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By Charumini de Silva
Sri Lanka’s leading independent equity brokerage firm Asia Securities recently hosted its inaugural Financial Sector Investment Conference in Colombo, where experts shared insights on trends, challenges and opportunities, while exploring the best investment opportunities in the financial sector.
Titled ‘Shifting Gears: But Which Way?’ the Asia Securities Financial Sector Investor Conference marked the seventh under the ‘Wealth Insights’ series of investor events, which is now in its third year generating value added insights for the capital markets community in Sri Lanka.
Delivering the opening remarks, Asia Securities Chairman Dumith Fernando said Sri Lanka’s economy and financial system had benefited from happenings around the external environment, but more importantly from post-war regeneration efforts.
“The wealth creation in the country at all levels has driven a vibrant financial sector with banks and finance companies reaching far corners of the population in search for growth,” he added.
Noting that Sri Lanka’s financial sector had dealt with unique challenges Fernando said their objective at the Asia Securities Financial Sector Investment Conference was to explore the not-so-obvious.
“We are pleased with the industry response to our inaugural Financial Sector Investor Conference. As one of the leading equity brokerage firm in the country, we feel it is our responsibility to be thought leaders for Sri Lanka’s capital markets community,” he added.
Furthermore he pointed out that this initiative helped them to provide the right platform for discussion, debate and resolution of the challenges facing the financial community while simultaneously examining the best investment opportunities in the sector.
Delivering the keynote address, the Central Bank Governor Dr. Indrajit Coomaraswamy said the global economy had a number of tailwinds for Sri Lanka, while insisting on the need to focus on mitigating the negative impacts of the international interest rates.
He asserted that the world economy seemed to be in better shape, providing a better set of external circumstances of tailwinds for Sri Lanka and considering all the macroeconomic factors, it offered the country a great opportunity to further economic prosperity.
Dr. Coomaraswamy focused his remarks from a macroeconomic perspective, outlining the favourable external economy, challenges, and opportunities, highlighting that Sri Lanka could gather momentum to progress towards a higher growth trajectory in accordance with a carefully-designed development agenda.
He asserted that Sri Lanka had a great opportunity to take advantage of China’s massive outflow of capital in the next 10-15 years.
With key export markets the US and the European Union now on an upward growth trajectory, Dr. Coomaraswamy said it had positively reflected on Sri Lanka’s past five month export figures.
“Sri Lanka will be the only country in the world that will have preferential access to China, India and Europe. We are also working on many bilateral trade agreements with India, China and Singapore. The real prize of these trade agreements is to show this preferential access to these markets and our location. These are massive differentiating factors for Sri Lanka to attract investors,” he pointed out. However, it was pointed out that robust macroeconomic fundamentals were necessary to maintain momentum of the economy through fiscal consolidation, exchange rate alignment, prudent debt servicing and introduction of a flexible inflation targeting regime.
“From my understanding there is a general perception that the next FED rate cycle will see an increase of 25 basis points (2%) in December, which is much less than in the past,” he emphasised.
As far as institutional investments are concerned, he said due to the buoyancy in advanced countries, their yields had increased significantly and the volume of money therefore coming into the emerging markets from institutional investors may get tempered.
“This makes it even more important for the individual countries to make sure their macroeconomic fundamentals are strong, so that they can make sure their share of institutional investors are not affected too much,” he added.
On long terms debts, Dr. Coomaraswamy cautioned on the rising cost of sovereign bonds would come under upward pressure as the normalisation takes place in monetary policies of major economies globally.
“As we are still a twin deficit economy, we have fairly high premium above the risk of US. What we need to do is to strengthen our macro fundamentals to a point, where we drive down that premium. If we are able to drive down that premium, by more than increasing the risk-free rates, then clearly our cost of borrowing will be neutral or come down and that is what we need to do. We need to focus on getting our macro policies even better to drive our premium down,” he explained.
It was pointed that a new growth model based on the private sector being the locomotive for economic development, with exports and investment, including FDI, as key pillars was being pursued. “Maximising the advantages of our strategic location in the Indian Ocean, diversifying our export basket and enhancing trade facilitation will be imperative in promoting sustained growth and development.”
According to the Governor, changes to governance and institutional structures, regulatory frameworks and procedural fairness would enhance the investment climate, enabling Sri Lanka to stay competitive in the region.
Dr. Coomaraswamy also said the introduction of Liability Management Act would enable the Government to borrow more than the requirement for the Budget of that particular year. “Currently, the Appropriation Act limits Government borrowing through finance into deficits in the Budget. With the new legislation, we can raise additional resources.”
