DIGITAL BANKING IN A CRISIS

Sri Lankan banks in the nascent state of digital transformation know that their efforts—and investments—will take several years to pay off; but will rising bad loans and falling profits force a strategy shift? Ranjani Joseph, a Partner at KPMG Sri Lanka, doesn’t think so

Digital banking is an important agenda item in most boardrooms, but economic conditions are far from ideal to drive transformational changes that require heavy spending and a relentless effort to realign people’s attitudes and aspirations.

Even in the worst of times banking enjoys the coveted position of go-to stocks in Sri Lanka’s lacklustre equities market. However, shareholder returns fell in 2018 as earnings shrunk. An economic slowdown, low credit growth, rising non-performing loans, debilitating taxation and capital adequacy requirements pushed banks to a tight corner. Then came the new accounting rules on bad loans provisioning, coded IFRS-9, which requires banks to set aside provisions on expected loan defaults.

The impact of IFRS-9 was significant, but was expected to reduce in 2019, says Ranjani Joseph, a Partner at KPMG Sri Lanka and Head of Banking Services and Markets. The firm published the ‘Sri Lanka Banking Report December 2018’ last June which looked at the opportunities and challenges around digital transformation and the future of banking boards.

“One would have expected the impact of IFRS-9 to reduce because banks had already taken the hit from day one, but unfortunately due to the economic, political and social conditions, non-performing loans are still rising,” she said. This means provisioning will continue to increase and erode banking earnings further.

Hard times, but banks continue to invest in digital capabilities, Joseph says. Some boards have long term transformational goals well beyond fluffy banking apps and internet banking. “They may not satisfy all consumer expectations now, but banks are trying to bridge the gap,” she says. “The level of initiatives taken by banks is encouraging”.

Excerpts of the interview are as follows:

Can you give us an overview of the banking sector?

Banking profits narrowed in 2018 as expected. Returns on assets and equity fell. Interest margins were sustained but there was no growth. Non-performing loans increased due to the slowdown in credit growth, bad weather and the lacklustre economic environment. Therefore, agriculture, construction and real estate, retail and manufacturing businesses contributed to rising non-performing loans. Higher bad loans provisioning hit banking profits irrespective of IFRS-9, which only made matters worse.

How will banks be impacted by IFRS-9 this year?

Provisioning under IFRS-9 was only reported at the end of 2018, but not during the quarters, so the significant impact was seen only by the end of the year. The impact of adopting IFRS-9 from day one, or 1 January 2018, was an increase of around 20-35% compared to the provision charges of the previous year under the old accounting standard. In 2019, one would have expected the impact of IFRS-9 to reduce because banks had already taken a hit from day one, but unfortunately, due to the economic, political and social conditions, non-performing loans are still rising which means provisioning will continue to increase and erode banking earnings further.

Won’t the Easter Sunday terror attacks and communal tensions impact business and their ability to service bank loans?

Business confidence took a blow after the unfortunate events, particularly tourism and SME sector. However, the impact on banks due to non-performing loans will be contained on a temporary basis due to the debt moratorium announced by the Ministry of Finance and Central Bank. Also, there is some leeway for banks from how small and medium business loans are classified so that no additional provisioning needs to be made on loans which were in the performing category as at end April 2019. However, both these measures are temporary. The moratorium for tourism businesses will end next year. Small and medium business loans may have to be reclassified in June 2020 so that banks will have to make provisions for expected loan defaults at that point. The Easter Sunday attacks and subsequent events seem to have a ripple effect on other sectors of the economy that banks have significant exposure to, so the impact will be felt during 2019.

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Why is IFRS-9 useful?

Before IFRS-9, banks waited for indicators for a loan going bad before providing for impairment. It was globally recognised as a skewered method because instead of spreading provision cover throughout the loan period, a larger hit was taken when a loan was already in default, or when the loss was incurred. As a result, bank profits tended to fluctuate. IFRS-9 was introduced to address these problems. Now, loans are monitored from day one and banks will provide for expected future losses. There’s no cash loss immediately but a notional entry is made in the bank’s books. However, if the borrower does not default then the bank can reverse those provisions and realise the earnings.

