RURAL SMALL BUSINESSES LEND THE EMERGING OPPORTUNITY

Commercial Bank’s greatest advantages are its scale and stability. Chief Executive Jegan Durairatnam discusses how the bank can exploit new economic opportunities without compromising its strengths

SCALE IS OFTEN AN UNASSAILABLE ADVANTAGE, particularly in banking where margins are narrowing and infrastructure costs and capital requirements are rising. Sri Lanka’s Commercial Bank is the largest private sector bank and one of its most efficient. Its large branch network and customer trust enable lower-cost deposit raising and easier discovery of loan opportunities. Another advantage of scale is its ability to grant longer-term loans, due to its more stable deposit base and the over-trillion-rupee balance sheet, the largest among private sector banks.

During a wide-ranging interview Commercial Bank’s Chief Executive Jegan Durairatnam described how, in the peripheries, it was experiencing a spurt of loan demand from small businesses. In response, the bank has reexamined aspects of its lending approach to take advantage of opportunities now coming its way.

Durairatnam says forecasting long-term rates to lend in the long term is challenging. In the past, Commercial Bank has preferred to deal with businesses requiring long-term funding. However, the higher the perceived risk with long-term lending, the higher the return required: the lower the perceived risk, the lower the return expected. In a volatile interest rate climate, he says, long-term lending is challenging.

Excerpts from an interview with Jegan Durairatnam are as follows:

Commercial Bank has reported benchmark-beating return on equity consistently. What are its high-level strengths that will make it possible to continue delivering high RoE?
One of the things we possess is an aura of stability. We tend to be the bank people turn to in times of volatility. As a result, from a deposit and liquidity perspective, we hold a strong position. By design, our business case is stability. We make money on the premise that we are stable and good at what we do. This premise has been built over the last 10 years. Also, by the fact that, at one point, we were owned by Standard Chartered, its good initial policies, freedoms, transparencies and best practices have been built. Commercial Bank is also highly process-oriented. Everyone knows what he or she has to do, and if there is doubt, there is some place they can go to refer. The processes, procedures and everything else have been built for better delivery.

But, the whole idea of stability is that your money is safe for the long term; that’s the premise on which our business proposition has been built.

WE ARE SEEING NEW BUSINESSES STARTING ALL OVER THE COUNTRY. ECONOMIC ACTIVITY AT THE PERIPHERY IS UNBELIEVABLE

Recently, banks have increased capital due to BASEL III. When raising capital, you will also be considering its ROE impact and how it can be deployed in the most optimal fashion. At the same time, there has been a softening in the economy over the last few years. Consumer demand is weak, which is an area targeted by banks for growth. Leasing is also troubled. Small businesses aren’t doing so well. What’s your strategy here?
I disagree, in that we’ve never been a retail bank. We started lending to SMEs way before it was a fad. It became a fad in the last three years, and now everyone is lending to SMEs. But, we have had exposure here for the last 15 years. We have built small and mediumsized businesses that are now large corporates. We are seeing good credit demand.

So, why did we go ahead with this rights issue? We had reasonable capital, after all. It’s because we don’t want to stop growth because of an idea that we may get stuck with capital. We could have done this a year later. But, this year, we would have had to watch our backs, as we may get too close to the capital requirements. We wanted to continue to grow without interruption, without thinking twice about capital.

We see strong credit demand. It’s not retail, yes, but demand from SMEs is high. It’s not coming from Colombo, but from the periphery. One of the transformations that have taken place is that SMEs have become so important that they are demanding similar rates to corporates, which is a good thing for this country; this is something everyone will have to look at in the future. No more taking SMEs for granted.

The conundrum you may face is the low margins on corporate lending. Triple A-rated companies will borrow at rates lower than the government can. In that context, what are the priorities for deploying capital? What are your targeted areas for growth?
Our growth focus is, first, SMEs. SMEs yield reasonable margins. It’s no longer a five or six percent margin. It’s more like three and a half to four percent. Whereas, with corporates, you look for stability. The other factor is our savings base, built over the years, which makes it possible for us to offer competitive rates for medium-term loans. This helps us in the market, as there are few banks able to offer fixed rates for the medium-to-long term. We are one of the few banks offering fixed rates for housing loans. That’s due to our savings base.

Is leasing and personal loans an important business line?
We only offer leasing to existing customers. We don’t do walk-in leasing. A reasonable portion of our leasing portfolio is for machinery for our own customers. We don’t do much consumer-based auto leasing

From where do you anticipate high-margin credit growth?
The economy is opening up in the peripheries and people are able to get credit whenever they want now. Private sector credit to GDP is only 30%. That is an enormous opportunity for growth. We are seeing new businesses starting all over the country. Economic activity at the periphery is unbelievable. I think the future is about the businesses in the periphery coming of age. To an extent, the western province is now saturated, and banks in the western province are also saturated. The opportunity is for those prepared to take that risk at the periphery.