He stressed the investment promotions were being boosted through task forces to improve the Ease of doing Business and a more effective one-stop-shop, while trade facilitation was being strengthened through a single economic window and a trade portal in Customs.
In the context of natural calamities being experienced by the entire world today, Dr. Coomaraswamy said devising a growth framework while disregarding environmental sustainability was highly imprudent, hence crisis, preparedness and sustainability need to be embedded in the planning and budgeting process.
CB commits to strike a balance between regulation, innovation, digitalisation
He also said the Central Bank was committed to achieve a balance between regulation, innovation and digitalisation, whilst taking regulatory measures to minimise technological risks.
With a view to having a transparent policy and further strengthening risk management aspects of foreign borrowings by banks, Dr. Coomaraswamy said a new policy, which was prepared in consultation with the banks, would be issued to banks shortly.
“In relation to emerging risks, such as cyber security threats, the Central Bank, together with the banking sector, continues to explore measures that can be taken to address these,” he added.
To broad-base the share ownership in banks and to reduce dominance and influence of a few shareholders, Dr. Coomaraswamy stressed that the existing requirements will be reviewed and a policy on encouraging shareholders of international repute and those who could contribute effectively would be adopted.
“Macro prudential surveillance is being strengthened to address any undue formation of asset or price bubbles,” he added.
In addition he assured that systemic risks were also being taken seriously and the interconnectedness of the banking sector will be monitored.
Fintechs compete for a larger share of banking service value chain
With several new players entering the banking sector, the Governor highlighted that the banking space was set to witness an unprecedented changes in times to come.
“New non-bank players in the form of fintech companies are competing to grab a larger share of the banking service value chain. There seems to be a case for banks to open another alternative delivery channel through embracing fintech to improve efficiencies, lower transaction cost and promote financial inclusion,” he pointed out.
He acknowledged that banks need to create differentiation through e-KYC, digital-only banks, biometric enabled ATMs, smart banking through the usage of artificial intelligence for better customer response, block chain, green financing, cloud computing and so forth. “All this is likely to gain an increasing salience in competitive market in the future,” he said.
Dr. Coomaraswamy emphasised the current trends were such that critical mass would be necessary to succeed in an increasingly confident environment.
“Small and medium sized banks need to consider merging in order to have stronger balance sheets to enable mobilising funds from the international market, to have diversified funding sources to reduce risks, to foster innovation and product pricing and enhance corporate governance. The Central Bank will encourage consolidation going forward. Capital requirements will be steadily increased to achieve this objective,” he added.
Furthermore, he noted that the banking sector was expected to reshape their business models to support the needs of the economy by growing their balance sheets focusing on long term sustainable financing to improve the bank rating and the sovereign ratings, reshaping lending strategies and corporate and business plans, focusing to benefit from the establishment of International Financial Centre, improving operational and infrastructure standards in line with international best practices, better understand the financial needs of the customers and to develop a customer-centric business model, more focus on SME lending and creating a greater regional or even global presence.
Asia Securities Banking Sector Analyst and Head of Research Kanishka Perera pointed out that the improved macroeconomic conditions had created an encouraging environment for the banking sector to deliver strong growth, but also pointed out challenges such as the implementation of IFRS 9 and the proposed Transaction Levy.
Taking a cautiously optimistic view on the local banking sector, he said two years of tight monetary and fiscal policy had improved key macro variables, leaving headroom for growth-focused policies from CY18E onwards.
“We believe that this change in focus will drive a pickup in GDP growth over the next three years, putting banks which are strongly correlated to the economic growth into growth mode. We believe that SME-focused banks will see better growth than others in the near term, while medium term growth will be led by retail-focused ones,” he added.
Noting that they have broadly flat expectations on corporate lending at all points in their forecast horizon, he added that Net Interest Margins (NIMs) were likely to improve marginally prior to settling down from CY18E onwards. “We expect profitability to improve into CY20E on the back of improving income and increasing focus by industry players on driving branch efficiencies.”
Acknowledging that Basel III capital adequacy requirements were in effect with most banks in compliance following capital issuances, he said the State banks remained woefully undercapitalised, driving the expectation of a shift in market share towards the private banks.
“Basel III came into effect from 1 July taking up minimal capital requirements from the low Basel II levels. We note that the two State banks would need at least an additional Rs. 52 billion just to remain at low double-digit loan growth levels and make a meaningful contribution to Government coffers,” he pointed out.
