What is the best size for a bank in Sri Lanka ?

Dr. C. A. Salgado

BANKING: So the debate goes on. Are bigger banks better? Does size of the Bank offer any critical advantage when it comes to offering banking services effectively and in a more reliable manner than competitors? This debate is nothing new and dates back to the Great Depressions of the 1920s when banks, particularly in USA and Europe started failing, adding to the panic and uncertainty that symbolized the interwar period.

Banks of all sizes failed but generally widest publicity and biggest damage to customers and the respective economies came from the failure of the larger banks. The ripples created by the failures of smaller and medium banks were quickly evened out because of the localised impact and the ability to hold the ultimate owners accountable.

Since that time bigger banks have always been viewed with some suspicion by regulators as well as customers.

In USA, laws were passed to ensure that banks did not become too large by having branches in more than one state and in some cases by not permitting to open more than one branch even within the State.

The resulting benefits from such controls are still being argued but experts at least agree that it ensured a period of all round growth by spreading financial resources of the banking sector consisting of financial capital (equity and debt) and human capital (banking knowledge and expertise) in the widest possible manner.

In USA, the biggest banks were concentrated in New York (money centre banks handling international trade transactions) California and Texas, while most other States had a very large number of small banks numbering over 15,000 at one point.

This has now begun to slowly change with the legal amendments that followed. One important piece of legislation being the Riegle-Neal Act of 1994 deregulating interstate banking and the Gramm-Leach Bliley Act of 1999 permitting formation of financial groups but laying down strict rules on shareholder limits, eligibility of Directors and Management, capital requirements, firewalls, corporate governance and similar issues intended to protect depositors.

Japanese path

In Japan, the postwar priority was the reconstruction of the battered economy and transformation of large corporates geared for military production into world class industrial champions. No restrictions on size were imposed but Bank of Japan (BOJ), their Central Bank, kept a close eye on operations.

This however was not effective enough as Japanese banks expanded internationally without proper supervision both at home and in their new countries. Nevertheless, growth of Japanese economy offered enough and more opportunities for banks to expand. But things soured after late 80s with the bursting of the asset bubble and drastic drop in real estate values with an attendant drop in business confidence.

A phenomena, fascinating then but foolish in retrospect, was the expansion undertaken by the Japanese banks through large-scale mergers where banks kept on growing merely in size for the sake of growth and little else. With each merger the combined market value kept on declining even though asset wise the banks were growing bigger and bigger.

Uncontrolled asset expansion finally led to severe systemic risk threatening even the biggest such as Sakura and Mizuho. A few actually failed. One of the largest being the Long Term Credit Bank 'LTCB' which finally collapsed causing severe losses to customers and shareholders.

Of course the time LTCB failed, there were many other large banks and LTCB by itself accounted for only around 2% of Japanese Banking Sector assets and therefore its failure did not have a major impact on the Japanese economy. However, Analysts were of the view that had it been much larger, the failure would have resulted in many other smaller banks failing along with it.

Asia and Sri Lanka

Other industrial countries also followed policies which were primarily aimed at creating healthy competition among banks and spreading ownership, imposing strict rules on composition and eligibility of Board Members.

Similarly, most developing countries including India and Sri Lanka introduced laws limiting ownership of banks to levels considered appropriate for each country (5% and 10% for India and Sri Lanka, respectively) and was intended to achieve two objectives. One was that the ownership should not be too large to evoke 'Proprietorship Tendencies' that would harm the interests of depositors and the economy at large.

The other objectives that banks' ownership should not be too low, which would result in disinterest and abdication of responsibilities as a shareholder. Therefore, striking a balance between the two has been of utmost importance.

The laws enacted for this purpose in Sri Lanka made it the duty of the Central Bank, which enjoys wide powers vested in it though the Monetary Law and the Banking Act, to strike this delicate balance in the letter and spirit of the law.

However, considering that the State banks are still under 100% Government ownership, certain leeway was provided for the Finance Minister to permit shareholdings in excess of 10% where 'National Interest' was clearly being served.

