NEVER A MORE DIFFICULT TIME TO BE IN BANKING

DURING A THREE-DECADE-LONG CAREER AT DFCC BANK, ITS CURRENT CHIEF EXECUTIVE LAKSHMAN SILVA HAS EXPERIENCED MANY UPS AND DOWNS. BUT THE CURRENT CROP OF CHALLENGES ARE UNPRECEDENTED, HE SAYS

Many consider banking a plush job, but for Lakshman Silva, whose career spans three decades and all of it at DFCC Bank, he’s never experienced headwinds as now.

In January 2019, the bank announced a cash call as a rights issue, its first in a decade. But at its conclusion in April ‘19, only 42% of the planned Rs7.6 billion could be raised. DFCC expected to bolster its top tier capital buffer and finance growth from the cash call, which priced 106 million shares at Rs72 each.

Investors met the offer with little enthusiasm. Following the announcement of the issue, the bank’s share price fell from Rs123.5 in January to Rs71 by April ‘19, a level below the rights price.

Initially funded by foreign concessionary loans, DFCC Bank was established as a development bank by Parliament in 1955.

For the longest time, it did not have to raise deposits or money from shareholders to fund its lending. However, things changed when Sri Lanka graduated from a poor country to middle-income status. Low-cost funding evaporated, and the bank had to transform into a commercial bank and raise deposits to fund much of its lending. Deposit mobilisation and shareholder returns are more significant challenges for DFCC’s chief executive.

“High taxes on banking and new capital regulations like Basel III and IFRS 9 aren’t challenges I never dreamt of encountering when I started my banking career 30 years ago,” Silva says. “It’s a much more difficult time for banks than in the past. Our hands are tied.”

Excerpts from the interview are as follows:

You’ve been a banker for three decades; how has the industry changed over the years?
DFCC Bank has been around for 63 years, and I have been with the bank for about half that time. When I joined the bank 30 years ago, it was a development bank, and we could grow even without a branch network. Other banks had to raise capital from the market, invest in branches and mobilise deposits to grow their loan books. We had an advantage because we got foreign concessionary funding to engage in development banking activities.

… CHALLENGES I NEVER DREAMT I WOULD HAVE TO ENCOUNTER WHEN I FIRST ENTERED BANKING THIRTY YEARS AGO

Those low-cost funding sources dried up when the country was upgraded into middle-income status. We had to raise capital from the market at commercial rates, so in a way, development banking no longer became sustainable. It was then decided to merge with Commercial Bank (the country’s largest private bank). This didn’t happen because, as a development bank, we were not going to be a good fit in terms of expertise and culture for a commercial bank.

Later, we decided to venture into commercial banking by ourselves by setting up a subsidiary called DFCC Vardhana Bank, which I was seconded to lead. We wanted to keep development and commercial banking separate, hoping one could feed into the other. We had to start from scratch and compete with large banks all around us. Our people had backgrounds in development banking, so our challenge was to build a commercial banking culture and capabilities, which is always easier said than done. It was also difficult for me to find the right skills in the shadow of larger banks. Fortunately, DFCC had brand recognition, so we were able to recruit people, many of whom are still with us to this day.

Client acquisition was tough. We depended on development banking customers; entrepreneurs who had gone through the startup phase with us, who came to us for retail banking services.

As regulations began to change, a merger was proposed because capital and prudential requirements were tightened. Today, DFCC Bank and the banking industry, in general, are challenged more than ever. First, there is a problem with policy consistency. We develop medium-term plans that mean nothing because the policy either keeps changing or it does not transform as anticipated. This affects other industries too. On top of that, we’ve experienced natural disasters like flooding and drought. It affects us as well when our clients’ businesses are impacted.

High taxation imposed on the banking sector and new capital regulations like Basel III and IFRS 9 are challenges I never dreamt I would have to encounter when I first entered banking 30 years ago. The climate for banking is now much more difficult. Capital markets are not doing well. Our hands are tied in terms of delivering shareholder value and retaining profits for reinvestment given the new regulatory requirements.

aThe effective tax rate for banks is around 50-60%. People sometimes criticise banks for their easy profits, but this is far from the truth. They don’t see the costs of raising funds, employing staff, maintaining branches, and being compliant with regulations and audit requirements. There’s a cost to following exchange control regulations, monitoring transactions and investing in technology. When you pay 50-60% of your earnings as taxes, you are left with just 40% to pay dividends and to reinvest in growth. That’s why I say it’s a hard time for banks.

