A stitch in time saves nine: Consolidation to save ailing Licensed Finance Companies

COVID-19 continues to challenge the banking and finance industry as the pandemic continues to spread globally. The Licensed Finance Companies (LFCs) in Sri Lanka have been facing challenging liquidity conditions, rising NPLs even before COVID-19, which has resulted in the ongoing discussion of the consolidation of LFCs.

Contributing to only 7.4% of the total assets of the financial system as per the CBSL annual report in 2019, LFCs play a major role in the banking and finance industry by prioritising the subprime borrowers who have not been prioritised by the banking industry. LFCs also play a significant role in maintaining Sri Lanka’s financial inclusion on par with its peers.

The systemic importance of LFCs in the finance industry also brings along many challenges. Whilst the CBSL continues to tighten the regulatory requirement and supervision of LFCs over the years, the effectiveness of such strategies are still questionable given the recent bankruptcies.

Muted loan growth, debt moratoriums, lower interest rates following CBSL’s monetary easing strategies and rising non-performing loans are further going to challenge the performance of the LFCs over the years to come.

The right time for finance companies to consolidate?

This was an initiative brought by the CBSL back in 2014, when Sri Lanka had 48 LFCs, however now it has been reduced to 42 as per the latest CBSL Annual Report.

Analysing the performance of these LFCs over the past few years it is evident that further restructuring will be required in this industry.

Why should the finance companies merge?

The cost to income ratio is an important financial tool in analysing the performance of banks and financial institutions. It is the operating costs excluding impairment in relation to its operating revenue.

The LFCs with an asset base of over Rs. 100 b (large LFCs) maintain a cost to income ratio of an average of 40%, whereas the LFCs with an asset base less than Rs. 20 b (small LFCs) function at a cost to income ratio of over 75% on average as per the latest 3Q 2019 financial statements. 

One reason for this could be attributed to the loan growth of these companies. Whilst large LFCs do see a positive growth in their loan book on average the small LFCs see a negative or stagnant growth in their loan book. Most of the small LFCs are given a default credit rating by the rating agencies which has resulted in an obligation to fund their deposits at higher interest rates resulting in higher interest expenses which do not get set off to their low interest income.

Due to this reason, smaller LFCs are forced to provide financial products and services such as loans and leases at rates similar to the rates of the large LFCs which do not give them the benefit to attract customers. To add on to this the COVID-19 pandemic is going to challenge the small LFCs to get in new customers further. 

It can be agreed that consumption is going to decrease as the market participants follow conservatism and focus on their savings for the future. However, given the debt moratoriums introduced, market participants are going to question the financial health of small LFCs and their ability to honour the depositors on time. Therefore they will be willing to invest in a relatively larger and stable organization even at the cost of a 100-200 basis points.

In terms of meeting regulatory requirements LFCs were expected to meet an enhanced Rs. 2.5 billion absolute capital requirement by 1 January 2021 from Rs. 2 billion that was expected to be maintained by January 2020. The minimum Tier 1 capital ratio for LFCs was also increased from 6.5% to 7% on 1 July 2020, before increasing further to 8.5% from 1 July 2021. 

However, with the COVID-19 pandemic, the timeline to meet these requirements have been extended by one year. However according to the Fitch ratings report, out of the Fitch-rated LFCs, five had not met the minimum core capital requirements of Rs. 2 billion by 1 January 2020.

Whilst it is agreed that the one-year expansion is going to provide some space for LFCs which are pressured to meet the requirements, given the current situation whether they will be able to meet the requirements even with the extension is still a doubt. 

Small LFCs have averaged a ROE of -7.7% whereas the Large LFCs have been able to maintain an average of 12.8% as per the latest reported financials. With the poor performance of these LFCs, they are incapable of getting new investors on board even to support them with maintaining the minimum regulatory requirements.

The most common justification for consolidation is the cost reduction and superior operating efficiency that is expected to result from it. Consolidation is expected to reduce the duplication of resources that leads to higher costs. Secondly an increase in customer base could lead to higher utilisation rates, increased marginal productivity of labour and could support with the increase in revenues. If these arguments are true, it can be expected that consolidation will exhibit improved productivity, technical efficiency and scale efficiency that would reduce costs.

The CBSL introduced a 25% ownership limit in licensed finance companies (LFCs) to be implemented within a timeframe of five years by 2025, to strengthen the Corporate Governance practices. According to the CBSL, currently 30 LFCs, has a main shareholder who owns more than 50% of shares. Further in eight LFCs, more than 50% is owned by the main shareholder and related parties. In two LFCs, ownership is limited to two shareholders and only three LFCs have diversified ownership.