This accounting standard is a progressive one because it forces banks to assess the loans based on risks and recovery method (cashflow or collateral), align repayment plans with the cash cycle of the borrower, closely monitor loans and introduce robust recovery processes. If banks are collecting the instalments on time, then provisions for bad loans don’t have to be made on these.

IFRS-9 encourages banks to prepare repayment plans based on borrowers’ cash flow cycles. If a borrower gets inflows every three months, then the loan settlement plan will allow settlements every three months. However, because the risk is high as there are no collections for two months, the pricing of the loan (or interest rate) may have to be high. Borrowers prefer monthly instalments even if they default a few months rather than pay high interest. As a result, banks take a bigger hit on provisioning. Banks are struggling to move towards risk-based pricing because they don’t want to lose clients to competitors.

Most bank loans are collateralised so why make provisions for bad loans, let alone expected defaults?

That’s because when impairment is assessed, banks must decide how loans will be recovered: regular repayments or through realisation of assets placed as collateral. Banks can’t do both. It’s not easy to recover defaulted payments from collateral within a short period. Bankers need to calculate the present value of an asset which can be realised five or six years from now and then compare it with the carrying value of the loan to assess today’s provision needs. Despite the non-performing trigger, banks are reluctant to make provisions because the security value is high. Total exposure may not be covered fully when you discount the collateral assets.

If the recovery period is five to six years, banks must calculate the discounted value of the collateralised asset. That’s where banks with robust recovery processes really benefit because their realisation period is quite short.

The KPMG Sri Lanka Banking Report has a section on digital transformation at banks. Are banks really investing in transformational technology, or is it something very basic like systems upgrades and apps?

Let me deep dive into digital transformation. Customers continue to make new demands on banks which are already dealing with challenges from multiple fronts, and this is a critical challenge. Banks are operating in a tough environment. Credit growth slowed down in the last quarter of 2018 and that trend has continued in the first two quarters of 2019. Lower credit growth for banks means declining top lines and narrowing interest margins. Provisioning for bad loans has increased under IFRS-9 when banking profits were already hit by rising non-performing loans which continue to increase. Taxes are biting chunks off profits. Banks were slapped with two new taxes in 2018; a debt repayment levy and nation building tax.

Combined with corporate income tax and a value-added tax on financial services, banks now surrender over half their profits to the Treasury. Loyalty to banking brands are diminishing. People want to experience holistic convenience and have no qualms about changing to a bank with the best to offer. Banks are investing in technology and digitalisation to retain and grow their client bases and navigate the tough economic and regulatory environment. Going digital has its own challenges. Cost-to-income ratios are rising but banks are investing in technology even though it will take three to five years to realise returns. Banking leadership realise the critical importance of starting the digital journey now. That’s good to see.

What are the challenges around digitalisation of banking in Sri Lanka?

Digital technology is changing consumer behaviour at a rapid pace and challenging traditional business models. The challenge is compounded by the fact that technology itself is evolving at a fast pace. As a result, banks are forced to change the way they operate in order to meet new demands and deliver desired user experiences. Large banks are stuck with legacy systems that are too costly to overhaul. But digital transformation is a medium to long-term priority for some of the banks we spoke to. They’ve even recruited technology experts to leadership teams. Aligning the existing talent pool with diverse customer needs is another challenge. They’re thinking in terms of digital natives (people born after the widespread use of digital technology) and digital immigrants (those born before). Banks are trying to align digital native staff with digital native customers and training digital immigrant staff to deal with like-minded clients so it’s easy to drive people to digital channels.

Banking staff that don’t take to digital must be trained to take on other value-added functions, because retrenchment is not usual in Sri Lanka. One would expect the digital transformation to result in staff retrenchment and therefore falling costs, but that is not going to happen.Not it this market. Realignment and retraining is the best available option for banks which in turn can lead to cost optimisation.