Furthermore, CY18E will see IFRS 9 implementation which will drive an uptick in credit costs. “We believe that these issues are navigable by the local industry, driving our positive view. However, the proposed Transaction Levy would pose substantial headwinds, driving our cautious view. Absent of this levy, we would have a strong positive view on the sector,” he added.
Perera highlighted that an investor looking to play the sector should move into counters which are exposed to SMEs with a strong franchise, have a solid growing fee income base and strong capital levels.
According to Asia Securities, the next phase of cost or income improvements will be driven by a pickup in operating income. Sri Lanka contains one of the largest branch networks compared to regional peers leading to believe that branch expansion led expenses will be muted going forward.
“Our discussions with industry players indicate that they are largely looking at leveraging the existing network to drive growth leading to a very marginal cost on the next rupee of loans. All players are looking to improve branch efficiency to free up staff for more marketing related roles, where we notice an increasing prevalence of automation which frees staff from transactional work,” he said.
“We believe that Sampath Bank’s wide branch network, risk management processes and mindshare put it in an optimal place to capture growth from SMEs while keeping Non-Performing Loans (NPLs) in check. It has one of the lowest per branch operating costs amongst the large players which will drive profitability with growing revenue levels. The aggressive focus on automation will lead to further operating efficiencies. The current capital issuance allows it to meet Basel II requirements while aggressive growth will drive another capital issuance in CY19E. Hence our key pick for the sector is Sampath Bank,” he stressed.
In addition, Perera emphasised that they were bullish on SANASA Development Bank, which has a unique business model in driving growth from the unbanked with Government pensioners and retired armed force personnel being key customers. “The private placement concluded in December 2016 gives it a strong capital base to meet higher minimum capital requirements. As such, we consider that SANASA Development Bank will be a strong contender in the next 12 months.” However, if the proposed Transaction Levy is implemented in its current form, he said that they would cut their estimates on the broader industry.
“The Budget 2018 proposed a 0.2% Transaction Levy for the next three years on all financial institutions, with no clear indication on the modality. The Government has disclosed that it expects to raise Rs.20 billion from this, which would lead to 8.9% to 12% cut in banking industry earning forecast. However, we do note that the impact could come lower as there are various fees which can be introduces to customers with room to increase existing ones,” he explained.
He said fintech held substantial opportunities to drive efficiencies if players started offering the ability to carry out cheque deposits from a mobile phone. “We note that cheque deposits are one of the largest drivers of footfall to branches and consequently, teller time. A substantial understated threat we see is Dialog Axiata PLC’s acquisition of a non-bank finance institution license which allows it to offer all banking products bar a couple.”
The already-active mobile payment infrastructure in combination with over 12 million subscribers, gives Dialog pole position to drive truly digital banking in the country, Perera said.
Asia Securities Non-Bank Financial Institutions (NBFI) Analyst and Economist Lakshini Fernando touched on the fact that NBFIs needed to diversify in order to drive growth in a period seeing muted demand for financing consumption needs.
Taking a neutral view on the Sri Lankan NBFI sector which has seen a number of headwinds in the past two years, she said they expected to last over the medium term. This has come in the form of higher import duties and a depreciating currency combined with the lowering of the loan to value ratio which has reduced vehicle affordability.
She said that all companies under coverage had recorded significant impairments since FY17 which had continued into 1H FY18 on the back of a significant net advance growth during a conducive environment in FY14 and FY15, a high inflationary and slow growth environment combined with extreme weather conditions.
With a significant 40.6% YoY growth in loan advances during 2011 alone, she stressed on the momentum in this sector continuing its upward trend, mainly driven by economic growth which was on average at 5.8% from 2011-2016.
She said external conditions also supported higher demand with comparatively low import duties, a loose monetary policy resulting lower rates, combined with a favourable Japanese Yen against the Sri Lankan Rupee which made vehicle imports more affordable.
“Looking ahead, we do not foresee a favourable environment for leasing growth to continue its historical momentum. We expect the diversification strategies taken by most companies to fuel loan growth which we expect to lead net advances to grow at a CAGR of 23.5% from CY17E to CY20E,” she added.
Highlighting that the 2018 Budget introduced a 90% LTV on electric vehicles, Fernando said they saw this as a positive in the longer term, as the Government planned to eliminate fossil-fuelled vehicles by 2040.
“Overall, in our view, the regulatory pressure imposed from FY16 will continue to lead to changes in business strategies to diversify from leasing to new areas like gold loans, SME, mortgage loans, further pressure on the smaller NBFIs to consolidate and increase competitiveness with the banking industry. We believe better infrastructure for electric vehicles in the form of charging stations and specialised garages needs to be introduced before NBFIs see a material impact,” she said.
