Banking is a conservative business; so how are they generating casino-like profits?

ENTERING NATIONAL SAVINGS BANK’S Colombo headquarters is an unmistakable foray into the sphere of the state. Beyond the framed photographs of the president and prime minister, men and women in unflashy outfits staff the mortgage loans department on an upper floor. NSB’s unflashy customer service extends to mortgage lending as well. While officers are polite, the processes are rigid and bureaucratic. In 2016, a mortgage loan applicant, having submitted a dossier of documents as is required for such loans, waited three and a half months for approval. She was requested to “call next week” when NSB’s branch where the application was submitted to was contacted for an update.

Mortgage loans are now a major area of credit growth for NSB, alongside personal loans and gold-backed lending. At end-2016, mortgages were 22.1% of the loan book, second only to 38% lent as personal and pawing advances.

In banking, caution, stability and even being a little boring are virtues. In the developing world, investors seek out banks that run like utilities instead of like casinos. It’s emerged that some finance companies lending to the subprime sector and managed like casinos are in serious trouble. Typically, they get into trouble by funding risky illiquid assets like real estate with deposits or lending to related businesses that subsequently fall into trouble.

However, nothing about the forces shaping Sri Lanka’s rise in the middle-income league table suggests that banks’ and specialised banks’ existing business models are future-proof.

Changes are being forced on a number of fronts. Technology firms are vying to dislodge banks from their middleman role in finance, and regulators demand they take better care to understand their customers’ sources of wealth and imposed, increased capital to back the same risks. However, Sri Lanka’s largest savings bank’s challenges weren’t so conventional. In 2012, the struggle for NSB’s soul witnessed a watershed. Its purchase of a 13% stake in a finance company for Rs393 million at significant market premium and with negative net worth was reversed following suspicion that the deal was corrupt and made no business sense.

The trauma and NSB prevailing against robber barons was a watershed. In the four years since, NSB’s net interest income has doubled and profits have almost tripled to Rs9.5 billion. In the last three years including 2016, its return on equity was 30.2%, 31.2% and 29.4% chronologically, a windfall for the government, the bank’s sole owner. Over the last couple of years, three state-owned banks, including NSB, that regulators have since labeled “systemically important” generated casino-like profits, unmatched by private sector competitors.

In 2016, government-owned commercial banks Bank of Ceylon (BoC) and People’s Bank (PB) reported RoE of 28.4% and 27.5%, respectively (in 2015, it was 22.2% and 27.1%, respectively).

At a time when Sri Lanka is seen as having lost its appetite for liberal reform, three state banks reporting market-leading RoE have statists celebrating. Their success isn’t isolated. Large private banks are not far behind. In 2016, HNB reported 19.9% RoE, Commercial Bank 19.5%, Sampath Bank 23.4% and Seylan 15.1%. If the one-year Treasury bill rate of approximately 10% is the benchmark, bank shareholder returns are astounding. They haven’t always been this grand, but started turning around in 2015.

Perfectly competitive markets are extremely rare and, despite many competitors, banking appears to have what economists term ‘monopolistic competition’. In monopolistic competition, there are fewer firms than in a perfectly competitive market, and each has somehow differentiated its products from the rest. A competitive banking system will reduce the cost of doing business across the economy. Even a 1% reduction on the nearly five trillion in bank credit across the economy will boost economic growth and make borrowers that much more competitive. Not all Sri Lankan banks are as sound as their short-term shareholder returns indicate. The four largest banks by assets, including the state-owned BoC, PB and NSB, continue to be relatively risky for reasons beyond just the numbers. During the four years ending in 2016, state banks’ market share declined from 46% to 43% due to aggressive growth by private banks.

RoE, while useful, is also a crude and simplistic measure of profitability that distracts from banking’s complexities. Prospective investors are not as keen about short-term RoE as they are about achieving attractive risk-adjusted returns. Risks are relative, and those weighing on state banks will rise if the adverse trends aren’t checked.

Taxpayers bailed out Bank of Ceylon twice and People’s Bank three times over the last four decades due to such patriotic excesses.

Markets also prefer predictable earnings to higher multiples, the type delivered by private banks that don’t dabble in ‘patriotic’ loans to money-losing state ventures.