Another challenge is to align the entire length and breadth of a banking organisation by removing silos and creating a seamlessly connected enterprise around the customer. This will also help optimise technology and reap the full benefits of digitalisation. At KPMG we call this concept the Connected Enterprise Evolution. The brand, products, staff, infrastructure and external partners and alliances all need to be aligned to focus on customer strategy. For instance, big data analytics has grown in importance over the years, but most banks have multiple data points some of which may be entirely isolated from the rest. This makes any investment in analytics technology ineffective.

Banks also need to know the right technologies to invest in, how to optimise them for better results, get digital products and solutions to market fast and measure customer satisfaction. Banks must be smart because technology systems are expensive. Banks may not always have the necessary expertise, so they need to deal with external partners which bring other risks. Banks need to ensure sensitive customer information is secure and be very conscious of avoiding unnecessary costs when commissioning tailor-made IT infrastructure. Another challenge for banks is that regulators lag consumers in terms of acceptance of technology and expectations. Sri Lanka’s Central Bank is cautious given the systemic importance of banks, but the regulator understands the need to create a regulatory environment conducive to digital banking. Sri Lanka is not a market that can quickly transform into digital banking. However, some of the large banks have plans for a seamless transition over the next few years. There are still many people who prefer visiting a bank branch, so banks are investing in a ‘phygital’ strategy, that’s concurrent physical and digital expansion.

The so-called cost-benefit from going digital is not going to be realised anytime soon because we’re still going to have branch networks. Recouping investment and seeing the benefits from digital investments will take longer. It’s still good to see most of the banks starting the journey. The large banks are serious about digital transformation and have developed long-term road maps. Smaller banks are taking a bits-and-pieces approach investing in front- end services and apps.

Do you see evidence of banking boards giving digital transformation priority?

They certainly are. There are two reasons for this. One, banks are investing heavily in technology and they understand that it could take three to four years to realise the benefits of these investments, so close monitoring of digital projects is given priority. Second, consumer behaviour is changing, and banks don’t want to lose out to competitors by not being able to meet the evolving customer requirements focussed on convenience, overall experience and simplicity. Therefore, we do see that large banks have made digital transformation a medium to long-term goal. They may not be satisfying consumer expectations now, but banks are trying to bridge the gap. The level of initiatives taken by banks is encouraging.

It’s not just introducing an app, but they are changing infrastructure, and realigning staff in the front and back ends and the entire product mix. We’re now seeing more innovative mobile apps and higher penetration of internet banking. Smaller banks have also commenced their digital journey, though in a smaller scale and in specific areas. They have an advantage as they don’t have the challenge of dealing with legacy systems and can develop digital banking products and go fast to the market. In a competitive, crowded market, digital can help small banks to dominate a specific niche for growth. If not, consolidation may be the only other option to survive in a tough market like ours.

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What will future banking boardrooms look like?

Future banking boards will comprise financial sector and non-financial sector experience. Previously, the focus was on traditional core business and risk models. But now there’s a shift in focus to digital. IT governance and controls are important agendas across boardrooms globally. As Sri Lankan banks immerse themselves in digital transformation, boardrooms will need to build expertise in those areas. As technology improves security will become a critical agenda item due to increased risk of fraud through the proliferation of the network and overall cybersecurity. There must be an understanding of how digital technology is shaping consumer behaviour, increased awareness of data protection and emerging cybersecurity risks. The large banks are looking at it and some have even on-boarded IT professionals as directors.

There’s also a critical need to improve vigilance and compliance with increased pressure of regulatory scrutiny. The current Banking Act is being reviewed at present with the intention of strengthening the position of the Central Bank with more powers to regulate the financial sector. Structures and processes need to be put in place and key leadership held accountable because lapses in internal controls can lead to non-compliance related fines, sanctions, and worst, for a small competitive market like Sri Lanka,reputational damage which can erode client and investor confidence in a bank. In developed markets, regulatory sanctions have become a growing challenge for banks to deal with. Regulators subject banks to numerous analysis, monitoring and supervision that avoiding lapses with full proof systems is a costly exercise that had to be boardroom-led.