Banking sector needs reform: Can Ranil and Ravi deliver?

The FT on Wednesday highlighted the very divergent views expressed by the Finance Minister and the new Central Bank Governor. The Finance Minister certainly knows the game better than the Governor because he has been a vocal critic of the previous administration’s economic management for many years. However, it is best for both parties to work together to ensure consistency in policy. So for a start both need to sing from the same hymn book.
Some time back Parliament, despite opposition from the UNP lawmakers that there was no rationale for a merger between a commercial bank and a development bank, passed a bill to pave the way for DFCC Bank, the only remaining fully-fledged development bank in the country, to merge with the National Development Bank (NDB), a fully-fledged commercial bank, to create a combined entity with a market cap of over 80 billion, around 3+% of the total market.
The NDB, DFCC and DFCC Vardhana banks consolidation strategy according to the 2013 Budget statement was to establish a strong and dynamic development bank. However, what is likely to happen is that the new entity could end up competing with the 20+ commercial banks instead of facilitating investment to sustain long-term economic growth.
The country will certainly be challenged if we continue look for infrastructure spending through public sector budgets even though the expectation is that public spending will continue to remain a significant part of future infrastructure financing.
The reality is the share of public spending cannot continue at such a high level. As the total investment grows, it will put further pressure on public budgets. In addition, debt sustainability will also constrain public spending; especially given our high oversees borrowings. Therefore, the key role for public finance will be to facilitate private sector investment—by signaling policy commitment and covering shortfalls in revenues due to pricing and social constraints.
Most commercial banks in Sri Lanka are averse to cumbersome project preparation requirements and have limited capacity in house to evaluate complex projects and also lack adequate financing instruments.

 
Independence for private sector banks
It is common knowledge that in DFCC, NDB and CBC and also perhaps HNB, the collective shareholding of various Government entities at times exceeds 30%. In DFCC, for example, EPF, BOC, EPF, ETF and SLIC Life Fund that are directly or indirectly controlled by the State have 35%. Had these been private connected entities, their collective voting rights would have been restricted to 10% (or maximum 15%).
This shareholding has been used very often to put in politically-connected people on to bank boards to drive the Government agenda. This must be stopped. While the current shareholding could be first used to correct the situation and reconstitute the boards, since most banks will have their AGMs in March those directors considered unsuitable should be asked to step down or voted out and a balanced board that represent key areas to provide proper oversight should be appointed.
Once this is done, the Government shareholding should be subject to the same voting restriction as private shareholding to bring back the stability and to get rid of board toxicity, and the management deterioration. Then on the issue of consolidation any marriage of two clean banks with no toxicity from there on should be decided by the board and the shareholders, and not by the regulator or the Minister of Finance.

 
Lending to Government
Then the other issue is lending to the Government. There has been a significant increase in lending to State-controlled entities by the banks – Water Board, UDA, RDA. Most of these SOEs have no or insufficient revenue generating capacity to service these loans and hence there is a Treasury Guarantee.
While this is technically considered risk free, in practice it is an unequal relationship since in the event of Treasury not allocating funds to those agencies through the budget or not paying up under the guarantee, there is very little the banks can do to enforce and get cash which they will need to service their liabilities. There is no regulatory imposed limit on how much of such lending is permitted since it is possible to get exemption from Single Borrower Limit.
Often these borrowings do not get captured in Government debt [debt/GDP ratios, etc.] as these are not managed by the Public Debt Department. Therefore non-revenue generating Government agencies should either get funds allocated from funds raised by the Government through the Public Debt Department or by issuing listed debentures directly to the market. The exposure of banks to these entities must be capped.

 
Banking Act
Corporate governance requirements generally in Sri Lanka have been very rule-based and prescriptive and so are several other regulations and taken together they inhibit the ability of banks often to differentiate from others to offer a superior value proposition. Therefore, some of the directions need to be revised.
Generally, the problem is that all changes are regulator-driven and not business-driven. There is often no proper cost benefit analysis of new regulations when they are introduced and the regulatory costs have become a big burden for banks. While changes are sometimes advised in advance, most often the regulator has been inflexible when submissions have been raised.
Some of the Key Indicators have been manipulated to benefit the Government agenda; e.g. capital adequacy – No risk weight attached to pawning advances or foreign currency borrowings of Government from Sri Lanka banks; liquidity – illiquid long term foreign currency debt instruments of the Government are considered liquid assets although there is no secondary market.
If all these are factored into the balance sheets of some of the banks in the banking sector, they could look very, very different. Banking sector stability undoubtedly is an important driver of GDP growth and therefore Government policy should therefore pay more attention to banking sector soundness.
Therefore in the final analysis, Ranil and Ravi have a super opportunity of giving a strong signal to the market that they are ready to support genuine investor appetite and provide businesses the freedom to create wealth.
(The writer was a Bank Director from 2003 to 2014.)