pay and perks is only one part of the total reward experience for a high-performing employee to determine whether or not to accept a job and then stay in the company. Most high performers don’t work for money alone, therefore the total value proposition needs to be right to attract and retain key talent for the long-term success of a company,” Weerakkody stated.

Good governance

The final technical session for the day featured Murugesu and Neelakandan Precedent Partner Kandiah Neelakandan as the presenter who spoke on the topic ‘Good governance: Key ingredient to sustainable banking,’ and was chaired by Nithya Partners Precedent Partner Arittha Wikramanayake.

He commenced by defining corporate social responsibility as being the commitment of business to contribute to sustainable economic development, working with employees, their families, the local commitment and society at large to improve their quality of life. Corporate goals are to be aligned with those of the society.

Corporate governance in Sri Lanka can be divided into two: it is dictated by the company law and the regulatory framework which is dictated by CSE rules and the Central Bank.

Principles of good governance have been a major component of international financial standards and are seen as essential to the stability and integrity of financial systems.

The International Monetary Fund (IMF) declared in 1996 that “promoting good governance in all its aspects, including by ensuring the rule of law, improving the efficiency and accountability of the public sector, and tackling corruption, as essential elements of a framework within which economies can prosper.”

“The United Nations has been emphasising reform through human development and political institution reform.  According to the UN, good governance has eight characteristics. Good governance is consensus oriented, participatory, follows the rule of law, is effective and efficient, accountable, transparent, responsive and equitable and inclusive,” he detailed.  

“The Asian and Russian crises in 1997 created an interest for international organizations in minimum standards of corporate governance. The IMF and the World Bank identified corporate governance failures in particular in Indonesia as having contributed to the Asian crisis and wanted minimum standards to be attached to their lending assessment criteria,” he said.  

In response to this the Organisation for Economic Co-operation and Development (OECD), in partnership with the World Bank, developed a set of minimum standards of corporate governance based firmly on the UK and US corporate governance standards (the Cadbury Committee’s work in particular) which have since been promoted by those organisations throughout the world.

“The complexity of the banking business increases the asymmetry of information and diminishes stakeholders’ capacity to monitor bank managers’ decisions.  Banks are a key element in the payment system and play a major role in the functioning of economic systems. They are also highly leveraged firms, due mainly to the deposits taken from customers.  For all these reasons, banks are subject to more intense regulation than other firms, as they are responsible for safeguarding depositors’ rights, guaranteeing the stability of the payment system, and reducing systemic risk,” he noted.

While banks play a crucial role in promoting sustainable development, the industry got off to a late start in acknowledging sustainability as an item on its agenda. In the 1990s, however, it started to play a more active role in sustainable development. The major shift happened when bankers realised poor environmental performance on the part of their clients represented a threat to their business success.

The interdependency between a bank’s profitability and the environmental record of its clients has influenced the business strategy of both banks and their corporate clients. This has happened in several ways.

To decrease their exposure to environmental liability and to improve risk management, bankers started to look more closely at the environmental performance of their clients. They developed mechanisms to assess the environmental risk exposure of their customers, and to protect themselves from potential losses.

This growing concern about clients’ environmental performance, manifested in lending and investments decisions, began to act as an additional driver of sustainability in the private sector. Companies were given one more reason to pursue environmentally and socially sound solutions.

Governance failures have been identified in some sophisticated banks in developed countries such as the US and UK. The analysts have identified the areas of failures into the following categories: risk governance, remuneration and alignment of incentive structures, board independence qualifications and composition and shareholder engagement.

The relevance of banks in the economic system and the nature of the banking business make the problems involved in their corporate governance highly specific, as are the mechanisms available to deal with such problems.  

Panel discussion

The convention concluded with an interactive panel discussion featuring Sampath Bank PLC Senior Director Sanjiva Senanayake, First Capital Group CEO Jehaan Ismail, Central Bank of Sri Lanka Assistant Governor P. Samarasiri and was moderated by Commercial Bank Managing Director Harris Premaratne who deliberated on the topic ‘Repositioning, redeveloping and reengineering the banking industry for sustainable growth.’  

Premaratne: Is the banking industry in Sri Lanka in such a situation that we need to relook at what we are doing today? The last five years have brought banks and bankers into the spotlight starting from the US crisis which saw the collapse of several big banks in the country. The waves hit Europe and other nations in the world and Europe subsequently suffered.

The crisis was brought upon by the banks. Bankers per se have come to such disrepute worldwide. People are now asking if the industry needs more regulatory control to the extent that the US is questioning the remuneration bankers of top bankers – which may be why bankers here want to relook at things now.

Q: Could you each give me your views on this situation?