There are three reasons that make state banks, despite their stellar 2016 returns, relatively risky. They are high lending exposure to the state, poor capacity to lend to growth sectors like consumer loans and their weak capital position. Weaknesses in state banks leave banking overall less competitive than it appears.


QUIETLY, NSB HAS BEEN RESTRUCTURING its business to better relate to the country’s financial plumbing. For half a decade since founding, despite its misleading name, NSB operated like a mutual fund. It raised low-cost funds through the post office network, which collected deposits on its behalf, and invested these in government debt. Returns from these bonds paid interest to savings and fixed depositors.

Government ownership, an implicit trust about security and knowledge that deposits are invested in gilt gained NSB customers’ confidence in an era when bank branches were sparse and finance companies were much riskier.

However, NSB’s successes was relative, in perspective. While it satisfied the need for capital security, returns lagged inflation, impoverishing depositors. NSB couldn’t control inflation; savers in other financial institutions were no better off, but it was the standard bearer for bank savings. For savers, those were bleak decades. Over the last couple of decades, NSB reopened old questions about strategic direction numerous times. Will it evolve into a housing and consumer lending bank, a path it considered favourably, or morph into a stateled development bank, a model given legs by China’s relative success with such ventures?

NSB’s legacy business model is now outdated. Its low-cost operations edge is diminished due to a growing branch network, as people no longer visit their local post office for banking transactions. Competitors have gained an edge with technology, better customer service and nimble business models. NSB is also no longer the price-setter it used to be for savings and fixed deposits.

Over the last few years, it’s accelerated its lending for mortgages, personal loans and pawning. In 2016, its loan book grew 18%, and now accounts for 32% of assets. Its growth focus areas also happen to be ones requiring the least capital, for now.

NSB’s treasury bills and bonds portfolio was 57% of the balance sheet at end-2016, a significant shift from the over 90% levels a decade ago. It also accelerated the pace of change in 2016. Its government debt maturing beyond one year declined from 60.8% of assets to 55.5% at end-2016. The Treasury bond portfolio declined Rs10 billion to Rs505 billion in 2016, and its Rs62 billion deposit growth funded long-term lending.

It’s due to NSB’s hybrid model of reform, expanding consumer lending and foreign currency loans to the government that its strategy becomes muddled.

Long-term loans, where mortgages, business loans and government lending are included, increased 5% to 87.7% of the lending portfolio. From the state banks, the government now obtains foreign currency loans to build infrastructure. Sixty percent of outstanding bank borrowings are in foreign currency, up from a share of 30% in 2010.

State banks funding infrastructure by borrowing foreign currency from overseas and lending this to the government may be in the national interest, but not of the banks. Government infrastructure is a pit of corruption, and private banks are steering clear of it. Of state-owned Bank of Ceylon’s Rs1.66 trillion in assets, Rs750 billion or 45% is invested in government debt, or granted as loans to the state or state-owned entities. As a portion of BoC’s Rs1 trillion loan book, lending to the government and state enterprises was 32% (excludes investments in public debt). At People’s Bank, as a portion of the Rs890 billion loan book, 35.6% was lent to the government and state-controlled ventures at end-2016. A year earlier, it was 45.3%.

NSB’s lending exposure to the government isn’t transparent in its annual report. State banks’ large exposure to the government is the first reason for the illusion that banking is more competitive than it is. If, on average, more than half of state bank assets (BoC, PB and NSB) are lent to the government directly or used to purchase its securities, those will account for at least 20% of banking assets available for lending and investment.

The second reason for the monopolistic competition in banking is state banks’ weak lending capability.


DESPITE ITS SIZE AND BRANCHES ALL OVER THE COUNTRY, NSB’s loans-to-deposit ratio is just over 40%, versus an industry average of nearly 90%. Not surprisingly, this is the lowest ratio of loans to deposits at any large or medium-sized bank, and is the result of NSB’s legacy.

As Sri Lanka transforms, banks will find profitable opportunities with growing demand for consumer credit, small business loans and working capital finance. South-East Asian banks saw a similar boom when their economies entered the middle-income league, businesses gained scaled and became globally competitive, people’s consumption habits changed and demand grew, and large businesses needed more working capital to continue expanding.