What about your current setup gives you confidence that the Bank is able to make the most of these businesses coming of age in the peripheries?
One of the biggest risks is businesses not valuing loyalty once they’ve become big, because lots of people will be waiting to lend to these businesses. One of the things we continuously face is that, if we evaluated a proposition and offered a certain amount of money, others are prepared to give more at a lower rate because we have evaluated it. That is our biggest challenge in the market.

Your interest margin is one of the lowest among the big banks. How do you view this?
We aren’t worried about that. There are two reasons for it. One is our liquidity. We have high liquidity at the cost of profitability. That’s a good place to be; we are making money and we are liquid. The second reason is the size of our foreign currency balance sheet. Twenty five percent of our balance sheet is in foreign currency, which very few banks in this country have. Being a developing country, foreign currency is at a premium. Foreign currency margins are either one percent or below. So, it brings the net interest margin down. But, the rupee margin is reasonably good compared to others.

We would continue in this line of business because this is our main proposition: stability. The amount of foreign currency we have in excess is a sign of that stability. Our foreign currency liquidity is the reason we are able to obtain funding from overseas banks at rates that others envy.

Despite even central banks limiting credit expansion, most large banks are growing lending at a greater rate than their internally generated capital can support. Will this trend continue?
I think so. We should be able to continuously raise funds not only from depositors. We at Commercial Bank don’t have that problem. We are at an 84% loan-to-deposit ratio. A lot of others will be at the border. But, from an industry perspective, I don’t think we can rely on deposits alone if we are to do great things. There will have to come a point where a continuous flow of capital is necessary, including tier 2 capital, which we will have to raise either here or abroad.

When you are growing book, you must be having an eye on capital intensity at any line of loan growth. With that in mind, where do you think your bigger opportunities lie? You have already identified SMEs.
We look at it mostly from a long-term perspective, and rarely for the short term. One of the key areas is trade. Trade is essentially short term. But, we look at trade relationships over a longer period. Whatever you do, you require capital, and it’s a question of deploying it in the most profitable way. One is SMEs, and the other area we are concentrating heavily on is trade.

Because of our stability and relationships, we have many overseas lines, which others don’t possess. We leverage on those lines, and sometimes, we can open a letter of credit for three or four years, which very few people in this country can do. We can borrow for seven years, where people would struggle to borrow for three years. Our stability brings about an ability to do business in the long term. We look at trade in that perspective.

Do you sometimes wonder, if you stick to the stability game plan, there is always a danger that somebody out there may pull a new trick out of the bag? Consolidation can be that trick, to gain scale and be more competitive with margins. How do you strategise when the climate is primed for consolidation?
Consolidation is good, but we have to look at reality. The reality is that it is too politically sensitive because any good consolidation will end up with job losses. I don’t think that is a recipe any good developing country government will accept: job losses and bank closures. These are the factors hindering consolidation, not regulation.

We are always looking for consolidation. But, we have this elephant in the room: job losses and branch closures. It’s wrong for us to think that we can just sit here and wait. We have to consolidate, because there are far too many banks and it’s becoming uneconomic to spread branches anymore. The world is changing and we have to change with it. However. we also have to think twice about how we do it. Say, we will acquire, but we will only take 50% of the people.

Is this something you would like to be measured against? Will you be the big bank chief executive who will make this happen?
If it is possible, if there is a good target or even if it is my last week at work, I will do it. But, it’s always measured against what is good for this bank. What I am actually doing is growing overseas. I’ve done Maldives this year, and its doing fine. We are looking at Myanmar this year, too. Similarly, we are looking at other markets and areas where others find it difficult to compete. We are doing very well in Bangladesh. That is also a part of this: so, don’t just sit back, do something.

Are you ramping up Bangladesh faster than in Sri Lanka?
No.

Why not?
Bangladesh has 55 banks. We are a niche player. We are also a trade-based bank. Our systems are not ready to do retail yet. We rely heavily on identity, and there are various other issues that we think are necessities. Those conditions are not easily found in Bangladesh. Bangladesh is a great market, we are very bullish, as it’s also a virgin market. But, us being an outsider are restricted by certain facts of business. We would rather grow in the way of a typical commercial bank, at a steady pace, and not burst.

Is retail an option in Bangladesh?
Not at the moment.

Maybe in the next five years?
It’s unlikely, because there is a lot of room in corporate. We haven’t even started approaching high-end SMEs. We are not looking at that. There is enough business coming from highend corporates. We are only now starting to look at the top-end SMEs. So, there is a lot of room for growth; especially a bank that has expertise in trade has a lot of potential there.