Samarasiri: In reality, in this part of the world does not have sustainable growth. What we see are business cycles. The priority of banks is the next important point which is about customer confidence and risk management. Wherever the latter is poor, the former will be shaky. Those are the two areas we will try to balance as regulators.

If you get the banks to cater to growth priorities, looking at the banking problems in the past, whenever you try and get banks to promote growth, they expect the relaxation of regulations. With that, we are trying to encourage innovation and more risk taking. The root of the financial crisis is the subprime mortgage – getting banks to fund the housing industry in the US. Behind the housing industry, a different financial market came up with ratings and financial derivatives.

The Asian financial crisis, the so-called Asian tigers’ development came through bank funds through short term foreign borrowings. That mismatch created the Asian crisis. The state bank’s problem is the government’s use of big banks to finance the lending – this is the case in any country.

Whenever we talk about economic growth, the bankers’ next argument is that we have small banks, so how can we facilitate the large businesses. This needs to be carefully looked at because the consolidation itself because banks face problems due to their large size as well. In addition, we have specific concerns.

Consolidated banks require specific approvals and policies, globally now the regulatory model is to have small banks. Big banks are being asked to reduce their size. With all these comments, since we are talking about doubling growth over the next five years, there is no question that banks need to get into this and there is no question about the fact that business models need to be revisited but how should this be done?

Banks need to get out of retail banking and move to other financial business areas but not within the bank instead with external entities in the banking group. This facilitates regulation. This business also has to involve cross-border ownership with global stakeholders. If you want to be growth environment in this global environment it cannot be just domestic growth.

Senanayake: It is important that bankers should be more focused on risk. The rise of the Asian economies is being slowed by the West’s problems. These are all interlinked economies and we are totally trade-dependent and we cannot be expected to be isolated from all this – we should try to make use of it.

Another issue is the Middle East and we may have a big problem in Iran over the next couple of month, oil prices may shoot up and remittances may dwindle. With this slowdown, there’s a lot of competition for the rest of the companies.

People are asking for increase in capital and Sri Lanka has the additional concern about the fiscal gap, inflation is officially expected to move up and then we will have problems with borrowers who have budgeted differently. More banks and companies are going out and borrowing in foreign currency which changes things as well and when they are due, we’ll have to raise money at that time.

As interest rates move up, the Government is also highly borrowed and that deficit will be pushed forward – this means that banks will face more risk and volatility we need to focus more on getting international funds.

The credit environment is changing in Sri Lanka as the country has one of the fastest aging populations and the fact that our unemployment is slowly moving up will have implications on the retail sector, marginalisation of some sectors of the economy is likely to happen as we move on. Lots of companies borrowed heavily to finance their operations and now they find that interest costs are piling up.

We also need to check our client base that is import dependent – rising import costs will affect them. Keep an eye on companies heavily dependent on Government contracts.

We have a proactive view of asset quality but we need to look at NPLs in a dynamic way and we need to have more frequent and active reviews. Another aspect is the implementation of IFRS as it will be quite an involved process. From a directors perspectives, directors are held for account much more now.

Another aspect is to build businesses for tomorrow. There are new types of businesses coming up and I don’t think commercial banks fund them much. We will also have new matrices – new ways of measuring banks’ performances, taking into account the risk factor. The other aspect is leverage, you can have a very high level of borrowing compared to your equity base and come up with good results but looking into the risk aspect, it may not be adequate.

Ismail: We are actually quite advanced in terms of IT systems, we’ve got good clearing systems, our level of governance looking at the operating level of a financial institution are not bad at all. The thing we are not focusing on is our cost income ratios, we’ve got good technology but with all that we insist on opening branches all over the island while we should be moving into virtual banking which is the future and that will imply a significant reduction in costs.

Consolidation is something we need to bring into this country because I think we are overbanked at this moment in time. You can see some of the annual reports haven’t been great and some of these banks can become targets in the future.

If banks are to gear up, we can’t depend solely on debt, we need investments and because our capital market is shot to pieces we need to rely on international investments which are essential for the development of banks in this country.

Another point is talent development. We’ve exported our talent overseas but we don’t seem that many foreign bankers in our country. They need to be encouraged to come in and work at different levels so that best practices are migrated which will add a different dimension to the banking sector which we need. Local banks looking to reposition themselves in the future need to bring in such talent too.

The fact that we don’t price risk properly – banks are still not very good at risk assessment and one way to look at that is that there should be disintermediation of lending as well. We should try to encourage the corporate debt market. Banks can only take a certain amount of risk and we should let other organisations to take the risk on their books. The corporate market isn’t as big as it should be for a country like ours. It’s something we need, just as much as we need a robust stock market.

Pix by Upul Abayasekara