In addition she noted the NIM squeeze which was evident in most of FY17 had largely prevailed in 1H FY18.
“We expect a pickup in industry NIMs in the next two to three years on the back of loose monetary policy, but expect this pickup to be relatively slow compared with the high NIMs recorded in the past. Meanwhile in terms of the sector, we expect smaller NBFIs in terms of net advances would see a slower pick up in NIMs compared to our coverage universe which we expect to pick up from FY19E onwards.”
Given the negative backdrop currently prevailing in the NBFI sector, they expect impairments to increase in FY18E.
“Consequently, we expect these to lead to higher NPLs. However, we note that NPLs may be offset by the relatively higher prices fetched at auctions on repossessed vehicles compared to past years. NPLs are also likely to be impacted by higher inflation which causes lower purchasing power for a consumer. We anticipate the impact of the drought to directly impact most NBFIs as a result of exposure to the agriculture sector. However, given the circumstances of an external variable such as drought will have an adverse impact on lenders, we expect NBFIs to offer a level of short term relief in terms of the time period for repayments. On the positive we believe the higher LTVs will help control NPLs than those seen historically,” Fernando added.
Furthermore, the Central Bank has taken steps to tighten regulation on the sector, starting with increasing the core capital requirement by five times to Rs. 2 billion by 2020 and to Rs2.5 billion by 2021, which they believe will lead to the consolidation of smaller NBFIs during this period.
“We expect this to drive consolidation during this period given that 12 out of the 30 listed companies currently do not meet this requirement. In addition, we expect the tighter regulations to create a more transparent and stringent sector in the longer term. In the short-medium term, we expect the stronger NBFIs to remain resilient amidst the changes in the industry while reducing its dependence on vehicle leasing which has been the dominant product for NBFIs in the past,” Fernando explained.
According to her an investor looking to play the sector should move into counters which are exposed to commercial leasing, specifically construction and has dominant market share in non-leasing product offerings.
Several panel discussions were held at the conference. The first panel discussion titled ‘Looking Ahead to 2018: Challenges and Opportunities for Banks’ saw the Central Bank Governor Dr. Indrajit Coomaraswamy, Hatton National Bank CEO and Managing Director Jonathan Alles, Nations Trust Bank Chairman Krishan Balendra and McKinsey & Co Partner – Financial Institutions Ganaka Herath at engaging in a vibrant discussion on the topic.
A key takeaway from the panel discussion was that the macro environment was improving but State Banks would need to raise at least Rs. 50 billion in order to stay in business with the higher capital requirements and double that in order to deliver meaningful growth.
The panel discussion titled ‘Financial Sector Valuations: Cheap or Challenged?’ included leading industry practitioners Softlogic Head of Investments Niloo Jayatilake, Asia Securities Head of Research Kanishka Perera, Actis Private Equity Partner, Head of South Asia Asanka Rodrigo and Morgan Stanley India Managing Director Sachin Wagle. The panel highlighted that the valuations of banks had fallen, making them an attractive investment opportunity. There was consensus that fintech posed an opportunity as well as a threat over the long-term, compelling banks to proactively adapt to it to preserve value.
The session titled ‘State-Owned Banks in the Post-Basel III World’ featured Morgan Stanley India Managing Director Sachin Wagle, PwC Sri Lanka Managing Partner and CEO Sujeewa Mudalige.
Sharing learnings from the Indian financial sector, Wagle said that majority of fund inflows had been directed towards the banking sector when compared with others, but that low capitalisation had been a constraint on the growth potential for State banks when compared with private banks and had led to market share losses.
He also noted that the raising capital has allowed State-owned banks to grow and has led to substantial levels of job creation especially in rural areas which has positively led to improve lending to more SMEs.
Mudalige spoke about the impact of Basel III implementation and upcoming IFRS 9 accounting standards on the Sri Lankan banking industry. In his opinion, the banking industry as a whole is largely unprepared for IFRS 9 requirements and will need to do a substantial amount of work heading into 2018.
McKinsey & Co Partner – Financial Institutions Ganaka Herath delivered a thought provoking presentation on the fintech space followed by a panel discussion which included Dialog Axiata Vice President – Digital Services Fariq Cader, Synapsis CEO Dinesh Fernandopulle, Nation’s Trust Bank Chief Operating Officer Thilak Piyadigama and Herath.
There was consensus on the realisation that banks would have to deal with fintechs going forward where technology would play a significant role in shaping the financial sector. They called on all stakeholders of the banking industry to be fully prepared as it was taking shape faster than everyone expected.
Pix by Lasantha Kumara
