Rajendra Theagarajah, is a name synonymous with Sri Lanka’s Banking and Financial Sector. As the former CEO of the National Development Bank, Hatton National Bank, and more recently Cargills Bank, Theagarajah has overseen significant growth during all his tenures. He is also a previous recipient of the Asian Banker Leadership Achievement Award in 2013 for Sri Lanka.
Commenting on the current economic environment, Theagarajah says that he believes that the banking sector needs to realign in order to streamline economic growth, and stresses the importance of a specialized Development Financial Institution to cater to the urgent needs of the country’s entrepreneurs.
With over 34 years’ experience in the local and international banking sector, Theagarajah offers his opinion on the needs for the industry, as the country strives to recover and progress following a year of unimaginable challenges.
What are your thoughts on the state of the banking sector leading up to 2021?
The year 2020 was one where two key events posted a ‘double whammy’ for banking in Sri Lanka. Firstly, the ‘over-spill’ into 2020 from the April 2019 impact on tourism and business in general, with moratoriums and the ‘hand holding’ of several sectors.
Secondly, the surfacing of the COVID-19 pandemic devastated several sectors due to them having to grapple with the unknown, and learn to live with working from home as a new norm. Lockdowns both locally and internationally, and restrictions on tourism, limited access to markets for many sectors, which in turn, slowed down the economy to record negative growth, and also led to a slow but sure rise in Non-Performing Loans in Bank & Financial Institution (FI) lending portfolios.
The negative economic growth and the downgrading of the sovereign rating no doubt has put further stress on the credit loss models in computing ‘Probability of Loan Loss’ and ‘Loss Given Default’ ratios, which impose additional stress on FI profitability, as well as a need for additional capital infusion in an environment where many investors have adopted a wait and see attitude (other than the upside seen in the CSE from a few stocks).
The banking sector has, to date, rallied around the government’s initiative to infuse relief by way of moratoriums to businesses for bank borrowings. The real impact however, will probably be known later in 2021 when moratorium deadlines expire, and the behaviour of foreign shareholders is seen when ‘the freeze on declaring cash dividends by banks is removed’, and whether the impact of excessive liquidity in the system actually reaches borrowers to fuel real growth.
The Central Bank has announced that a single-digit interest rate regime will be maintained. How will this affect the banking sector as well as the economy?
Single digit interest rates have two components; one on the pricing of bank deposits, and the other being the pricing of loan products. In a declining interest regime, the latter tends to adjust itself faster than the deposit base, due to the prevalence of a substantial chunk of bank deposits being fixed deposits.
While a single digit interest regime will naturally encourage businesses to think of activating investment and growth plans, what is pivotal to its success is (a) consistency in such a policy announcement, and (b) defending such a policy in the medium term at least for 5 years. In doing so, what is of paramount importance is regular, clear communication with the public on measures taken to defend such a policy despite “blips” in other factors contributing towards economic growth, such as revenue to GDP contribution etc.
Without intending to sound negative, my concern is that past attempts to maintain single digit interest rates have not been sustainable, mainly on account of the balance of payment position of the country. We will obviously have to look at this challenge in relation to future external debt repayments over the next five years plus time horizon.
While confidence reposed on borrowers will naturally look towards more borrowings, the drop in the price of deposits will also affect the large percentage of pensioners and those depending on deposit interest for their existence.
What is needed in parallel is the development/rollout of long-term savings options by the Colombo Stock Exchange, which can also offer a better yield from issuers who have sustainable business models.
Three further issues to watch for are, (a) the danger of an external imbalance due to large imports which could result from investment decisions, and (b) dampening of foreign investor interest in the inflow of ‘Hot Money’ into the country, and (c) ensuring that lending rates fall sharper than the drop in inflation, thus improving the ‘real rates’ at which commercial borrowings from banks become attractive.
What is the role of a development bank for a country, and how is it different to a regular bank?