Will the politics of being a foreign bank prevent you from being a little bit more aggressive in Bangladesh?
No, absolutely not. They would love us to grow even into retail. It’s just our own reluctance. We have this culture of being 100% ready. Even when we bring technology to the market, we say, we need to be absolutely sure it will work. We won’t run with technology that does not work.

So, any technology, anything we do, we first have to be convinced that we are ready. We are now ready to grow into SMEs there because we have the evaluation capabilities, we know whom to look for and we know how to talk to people.

What are those top items that occupy the greatest space ofyour bandwidth? The big stuff you need to be on top of?
Managing the generational change. That’s one of the biggest things I’ve done over the last five years: moving from one generation to another, and 50% of our staff is of a third generation now. To assimilate them, inculcate Commercial Bank values and build a new generation to take over this bank has been a tough task. One is in terms of loyalty, and the other is in terms of mobility. This is a generation that does not care to stay.

But, at Commercial Bank, we have been aware of this. To an extent, we have now come to a position where retention ratios are very high. That generation is now able to talk to the new people who come in. We can’t talk to them, they don’t listen to us. But, the generation that we built over the last four years is now able to take on that mantle. That was one of my biggest worries.

Then, there is the technology and security of technology: the question of what path to take and where to invest because good, safe technology is very expensive, as well as investing in the right thing at the right time, because technology is also moving fast. If you invest too early, by the time people want it, the technology may be obsolete. That decision making and going into the right technology has also been one of my biggest challenges.

Branch or no branch is another big decision that we’ve had to take. These are some of the main things I’ve been thinking about over the last few years, and I’ve always been reevaluating my focus.

You must be looking at a dashboard of numbers every day. Of that data, what do you think will substantially change over the next few years?
Margins are thinning. We need to learn to work with narrower margins and a large business. Capital rising will become a challenge. Once the margins thin sufficiently, only large banks will survive.

Another is interest rate volatility. We are finding it very difficult to forecast long-term interest rates although we tend to lend in the long term. We like to deal with businesses that need long-term funding. But, interest rates are volatile and some of our liabilities are short term. Sri Lanka has to learn to save for longer terms. That is something I look into each day, and at each bucket, I ask what is the rate affecting it. What’s the amount we are getting in each bucket? That’s what I look at daily.

Another thing that must change is the volume of currency notes that banks hold. It’s a serious amount of cash we hold in 256 branches and 690 ATMs. This has to change. I keep telling the government to push digital transactions as well. You have to incentivise people to move to digital. We can deploy the technology, but the push can come only from the government.

WE HAVE TO CONSOLIDATE, BECAUSE THERE ARE FAR TOO MANY BANKS AND IT’S BECOMING UNECONOMIC TO SPREAD BRANCHES ANY MORE. THE WORLD IS CHANGING AND WE HAVE TO CHANGE WITH IT

One of those key ratios for the long term is the cost-to-income ratio. It’s just over the 40% level now. Do you think this can be reduced further, and how?
I am very bullish about this. Everyone talks about rising costs and wages. But, one of the defining things today is automation at branches. Digital uptake is slow, but branch automation is taking off exponentially. For the first time, we are seeing people queueing up to deposit money in a machine. Imagine the possibilities this brings. It allows me to redeploy that staff to collect more deposits. For me, branch automation is what will drive the cost-to-income ratio down. And this change came within the last two years.

I went to Jaffna recently and the queue at the Cash Deposit Machine (CDM) was much longer than the queue inside the branch. Even in one of the most conservative places in Sri Lanka, people are ready to put money in a machine; this is what will change the landscape.

As societies advance up the middle-income sphere, something that has been observed elsewhere is that people are unwilling to save money in banks. They prefer to invest in pension products instead. In all likelihood, this shift will also happen here in the future. How does the Bank adjust to that?
The moment that shift happens, we are prepared to go to the capital markets and raise money. We have enough instruments in the shorter and longer terms.

People will continue with main deposits. If they think the bank will be stable for 10 years, they will put 10-year money. We maintain this aura of stability. One day, we will collect a bigger portion of money from capital markets rather than from deposit markets.

The government policy towards banks has altered in the last five years as they are increasingly viewed as an easy place to levy higher tax. However, taxes don’t seem to have impacted banks’ ability to generate good shareholder returns. Most banks are attractive in an RoE point of view. What would your advice be to the government?
What I tell the government is to not view this from a numbers perspective. Look at it from an RoE perspective. If the banks are making 17-18% RoE, that’s good. If they are making 40% RoE, then you must take away some money. But, at 18% RoE, they will retain some of that capital for growth. One of the things that people forget is that we are one of the few industries putting money back for next year’s growth. If we don’t put money back, we won’t grow next year. Take an average bank: If you reinvest Rs60 billion, it will grow by that amount, and if it does not reinvest, capital adequacy will decline. So, governments have to learn to look at it that way.

