Urgent banking reforms vital for economic growth

Banks are important financial intermediaries in the economy:

by Dinesh Weerakkody

Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid and charged to depositors and borrowers.

The process performed by banks of taking in funds from a depositor and then lending them to a borrower is known as financial intermediation.

Through the process of financial intermediation, certain assets are transformed into different assets or liabilities.

As such, financial intermediaries channel funds from people who have extra money or surplus savings (savers) to those who do not have enough money to carry out a desired activity (borrowers).

Vital institutions

Banks thrive on the financial intermediation abilities of financial institutions that allow them to lend money and receiving money on deposit.

The bank is the most important financial intermediary in the economy as it connects surplus and deficit economic agents.

Banks are vital institutions in any society as they significantly contribute to the development of an economy through the facilitation of business.

Banks also facilitate the development of saving plans and are instruments of the government's monetary strategy among others. The most important service is the credit provision.

Credit fuels economic activity by allowing businesses to invest beyond their cash on hand, households to purchase homes without saving the entire cost in advance and governments to smooth out their spending by mitigating the cyclical pattern of tax revenue and to invest in infrastructure projects. Therefore, the key role for a financial institution is to facilitate investment to sustain the long-term economic growth of the country.

Development goals

Despite a slowdown in 2015, Sri Lanka's construction industry is set to accelerate over the coming years on account of rising public infrastructure spending, sustained investment from oversees and increasing tourist numbers.

The industry's expansion will continue to be tempered by political uncertainty, bank lending, currency volatility and skills shortages. Sri Lanka's construction industry recorded real growth of 5.5% in 2015, reaching a value of US $ 9.0 billion.

Analysts forecast the industry's real growth to accelerate to 8.3% in 2016, largely on account of increased public expenditure. Between 2016 and 2025, the industry is expected grow around 9% annually, largely supported by sustained public and private investment and rising tourist numbers.

However, the country will certainly be challenged if we continue to 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.

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 revenue due to pricing and social constraints.

The other challenge we have is that most commercial banks in Sri Lanka are averse to cumbersome project preparation and have limited capacity in-house to evaluate complex projects and also don't have the balance sheet size and lack adequate financing and lending instruments.

Lending to government

The other issue is lending to the government. There has been a significant increase in lending to state-controlled entities by banks, such as the Water Board, UDA and RDA.

Most of these state-owned enterprises (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 it 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) as these are not managed by the Public Debt Department.

Therefore, non-revenue generating government agencies should either get allocations 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 needs to be capped.

Banking reforms

Corporate governance needs in Sri Lanka generally 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.

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 in the past have been manipulated to benefit the government agenda: e.g. Capital adequacy - no risk weight attached to pawning advances or foreign currency borrowings of the Government of Sri Lanka (GOSL) from Sri Lanka banks. Liquidity - illiquid long-term foreign currency debt instruments of the GOSL are considered liquid assets although there is no secondary market.

If all these are factored into the balance sheets of some of the banks it would look very different.

Money recovery laws which has significant impact on cost of capital of lenders also needs to be reformed. The banking sector stability undoubtedly is an important driver of gross domestic product (GDP) growth and therefore, the government policy should pay more attention to banking sector soundness.

Mergers

Sri Lanka also needs a minimum of four banks with an asset base of Rs. 1 trillion to get us to a US$100 billion economy by 2020.

The government should also set the record straight on the merger of banks, saying any initiative has to come from the board of the banks concerned, keeping in view synergies and benefits of the merger and their commercial judgment and the govt. role is only that of a facilitator.

However, in certain institutions there is certainly a need to get rid of board toxicity and management deterioration.

In the final analysis, the Prime Minister as the Minister of National Policies and Economic Affairs (the ministry supervising the Central Bank and the SEC) has a great opportunity to achieve his twin agenda; creating a million jobs and enhancing income levels by driving the financial sector reforms agenda, thereby giving a very strong signal to the market that they are ready to support genuine investor appetite and provide businesses the freedom, to create wealth.

The writer is a former banker