Financial Times

Banks in turbulent times - Where are they heading?

By Nihal Welikala

The global financial and economic crisis - what caused the problem? To paraphrase Warren Buffet, President Bush was looking in the wrong place for weapons of mass destruction. They were hidden not in Iraq but in Wall Street, and have exploded with devasating consequences for global banks and economies.

A lethal combination of government profligacy, accommodative monetary policy and loose regulations set the stage. Demented sub-prime mortgage lending by major US banks, distribution across the world by investment banks of the resulting toxic brew based on unreal credit ratings, fed an unprecedented consumer boom, and created real estate bubbles, on borrowed money. Banks were permitted to morph into undercapitalized hedge funds with borrowings large enough to threaten the solvency of sovereign nations. Around $1 trillion of the capital of banks was destroyed in the process, and lending ground to a halt, as depositors lost trust in banks, and banks lost trust in their borrowers and in each other.

Governments globally acted in concert to control the carnage, with synchronized cuts in interest rates, massive infusions of liquidity, buying distressed assets of banks, injecting new capital, thereby effectively nationalizing household names such as NatWest and Citigroup, and guaranteeing deposits.
Are the problems over?

Banks are inherently fragile institutions because of their high leverage (the ratio of borrowings including public deposits, to shareholder funds). Leverage exaggerates profits and losses. To give a simplistic example, if the value of the assets of a bank with a leverage of 33 times increases by 3%, return on shareholder funds is 100%. However, if the value declines by 3%, capital is wiped out. US and European banks were very highly leveraged before the crisis e.g. the median leverage of UK banks is over 30, with a range of 16 to 55. Once asset values collapsed, highly leveraged banks quickly became insolvent. The fragility of banks is illustrated by 112 systemic collapses around the world since the 1970s.

However, the scale of the present crisis took most people by surprise. The admission by the iconic Chairman of the Federal Reserve, Alan Greenspan of “shocked disbelief” at the failure of banks to protect shareholders, has been compared to someone who had always claimed that the sun went round the earth, saying he had just heard an extraordinary story from a fellow named Copernicus. Meredith Whitney, the prescient analyst who famously called the crisis early, has recently opined that “the big banks will not fail, but will not grow”. Concerns include the quantum of their level 3 assets estimated at $610 billion, which is many times larger than their market capitalization.

The US Financial Accounting Standards Boards permits this category of assets, where market values are not ascertainable, to be valued by the banks themselves using “observable inputs”, a valuation methodology popularly known as “marking to make believe”. The prospect of eventual large write downs of these loans, and capital calls to restore solvency, cannot be ruled out. Further, although lending has eased a little from the nadir of the Lehman collapse, risk aversion rides high, as reflected in sky high risk premia, e.g. the TED spread , the difference between the interbank lending rate and risk free US Treasuries, increased eighteen-fold on its historic average at its peak.

The repatriation of overseas assets by US entities and the flight to the US dollar, which enabled rates on 3 month Treasury bills to be cut to zero, and long term rates to 50 year lows, exemplify the point. Whitney cites a further example of risk aversion in the form of an expected cut in credit card lines in the US by $2 trillion in 2009. Banks will continue to de-leverage i.e. reduce the size of their loan books, to meet capital adequacy standards, with dire consequences for economic growth.

The party is over
The impact of the banking crisis on the global economy is apparent from the dismal statistics of unemployment and recession, which are emanating from the US, Europe and Japan, but also from the broad spectrum of emerging markets. The theory that Asia, powered by the emerging giants of China and India, had decoupled from developed economies has proved to be fanciful.

A painful adjustment to global and domestic imbalances will need to be made, if economies are to be restored to health. Over the last decade, surplus savings estimated at $2000 billion by China, Japan, Germany and the oil exporters, have financed government and private sector deficits in US, UK and Europe, resulting in consumption led growth and real estate bubbles. Private sector spending and investment is now collapsing there.

There are three ways the system can adjust. Firstly, assuming global imbalances remain in place, deficit governments can spend aggressively to replace household consumption. Fiscal imbalances in the US are in fact exploding as the government bails out banks and critical industries, and also seeks to stimulate demand to minimize the risk of a long and deep recession. Inflation is seen as the solution, not the problem, with the Fed considering helicopter drops of massive amounts of printed money to fan the flames. However, these are unlikely to be durable solutions as they carry the risk of a future inflationary spiral. The second is for surplus countries to use their cash to stimulate local consumption, avoiding the temptation to depreciate their currencies and export unemployment to the US and Europe. The signs are mixed e.g. the Euro 200 billion stimulus package in the EU, has more to do with public relations than the infusion of new money. A decline in US consumption of say 5% of GDP would require a compensating increase in Chinese consumption of 17% of GDP, or nearly a 40% increase in consumption, which is improbable. The worst option is the adoption of protectionism, competitive currency depreciations and similar “beggar thy neighbour” policies, which will aggravate the downturn.

Global crisis and Lankan economy
Sri Lankan is highly co-related to the global economy through our relatively high level of trade in international goods, services and remittances. The global downturn is therefore likely to impact the economy in a number of ways.

Positively, the reduction in oil and commodity prices will assist the economy enormously, within the constraints of hedging obligations. A peace dividend would be an added bonus. However, our export sector, whether garments, rubber, tea and manufactured goods is feeling the impact of depressed demand and an uncompetitive exchange rate. Similarly, international services such as shipping, aviation and tourism are facing problems, while inward remittances are unlikely to grow at the expected pace, based on global forecasts for 2009 by the World Bank, and recent statistics from the Philippines. Domestic demand is slowing as a result, and also because of high inflation and interest rates. However, the capacity of the government to increase spending to stimulate demand is limited by persistent fiscal and external deficits.