One of the other things we’ve been telling governments is, don’t have too many taxes on the side. If you want to tax a bank, it should be a corporate tax, not various little taxes that cannot be measured and put into the system.

Governments must understand that if you want banks to grow, if you want them to look international, there are only a few things you can do. When you introduce taxes that people cannot understand, foreign investors will not look at these banks, and foreign bank credit lines get looked at carefully. That’s what we’ve been telling the government.

There is also directed lending?
Directed lending is not bad. Although people say it is directed lending, it is only to agriculture. Ten percent for agriculture is fine. If you look at South Asia, the levels are much higher. We can easily match every other area. We have no problem lending to exports, SMEs and tourism. The only problem we had was women and youth, and not because we don’t want to do it, but because we may struggle to grow that in the short term.

WE HAVE THIS CULTURE OF BEING 100% READY. EVEN WHEN WE BRING TECHNOLOGY TO THE MARKET, WE NEED TO BE ABSOLUTELY SURE IT WILL WORK

We have no problem about the guidelines that the country wants because we think those are good sectors to lend to anyway, like tourism and SMEs. We don’t see what the hullabaloo is about.

Will it become a struggle for a small bank?
Why wouldn’t you want to lend to tourism, SMEs and such sectors? It’s an opportunity for each bank to look at their portfolio, and if they don’t have enough money, to raise it.

It’s an opportunity for you to acquire a bank that is struggling to meet these. I think everyone will meet these. It’s quite easy to meet.

Is there something that keeps you awake at night?
Interest rate volatility is one thing that keeps me awake be cause it’s sometimes irrational. Sudden four or five percent interest rate volatility is not something banks can cope with. You have to understand that we have to deploy funds over five or six years, and we have to buy bonds over five or six years. We can’t only commit to short-term assets. That’s one of my biggest worries; that you get up in the morning and the rates would have gone up by one percent or come down by one percent.

Are you looking at shifting your balance sheet in an appreciable way?
We are relooking at cards. Being what we are, we have been very conservative on cards. But, we think that the market and demand for that product is growing. So, we are refocusing our energies on cards, which is a new line of business.

One of the reasons why we didn’t look at this is because we did not understand the business. It took us some time to learn the business. Once we learnt the business, we missed an opportunity, as we did not push it at that point. Of late, we have re-thought our risk appetite, and we are pushing it strongly. Our push into the consumer market is two-fold: Internet payments and cards.

How big is this shift? Cards are under two percent of lending. Even a one percent shift is substantial. But, from an income perspective, it will yield much more than a four percent loan shift. While this focus is there, we won’t forget our core business.

In South-East Asian countries, with long periods of high economic growth, banks are most profitable because they focus on retail. They lend for credit cards, mortgages and personal loans, and offer services like wealth management. You must be considering the possibility of a similar transformation in Sri Lanka. But, there are other banks better positioned to take advantage of such a transformation than Commercial Bank in Sri Lanka. How do you view this?
We come back to that responsible lending theory. We will lend to anyone if it will enhance their life. We look at three to four years into the future. We are actually rethinking our model as we are still looking at income as static. But, it’s not. Income can increase or decrease. We are trying to adapt our models to adjust to periods of low and high income, something no one else has done. We are rethinking and reenergizing our frontline to start looking at this differently. We have slightly shifted our risk appetite as well.

MANAGING THE GENERATIONAL CHANGE IS ONE OF THE BIGGEST THINGS I’VE DONE OVER THE LAST FIVE YEARS: 50% OF OUR STAFF IS OF A THIRD GENERATION NOW

Do you worry that you may get caught out because your risk appetite may be lower than your competitors’ in a growing market?
We don’t have a low risk appetite. We have a reasonably good risk appetite, but it’s evaluated risk. That’s the difference. We won’t jump into something because we can. We will first evaluate the risks.

Our problem is a good problem. We take a little time, but we offer good advice. Those who have banked with us have seen the value of that. We are not worried about being caught out because, if there is good business, we will go after it. But, we won’t do business for its own sake.

Do you consider yourself lucky because, despite its size, Commercial Bank does not have a dominant shareholder?
That’s been God’s grace. That’s one of the successes of Commercial Bank. The entire board is generally focused on the bank’s improvement rather than their individual stakes. The board has contributed immensely to the growth of this bank. They are very close to the business and close to people in the market, so they tell us where to look. When we sit here, we have certain fixed models and we think we are growing. But, when they come and tell us and give us direction, suddenly there is new perspective. Credit cards were one of those ideas. We were happy where we were, but they saw this opportunity and pushed us. So, yes, it has been a success story.

Is Commercial Bank’s health and growth a good proxy for Sri Lanka’s economy?
Of course. Whenever we attend investor conferences, we are seen as a bank whose prospects are used to judge the country by. Our growth, stability, liquidity, ability and demand for our shares are benchmarks for doing business in this country.