This concession was included purely to accommodate the State banks and the Development Banks which were operating under State ownership and sponsorship, primarily engaging in long-term development lending and also funding the poorer segments who were not being accommodated by the private and foreign commercial banks.

Model for Sri Lanka

Regulators of developing countries agree, what really matters is not the size of a bank but the willingness to undertake riskier type of advances for the sake of the country while at the same time earning higher returns than the staid commercial lenders.

Particularly in developing countries, banks becoming very big with opaque ownership has its own disadvantages which were clearly analysed in a recent survey conducted by financial analysts covering Third World countries.

The biggest single risk identified was the inevitable political meddling intending and operational decisions and influence peddling by rich politically connected entrepreneurs often making underpaid and pliant central bankers ineffective or powerless.

Analysts concluded that, when a bank grows too big, regulators are also compelled to work 'around the bank' fearing that the slightest hint of investigation into the bank would trigger a ran on it thereby, preventing regulators from taking corrective action until the problems become too large to handle.

		Recommended limit to size of a bank
		        Assets as a	   Deposits as 
				   	   a percentage
		        percentage	   of total deposits of the
		        of GDP	           banking sector
Developed countries	1-2	  		3-6
Developing countries	2-4			5-8

		Assets of the bank as a percentage of GDP
			As at 31.12.2005
			(Rs. mn)
	                Assets	      GDP	     	%
CBC	                180,135	     2,366,000	   	7.61
HNB	                174,987	     2,366,000	  	7.40
DFCC	                53,442	     2,366,000	    	2.26
CBC+HNB+DFCC  		408,564	     2,366,000	   	17.27

		Deposits and advances as a percentage of
		    total bank deposits and advances
			Net		Total	     	    %
			advances        advances  
 CBC			118,679	        907,236	     	 13.08
HNB			106,567	        907,236	    	 11.75
DFCC			37,109		907,236	    	 4.09
CBC+HNB+DFCC		262,355		907,236	         28.92

			Deposits	Total		 %
					deposits in
					Sri Lanka
CBC	                127,490		1,242,377	10.26
HNB		        128,130		1,242,377	10.31
DFCC		        8,170		1,242,377	0.66
CBC+HNB+DFCC  		263,791		1,242,377	21.23

The consequences of the failure of banks are well understood and documented. Through experience gained, regulators often specify prudent limits for sizes of banks which of course vary depending on size and the orientation of the economy (whether primarily - industrial, agricultural or service oriented) and have been set as follows:

In this light, it would be of interest to see how the two main private sector banks in Sri Lanka and the main development lender, DFCC meet these yardsticks because allegations are being made that a business tycoon is doing his utmost to bring these three institutions under one entity thereby creating a 'financial powerhouse'. These figures are very revealing.

Even individually, CBC and HNB have already crossed these thresholds in every criteria posing a threat to the stability of the financial sector of Sri Lanka. Even on issues as shareholding limits and good governance practices, CBC and HNB have been testing regulatory limits with a group of minority shareholders being compelled to seek legal remedies when the Central Bank possessed the necessary authority to give the directives to prevent violation.

It is clear that a merger of all three entities is going to create private sector banking behemoth accounting for over 17 per cent of the country's GDP and 1/3 of total loans. What is more risky and damaging is that it will, for all purposes be controlled by one party having competing interests which conflicts with most of the major customers of the bank.

Therefore, it is up to the regulators to at least now draw the line where it is necessary and to issue firm directives not permitting any further consolidation in the banking sector and to strictly enforce the 10 per cent ownership rule on banks for direct and indirect holding.

The recent amendments to the Banking Act, which clearly specifies that no party whether directly or indirectly could control more than 10 per cent of a bank will only strengthen the hand of the Central Bank in taking these difficult decisions.

However hard it may be, Central Bank will immediately have to take that decision in the interests of the country and its people, as the saying goes 'justice delayed is justice denied'.