The more immediate concern is the risk aversion of the international credit markets in relation to emerging economies. Financing of Sri Lanka’s deficits from these markets will be more problematic, at a time when even trade related credit lines are under pressure everywhere.

Sri Lankan banks: adjusting to new economic realities
Banks are a proxy for the economy, as they reflect both the successes and failures of their customers in the wider economy.

As the economic going gets tough, banks will need to refocus on the fundamentals, namely access to capital and liquidity. The numbers show the need to bolster solvency ratios sooner rather than later. Banks can neither grow without it nor build needed equity cushions against unexpected losses. However, they need to recognize that they are competing for capital in difficult markets, where investors will compare quality of management, balance sheets and returns, against regional options. Sri Lankan banks are generally disadvantaged in this respect by comparatively high fixed overheads, caused by the lack of scale of individual bank operations and rigid organizational structures, costly and rising non performing loans and importantly, a taxation rate of 60%. This results in returns on capital which fall below both the risk free rate and the returns of regional banks.

If banks are to address these structural issues, it will be necessary though not sufficient, for them to re-engineer at the individual entity level. What is also needed to compete for capital, is to build scale by pooling resources. It is an unaffordable extravagance for 23 banks to build individual distribution, brands, technology platforms, risk management processes and the like. Consolidation of the industry is necessary if our banks are to have the capacity to weather economic storms, and to support national growth when the economic cycle reverses.

Additionally, if this objective is to be achieved, the government needs to reduce the excessive and discriminatory taxes imposed on banks, which severely constrain capital accumulation and loan growth.

2008 Performance: “Neither a borrower nor a lender be”
Sri Lankan banks seem to be following the advice of Polonius in Shakespeare’s “Hamlet”. Thus, while growth in bank lending outstripped or at worst, kept pace with nominal GDP growth over the last four years, 2008 is likely to show a significant reversal of the trend, with loan growth likely to end up in single digits, far below nominal GDP growth of over 25% . Since bank lending plays an important role in fuelling economic growth, a fall in lending growth of this magnitude, is a cause for concern.

Non-performing loans
Additionally, non-performing loans have increased by Rs 24 billion in 10 months, a lagging indicator of future incremental costs e.g. If the additional NPLs persist for a year, profit is expected to decline by around Rs 8 billion, based on lost interest income and increased provisioning for that period. It is noteworthy that specific provisions made against NPLs have reduced from 66% in 2005 to 46% currently. Provisions and capital may need to be built up in 2009 to de-risk balance sheets.

Liquidity – government pre-emption in tight markets
Rupee liquidity growth has been adversely impacted by overall tighter monetary policy this year, falling disposable income and savings, and the continuing pre-emption of available funds by the government. It is estimated that the major governmental financial institutions, namely the Bank of Ceylon, People’s Bank, National Savings Bank, EPF and ETF together absorb 60-65% of savings in the financial system. Among others 21 private commercial banks, 14 licensed specialized banks, 32 finance companies and 22 leasing companies compete for the balance in a small economy.

US dollar liquidity is under strain as the government and the banks compete for a shrinking pool of funds caused by heightened risk aversion by global banks. The repatriation of funds back to the US, and the flight of capital from emerging markets have left many countries with serious dollar shortages.

Leverage and the loan to deposit ratio
Overall, the leverage of the banking system in Sri Lanka is comparatively low at around 10 - 15 times, similar to the regional average and much lower than the numbers for global banks. The percentage of loans made out of deposits in Sri Lanka, at around 95% is higher than regional competitors which average 70%. Since 30% of deposits is not permitted by regulation to be on-lent to customers, a higher loan to deposit ratio implies greater dependency on bank borrowings for lending operations, the risks of which depend on factors such as tenor and rate mismatches, and uncertain market conditions.
Changing the architecture of the Sri Lankan banking system- irresistible force meets immovable object?

The arguments for building scale among banks to reduce costs and attract capital are overwhelming. The question is whether banks will continue to attempt to do so individually or pool their resources to achieve a common goal. Clearly it is better to swim together than to sink alone.

The dominance of the state in the financial market space has been noted and is unlikely to change without fundamental fiscal reforms. Four established local private banks and two foreign banks dominate the available banking space, while a few other banks have the capital and skills needed to make a credible challenge for inclusion at the top table.

The remaining banks will have to find both the capital and the business strategies to challenge the incumbents, or find profitable niche roles while maintaining minimum capital requirements. Both are daunting challenges.

Stakeholders in change
If mergers and acquisitions are to happen, all stakeholders need to play their part. If shareholders are asked to dip into their pockets deep and often for capital, it is a question of time before they push boards and management to provide them with comptitive returns. However, shareholders will have to accept in return, the reality of broad-based rather than concentrated ownership of banks. Central Bank rules permit a period of five years for ownership dilution to 10 or 15%.

It is clear that many banks will need new capital for growth before that. Will dilution occur earlier to facilitate capital infusion or will owners curtail growth in order to retain control for a few years longer, or will the rule be changed?

Management and employees will also need to choose between building the structural productivity gains required to accumulate capital and create sustainable jobs, and the present low return strategy, with attendant risks to institutional and employment viability.

Consolidation cannot happen without robust and public support by regulators. They also need to ensure that regulations support without ambiguity, the complex implementation issues arising from mergers and acquisitions. Market participants cannot meet unexpected road blocks during the course of a live deal.

A partnership of stakeholders to strengthen and consolidate the Sri Lankan banking system and enable it to support future economic growth is an urgent need. What does it take to make it happen?
(The writer is Senior Advisor NDB Bank, and a former CEO of Citibank Colombo and NDB Bank).

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