Banks will require skilled talent, robust systems, engaging brands and responsive customer service to capitalise. Despite their large branch networks, state banks have weak business sense, are risk averse and are disinterested in customers. As a result, most lending is managed at the head office, either to the government or large companies at low margins.

A mortgage holder says NSB’s interest rates were 2% lower than four other banks’ that also scrutinised her ability to afford the loan. She chose NSB only due to its lower cost. A 2% saving annually on a Rs10 million loan totals Rs200,000, a significant enough amount in spite of the longer wait. Unless NSB undercuts, it may not attract customers.


Sri Lanka’s bank credit-to-GDP ratio is 30%, nearly unchanged from 20 years ago. In Vietnam, credit-to-GDP is 120%, 150% in Thailand 125% in Malaysia and 155% in China. Sri Lankan household debt is also low. All this points to potential that an expanding economy will generate much more credit demand.

In 2016, state bank loan growth reached parity with their more savvy private competitors. The share of loans granted increased from 23% in 2013 to 45% by 2016, about the same as state banks’ market share, stalling any further erosion.

However, not all loan growth is equal. Some are more profitable, require less capital to back, are less of an administrative hassle and position the bank for the future. Now that the government is borrowing less than it did three years ago, flush with unexpected cash, state banks will undercut the private sector. For borrowers, this is all good news.

Sri Lanka’s seven largest banks (including the three largest state banks), identified as ‘systemically important’ by the regulator, used to have far less capital than they do now. Many have tapped existing and new shareholders to meet the first deadline in July 2017. In two further steps over two years, the Tier 1 capital requirement will rise from the pre-July 2017 5% to 10% by January 2019. This is the third and most significant risk confronting state banks.

Internal capital generation at state banks has been weak. Fitch, a credit ratings agency, says 76% of profits of the three largest banks in 2016 were paid as dividends to the government. It estimates that these banks will have to raise capital to meet the new Tier 1 (equity capital) levels by 2019.

Fitch also points out that state banks’ capacity to absorb losses is overstated, as their risk-weighted assets are understated due to zero risk weights on pawning and foreign currency exposure to the state. New capital rules will alter these. From a zero weight, foreign currency lending to the government will attach a 20% risk weight from 2018. Gold-backed lending, also attached a zero risk weight now, will have a capital charge based on the LTV method under the Basel III rules.

Until state banks are listed, their cost of capital won’t be transparent. However, in a report on Sri Lankan banks published in June 2017, Fitch says stronger capita buffers are necessary to counterbalance structural balance sheet issues and absorb unexpected losses. Besides the outright bailouts, state-owned ones in particular receive business benefits—essentially a fiscal handout—from regulatory forbearance and accommodative monetary policy. In the past, regulators have looked away when state bank capital was below the regulatory minimum.

Banks in general and state banks in particular benefit and sometimes owe their survival to transfers from the non-financial sector. Higher taxes, interest rate caps and directed lending have been unwisely used to control the sector’s impact, without addressing its greatest problem: poorly managed and atrociously governed state banks. In the short term, analysts expect pressure on banks to mount due to slow economic growth, deteriorating asset quality and weak internal capital generation.

State bank reforms to make them efficient will have to deal with governance, and tackling bureaucracy and vested interests. Given the government machine’s natural impulse to reoccupy commanding heights, only a significant private investment and influence will negate this effect.

Options must include part privatisation and a public listing, making it harder for politically linked unions and management to stall restructuring needed to keep up with the private sector. As long as the government controls these banks, anything other than polite belligerence is deadly for a reform- oriented board or management.

Without a clear sense about how they are going to extract themselves from being a ward of the state, it’s not hard to imagine that Sri Lanka’s weak government finances will result in more directions on lending to state banks. Despite their weak capital position, three-fourth of profits are being spirited away by their owner already. It’s unlikely that the desperate bunch of politicians will alter their approach. However, runaway profits in banking will become the norm unless state banks become efficient.

Even for private banks, a far more competitive industry will guarantee that the government doesn’t view their profits as unjustified and resort to measures that distort the market.