How do you improve shareholder returns in this climate?
The bank’s return on equity declined in 2018 because of rising non-performing loans. We had overextended to sectors like construction and trading. We’re just managing our exposure and bringing our non-performing loans to manageable levels. Under the new accounting rule IFRS 9, we have to make more substantial provisions for non-performing loans. In Sri Lanka, many customers don’t necessarily default, but they delay payments. Under IFRS 9, we have to make provisions for these regardless. We may train our staff about IFRS 9 and its implications, but changing customer behaviour is challenging, especially now when the economy isn’t doing well.

Debt recovery is another complicated process. People seek legal redress when we try to cease an asset, and our recovery processes get held up in courts.

Our profitability was also impacted by high taxes and a Rs1 billion mark-to-market loss in our trading portfolio. However, over the years, our interest margins and returns on equity have been improving. Margins have improved from about 2% to 3.6%. This is due to our focus in growing retail banking business lines like mortgage loans and pawning. We’ve also made an effort to increase our CASA (current and savings accounts) to lower the cost of funding.

However, going forward, maintaining interest margins at these levels will not be easy. We see many people switching from current and savings accounts to short-term fixed deposits, and this raises the cost of funds for banks. We also see people turning to non-bank finance companies who offer better rates. Banks are supposed to publish their credit ratings and so are finance companies, but people still look for returns rather than credit quality of the institute they’re giving their money to. There was a time people’s confidence in finance companies was shaken, but that is no longer the case. I’m not sure people are as cautious.

The new Basel III rules also require us to maintain different prudential ratios of different types of deposits. For instance, a deposit from an institution requires us to maintain a 40% buffer so we can’t possibly offer the same deposit rate across the board. So we have to make a call about the quantum of retail or institutional deposits we are going to accept. There will be different rates that apply for each. Otherwise, banks will end up tying up too much capital without the ability to lend.

You also have to make allowances for a loan going bad no matter how good a borrower’s credit profile. There will more evaluations and scorecards as banks will also have to begin to rate their own clients. The intent of Basel III is for a stable banking industry, but there’s a steep learning curve, so realising stability will take time.

What are alternatives to funding?
That is the challenge. It’s a balancing act. This is what I meant when I said earlier that our hands are tied. There was a time we could accept as many deposits as we reasonably could, and then lend in the same basis. But now, banks must be selective about the deposits they accept and their lending.

Over the past few months, deposit rates have increased faster than lending rates. Some deposits were taken out when six or seven months ago the cap on interest rates finance companies can offer was raised. We had to raise deposits rates at the bank’s cost to retain customers. So this is why deposit rates have risen faster than lending rates. Raising lending rates is not the solution because then borrowers can’t survive.

On the other hand, we have to think of margins and shareholder returns. So it’s a delicate balancing act. Loan demand is low. We’re not aggressive in expanding our loan book either. For lending to pick up, the economy needs to start moving.

Raising shareholder funds is another option, but the environment is not conducive for that. Investors would like to see more consistent policy and less of measures that can hurt banks like high taxation. Banks are an easy target for high taxes, but going forward, this cannot continue. Basel III and IFRS 9 require more capital and buffers. If you don’t have this, then you must retain and preserve more profits. This won’t be possible if taxes are too high so the governments may have to rethink their taxation policy on banks going forward.

The capital market needs to be more vibrant so investors can be confident of entering and exiting profitably with ease. Foreign investors are still taking a wait-and-see approach as recent political developments have dampened investor sentiment. The third option is for the bank to borrow commercially, raising debt capital in Sri Lanka because of the tight market liquidity. It’s not a good time to raise money from global markets because the sovereign rating was downgraded over the political impasse in October. So deposits seem to be the best option available, but the conditions are far from favourable.

RAISING SHAREHOLDER FUNDS IS ANOTHER OPTION, BUT THE ENVIRONMENT IS NOT CONDUCIVE FOR THAT

What is the way ahead like?
We had plans to elevate ourselves as a systemically important bank by 2020, but the new banking regulations, taxation policy and uncertain economic environment could delay that. We’re looking for organic growth, but if there’s an opportunity for a viable acquisition or merger, we will be open to it. There are too many banks in Sri Lanka. The Central Bank is not forcing mergers, but the new regulations and laws may force smaller banks to consider these if they want to grow and provide adequate shareholder returns.

We need to reach a critical base of one million clients to be considered strategically important. We’re investing in technology and rolling out digital banking products because that’s how we’re going to enlarge our footprint. We’ve already introduced an e-wallet and online cash management system. We will keep investing in technology so that our target 20-40 age group can bank with us on their own terms. However, a lot depends on where the economy is heading. Economic growth over the last few years is nothing to talk about. India and Bangladesh are growing at 6-7%. Sri Lanka needs to see fundamental changes for there to be prosperity. We need a government with long-term and consistent policy plans.