A development bank as a model should take a medium to long-term view of a business and its entrepreneur, and be able to assist in the growth of the business whether it is, (a) value added exports, (b) import substitution catering to domestic demand, and most importantly take a positive view on financing either capital expenditure (for manufacturing related entities ), and or support the strengthening of supply chains including dry/cold storage, transport from source to manufacture, manufacture to distribution, and/or shipping locations.
Regular banks traditionally engage in retail, consumer-related financing, acceptance of deposits, and mainly provision of short term working capital needs for both manufacturing and trading businesses.
While some regular banks have extended the portfolio offering to address some of the above areas relating to development finance, there is more room for a specialised Development Financial Institution (DFI), to play a more meaningful role, especially when the moment in the country’s journey towards building sustainable economic growth requires a clear long term view.
Why has Sri Lanka not ventured into development banking?
I believe that two institutions in 1955 and 1979 were set up under special acts of parliament to identify and promote development banking. These two institutions as a model, (a) did not accept public deposits, (b) did not engage in foreign exchange activity with customers, (c) did not engage in consumer or retail banking, and (d) over decades built solid ‘project and industrial financing’ capability, with structured training given to a carefully selected cadre of staff including those with sound engineering, financial analysis and structured financing capability.
These DFIs were also able to take equity stakes in businesses they financed, were allowed to sit on such company boards as observers adding valuable inputs to decision making etc. Another critical success factor of these DFIs was that the lending portfolio was not financed by short-term deposits from the public, but from structured credit lines negotiated both with local institutions as well as multilateral agencies, and DFIs with a long term appetite.
When the first wave of economic liberalisation was opened in the late 1970’s, the demand appeared to favour the fostering and encouragement to open a flurry of new Licensed Commercial Banks (LCBs), both with local sponsorship and/or as branches of regional and international banks.
These institutions mainly focused on short-term retail and working capital financing of a trading nature, with little or no focus, nor intellectual capacity for long-term project related financing. As a result, the banking ecosystem is skewed towards a few playing their rightful role in contributing towards nation building, while others simply mobilise deposits and take a very short term view.
As far as the two DFIs mentioned above were concerned, both had ventured into commercial banking including retail, by acquiring retail banking franchises and merging them into the DFI model and getting necessary regulatory approvals to get out of the respective acts of incorporation. Somewhere around 2014, the then government announced the facilitation for both banks to merge for a new development-focused Licensed Commercial Bank to be formed.
By doing so, the objective was to also harness and preserve the project/development finance skill set of respective banks in the new bank, which would have a sizeable balance sheet with a dedicated Development Banking pillar inside the overall model. A global advisory firm, highly experienced in bank M&As, was engaged by both boards to create the roadmap for amalgamation and a substantial amount of ground work had been done towards implementation.
Unfortunately, with the change in government at the time the project was dropped, and in my opinion we lost a golden chance to create a special vehicle harnessing the best in established development banking and commercial banking. The lesson for the future from this is do not reverse a good policy initiative merely because of a change in regime.
Why do banks continue to prioritise the trading sector over the manufacturing sector?
Over the years it was easier for LCBs to finance short-term working capital and trading related financing based on underlying short term deposit bases, which were the main source of funding. Secondly, Sri Lanka’s capital market has seen very little progress in non-deposit based funding tools from both listed and unlisted sources.
The maturity profile of a corporate debt instrument typically ranged from 2-5 years. Anything with a longer tenure had to typically see a reduction of 1/5th annually, instead of a bullet repayment in order to qualify for ‘Tier 2’ eligibility of capital adequacy.
At the same time the human capital capacity of LCBs was skewed mainly towards, retail, consumer, and branch banking with very little capacity in project financing.
Have Sri Lankan banks created an environment that supports the growth of a start-up and innovation led economy?
I would say relatively no. There are several reasons for this. In the start-up eco system, there are multiple cycles ranging from, (a) promoting a smart idea, (b) experimenting with innovation till commercial viability or otherwise is established or validated, (c) engaging banks for funding commercial activation including access to local and export markets, and (d) the patience to build a domestically testable model on 20 million people which is subsequently highly scalable to regional and international markets.
