Profit optimisation through optimal capital utilisation: Banking sector
Thursday, 24 April 2014 00:00
The Sri Lankan commercial banking sector has been solvent due to proactive and extra precautionary regulatory requirements exceeding that of global standards.
CAR and SLAR
When the European and US banking system strives to follow bare minimum requirement of regulatory standards, the Sri Lankan banks hold 5% to 10% in excess of certain regulatory requirements such as CAR (Capital Adequacy Ratio) and SLAR (Statutory Liquid Asset Ratio).
On one hand this has reduced the systemic risks for the economy, however on the other hand it has brought in complacency in management aspects of banks. This impacts the return on equity (ROE) for the share holders. Additionally Sri Lanka is not exposed to derivative markets, which estimates sometimes at 60 times higher than the underlining transaction.
Furthermore, Sri Lankan banks deal in few foreign currency derivatives/futures/options with almost all deals hedged against another transaction passing the risk to a third party, apart from limited FOREX positions banks take.
The Sri Lankan Central Bank sets CAR requirement 1% and 2% higher than the set BASEL international standards without being exposed to derivative markets, still one should question whether these extra precautionary rules are really necessary. One may argue that this extra measure is for offshore expansion of the banks or for consolidation of the financial sector.
The BASEL committee under BASEL II requirements sets 4% for Tier I Capital and 8% for Tier I and II, while CBSL had set it at 5% and 10% respectively in Sri Lanka. Furthermore banks are holding SLAR of 37.7% when the requirement is 20%. Had this been the situation in the Western world, the shareholders would have demanded that the excess capital be paid back by way of a share by back. These are not practiced in the Sri Lankan share market.
Similarly, shareholders are obliged to infuse capital if a rights issue is authorised on a solid expansion or investment plan. Similarly, when there is excess capital in a company or a bank, shareholders should benefit from that.
We at JKS E Consultants Ltd. have developed a business model which highlights the optimal capital utilisation in a bank while maximising profits accordingly. This business model will look at all of the regulatory ratios, ABC, RORAC, TP, new management accounting ratios and a simple dash board for the BOD/The Leadership Team to know how resources are utilised and which business segment brings them the best ROE. We have taken some concepts from the capital market theories of portfolio management in designing this business model. It will also look into the comfort zones of banks, looking at if the extra padding is absolutely necessary.
Anomalies in transfer pricing effects a profitable business reflecting it as non-profitable which will be a hindrance to attract future investment. This business model will highlight thought provoking transfer pricing strategies which will be helpful to critically analyse the current TP mechanism in the respective banks.
ROA and ADR
Some banks are fascinated with ratios such as ROA and ADR. They try to increase ROA and reduce the ADR at any cost. Is this right? These ratios should be looked at in the context of the whole balance sheet, the macro analysis of the economy and the future demand.
The ROA in the banking sector is unique as there are certain businesses one could engage in profitably without allocating any capital. However, these businesses impact the ROA negatively. What should banks do in this instance? The answer to this is provided in the business model.
The business model can be used to differentiate between the foreign banks operating in Sri Lanka and their advantages versus local banks. One would be able to see why foreign banks concentrate on certain segments very profitably. But if a local bank tries to compete in the same space, they will end up in utilising resources at a very marginal profit. There are however tactics of making this particular segment profitable to local banks with a differentiation strategy in service offer and process reengineering.
[The writer – FCMA(UK), FIB(SL), MBA(UOC), CCM(FASEC), CGMA(USA) – is a corporate trainer/consultant. For inquiries on the business model, please email firstname.lastname@example.org. Website: www.jkseconsultants.com.]