Clear demarcation between the management, owners and board is essential to maintain good governance. Failed Finance companies over the last four decades portray how concentrated ownership leads to the failure of these companies and the overall financial system. Merging LFCs at this stage will not only resolve the above said issues but also allow the CBSL to easily monitor the ownership of the finance companies.

On the other hand large LFCs are capable of recruiting professionals in the industry and adapt to the ever-evolving technology, the small LFCs have not been able to perform to adopt such technology or even raise the capital to stay with the competition. On another note apart from supervising the banking industry which comprises 33 banks, the Central Bank needs to monitor 43 LFCs and 5 SLCs. Monitoring and administering a large number of LFCs is also a challenge for the CBSL.

Whilst merging can bring many benefits to finance industry, it does come with few challenges

Unemployment is one main concern of consolidation. The finance and insurance industry employees around 193,750 employees according to the Sri Lankan labour force survey in 3Q2019. The merging of LFCs can result in a considerable amount of unemployment. It can range from the senior management to the front office employees. It can be assumed that at least 30% of the employees will be laid off and senior management will be given golden handshakes. 

In a situation where unemployment is on the rise caused by the global COVID-19 pandemic, consolidation is only going to make the situation worse. If consolidation is being approved, companies as well as the regulators will have to also think of strategies to minimise unemployment as well as consider the psychological considerations of many of the small LFCs shareholders and employees.

A threat to competition arises, as when LFCs are merged there is a possibility where it creates an oligopoly market, which will result in lower competition, and might lead to companies losing their innovativeness in making new financial products. Given the evolution of fintech in the financial industry, innovation is of utmost importance for the survival and growth of LFCs.

Another interesting reason opposing the merger is that Sri Lanka is still facing a lack of financial institutions. Taking the Asian countries with a similar GDP per capita as Sri Lanka, Sri Lanka’s financial inclusion is at a satisfactory level. Financial inclusion which has been measured by the percentage of adults who own any type of account with a financial institution has been at 74% according to the latest global Findex database in 2017. However Mongolia records 93%, China 80% and Thailand 82%.

Analysing Mongolia which has recorded one of the highest percentage in financial inclusion has a total of 14 financial institutions that accept deposits through their 1,512 branches which is 462 financial institution branches per million where as in Sri Lanka it is only 231 financial institution branches per million. Therefore the need for more financial institutions to increase Sri Lanka’s financial inclusion can be argued.

There is no doubt that the small LFCs are going to face liquidity challenges and it is evident that intervention will be necessary. COVID-19 has shocked the world and challenged the survival for many institutions across all industries and sectors. Whilst the CBSL is following easing monetary supply measures continuously and cutting policy rates further, the potential for the financial products and services of the banking and finance industry remains concerned. Small LFCs fear the attraction of new clients as their financial health is challenged with new regulations and a weakening economy.

The discussion to consolidate has been an ongoing debate. The main question is why it has not been brought to light and secondly why the authorities are not taking steps to protect the small LFCs from being liquidated. Whilst the cons of consolidating have been discussed, the benefits of consolidation do outweigh the costs associated with it. Many other countries such as Malaysia, India, Thailand and Taiwan have consolidated their banking and non-banking institutions in the recent past and it is evident that consolidation will result in improved productivity, efficiency as well as reduce duplication of resources.

Whilst the CBSL to the best of its ability is trying to induce consumption for the growth of the country, by measures such as the restriction on imports such as automobile and the current weakened economy does not signal a conducive environment for lenders and borrowers. The mindset has shifted to a more conservative mindset where consumers are willing to save fearing uncertainty. 

Housing loans as well as auto loans which are the largest components in the loan books of LFCs will not see growth until the end of the pandemic and some form of certainty and confidence is instilled in the minds of the consumer. Till then, the small LFCs which follow a cash flow optimisation strategy will be challenged in what strategies to adopt just for survival.

In summary, NPLs are on the rise and debt moratoriums have been introduced to challenge the liquidity positions further, muted credit growth recorded is expected to worsen over the times to come, regulations have been imposed but many of the small LFCs are grappling to achieve them and the COVID-19 pandemic isn’t making things better. If not now, when would be the right time to restructure the Small LFCs? A stitch in time saves nine!

(The writer is a financial analyst.)