In each of this stages, there is a high degree of uncertainty, risk of failure, lack of courage among entrepreneurs to rise from initial failure, re-engage with applying key learning from initial failure, and most importantly to build and drive a brand which is a competitive USP (Unique Selling Proposition) which does not rely on government protection in terms of either tariff or exchange rate movement.
Banks are simply not geared to understand such models, nor take such a degree of risk with depositors’ monies (the main source of funding loan portfolios). Banks are also not permitted to take up equity stakes in such entities, and furthermore LCBs are subjected to accounting standards which include ‘impairment for credit losses’, which has a direct impact on their capital bases. Hence this eco system has, to date, relied heavily on private equity, which is able to take an informed decision weighing all the factors mentioned above.
Also when LCBs typically focus on short-term financing, there is very little capacity available internally both at management level or board level, to understand and keep pace with innovation and how innovation can contribute towards creating a sustainable business model not dependant on protection.
How should the sector adjust in order to focus on the long term growth of the Sri Lankan economy?
The banking sector has to clearly align itself to the journey that seeks long-term economic growth of the nation’s economy. In doing so the following areas for a shift should be introduced by those in control of policy formulation:
- The Central Bank, having responsibility for monetary policy, must clearly articulate its policy on medium and long-term interest rates. In doing so, it must also regularly communicate to banks and other stakeholders its rationale, and steps taken to defend their policy so that there is confidence reposed on consistency.
- There has to be recognition of the importance of technology, relating to value added agriculture, financial inclusion and supply, and value chains. In my opinion, banks are operating in isolation mostly in relation to the above ecosystems. We need to encourage the development of a Technology Centric Platform (similar to a national fibre network) where the various ecosystems can plug and, (a) upgrade individual infrastructure into a common minimum standard, (b) have the choice of either investing in such a platform, or benefit from it on a “Pay-As-You-Consume” basis
- The sponsorship of such a platform mentioned in the second area mentioned above must be driven by the Central Bank as a key enabler of monetary policy stability. The reason for this is most bank CEOs/Chairpersons have a relatively short time frame in office, and probably do not have the luxury of time to drive such a vision for the sector. The anchor must come from an institution that has that bandwidth and long term vision. Future selection of bank boards must also have a good mix of skills that can think outside conventional models, and contribute towards steering the banks towards agility and competitiveness, whilst not compromising in risk and reputation.
- Currently the digitalisation roadmap for banks is driven by the Department of Payments and Settlements at the Central Bank. Some very good stuff gets discussed at technical official level, but it’s time that key developments, especially linking FinTech/AgriTech innovation with the financial system architecture of the country, must be escalated regularly to the attention of the Governor, Monetary Board and Bank CEO Forum to ensure there is strategic ‘buy-in’.
- The new Banking Act should actively promote the licensing of ‘Digital banking licenses’ with differential capital requirements, and limited service offerings (similar to the Monetary Authority of Singapore), which will bring in a new breed of agile innovation centric Financial Institutions into the ecosystem who can cohabit and compliment legacy FIs with larger balance sheets.
- The technology-centric platform mentioned in (2) must clearly foster the availability of data analytics and machine learning that can be offered to ecosystem players to improve their product offerings and competitiveness, instead of taking shelter behind a ‘protected’ ecosystem.
- LCBs should be encouraged to set up incubators, as well as commit a percentage of their capital into seed/start-up funds. That component can also be linked to a 100% deduction against assessable income of the respective bank.
Finally, on the setting up of the Development Banking Institution proposed in the recent budget, my humble opinion is that merging three institutions with little or no development/ project financing capacity will not achieve the objective. It is not too late to re-visit and re-activate the original tone set by the government in 2014, by merging NDB and DFCC and create a powerful balance sheet, positioning the merged bank as Sri Lanka’s premier Development Focused Commercial Bank.