EY shares key insights on financial sector consolidation
Thursday, 8 May 2014 00:03
The financial services industry is currently at a turning point, with the push for consolidation announced earlier this year by the Central Bank. While the move is acknowledged to be much-needed as Sri Lanka prepares to graduate to a middle income status, it is imperative that the consolidation process takes place in a seamless manner with minimal negative impacts.Ernst & Young (EY) Senior Partner Financial Services Asia Pacific Keith Pogson, who is an expert on this subject, was in Sri Lanka last week to share his experiences and thoughts on the move with senior members of the Central Bank and top heads of financial institutions. During his visit, the Daily FT met Pogson for a detailed discussion, during which he shared key aspects of the consolidation process, do’s and don’ts, recommendations, and a lot more that will help the sector get a better view of what it is stepping into.Following are the excerpts: By Shabiya Ali AhlamQ: What is the purpose of your visit to Sri Lanka?A: Over the last 18 years I have spent a lot of time in Asia where I focused on working with governments, regulators and banks on finding their way through industry change in consolidation. In Sri Lanka I note that the topic of consolidation has become very hot with the Central Bank (CB) having a clear agenda on how it would like to progress in this regard.
I was asked by the EY team in Colombo to spend time talking to the CB and banks to share some of the learning and experience in other markets. To highlight what works and what does not, and what they might want to avoid.
Q: Who have you met during your stay?A: Along with meeting heads of six banks, I met with the senior members of the CB. I did a presentation for the Association of Professional Bankers where we had a very healthy dialogue about some of the opportunities and challenges on going through the consolidation process.
Q: You have assisted in the restructuring of banking systems in a number of countries. Could you share that experience?A:I started doing a lot of this during the Asian financial crisis. I spent a lot of time in countries such as Indonesia, Malaysia, Thailand, Korea, and also Taiwan and China. They all had slightly different reasons as to why the consolidation occurred.
In Indonesia, Thailand, and Malaysia, the foreign exchange rates fell apart and the banks were leveraged up in US dollars, which led to an outbreak of non-performing loans. At the same time, the governments saw the consolidation as a way of achieving a healthier banking system. Core banks were put together to make stronger banks, and the number of participants were reduced, thus taking away unhealthy competition which were weakening the banks.
Banking is one industry where you need to find the right balance between monopoly and too much competition. There needs to be some sort of oligopoly to have healthy banks, and have good competition between them.
Q: The approaches were certainly different from country to country. Could you shed some light on that?A: There is a combination of factors such as hygiene and motivator factors. The hygiene factors are those that are absolutely necessary to have, such as a legal consolidation framework. This is needed for consolidating banks for making it is easy for people to transfer deposits, assets and loans from one bank’s name to another, without having to ask every single customer.
Needed is also a tax framework that is lease neutral. In some countries you have to pay a transfer tax for every share that you move and so on, and that can make it really expensive to merge banks.
A supporting regulator is necessary. In addition to that, institutions need to think of HR and labour. If there are too many unions there could be more issues which could result in the slowdown of the process. Thus it is imperative to ensure everyone is onboard when this change is taking place.
One of the challenges we had with Korea was with labour unions, and it was very painful. Even today the country faces the consequences of the labour union involvement which came from the merger period.
"Banking is one industry where you need to find the right balance between monopoly and too much competition. There needs to be some sort of oligopoly to have healthy banks, and have good competition between them. At the moment getting the banks on a compulsion to merge is difficult. In reality they can build the business organically and probably cheaper than they could buy the business. The way in which the banks are owned with shareholders with different interest makes it difficult to make quick deals without justifying to shareholders as to why they should sellYou have got seller and buyers, but the sellers want a little more than what they have than the buyers are willing to pay for. If this was a commercial reason as to why the buyers should buy the NBFIs, they would have already done it. If there is an obvious economic deal, such NBFIs would have been brought before and it would not have been a difficult conversationSri Lanka has 58 NBFIs and that is far too many. The small institutions, do they have finances to invest in strong technology platforms that and serves customers effectively? Can they invest in the credit risk management processes, the support business, and also good for customers? Certainly not. For the size of the Sri Lankan economy, 58 is a big numberMy view on the timeframe is that it is very optimistic. But then again, if you don’t have a deadline, you don’t have actionFinance companies should be worrying about how they could survive and make money. There is lots of competition out there, so they need to be clear about their franchise– Ernst & Young Senior Partner Financial Services Asia Pacific Keith Pogson"Q: What are your observations on Sri Lanka with regard to the consolidation and the financial sector?A: I see the consolidation is a more CB-driven process. The situation is different to many countries since change is driven by crisis and in Sri Lanka I see that the change is driven by opportunity. It is a different scenario. When change is driven by crisis, the Ministry of Finance is always involved since someone needs to cut a cheque. In this case I am not quite clear if we need to be cutting cheques just yet.
About the financial sector, let me start with what I am impressed with. I am impressed with the strength of some of the management teams I see. They are very professional and open minded. I think the technology is evolving well in the system so we are seeing good progress for the technology in place for servicing customers in some of the banks. That is positive for me.
I am excited the way in which the banks have managed to get to grips with the peace dividend in terms of expanding operations and supporting economies.
The focus on SME banking is good. For many economies that is a challenge, extending funding to SMEs.
Q: How about the challenges?A: There are a number of challenges. One is the quantum of banks and as the market evolves, their ability to reach more layers. This country is not going to be just Sri Lanka to its citizens for long. There will be a lot of inward and outward trade for Sri Lanka. Sri Lanka also needs a lot of infrastructure to take it from where it is now to the next level and beyond. This requires a big amount of financing and you need big banks to take the hit on the nose to be able to fund this stuff. Even if you syndicate the loans you need a lot of banks syndicating to take the scale of investment.
Sri Lanka will also see fast development in the middle class wealth in this economy and you need banks which are able to provide that stability and the skill set for support as well.
Q: What are the possible areas where the consolidation can go wrong?A: There are a number of areas. One of them is getting the right value for purchases and this is one of the biggest issues in the market. You have got seller and buyers, but the sellers want a little more than what they have than the buyers are willing to pay for. If this was a commercial reason as to why the buyers should buy the NBFIs, they would have already done it. If there is an obvious economic deal, such NBFIs would have been brought before and it would not have been a difficult conversation.
Finding the appropriate value where we can bring the market together and actually get real transaction is going to be interesting. I think there are number of steps that we need to go through in terms of price determination to the extent that the CB needs to be involved in that.
There are a number of techniques that could be used that worked in other markets. In Sri Lanka, since the consolidation is not taking place due to crisis, there needs to be more commercial reasons as to why these deals get done and successful.
In essence, if I was consolidating the market I would make it easier for the banks to buy the high performing players, the A category, and then get those institutions to do horizontal consolidation across the market place.
In reality, banking and NBFI business are not the same. They have different management models, and different brand positioning. It is just very different but some people misjudge the similarities between the businesses. It is like selling trucks and cars. They are both vehicles but are sold to two entirely different audiences.
The NBFI customers are often not customers of the bank. They are in a more entrepreneurial market place. Banks are more about trust, reputation, security, safety, and are more conservative generally. So the brands and the business models don’t really gel together. What can be done is that the banks can be used to fund the NBFIs, and the strong ones in the later group can help consolidate the weaker institutions. I think that is an interesting opportunity and a more effective way of achieving the consolidation.
Again, to get the banks to consolidate, I think we have to see competition occur. That can start with sticking the state owned banks together. That may be a driving force for consolidation within private sector banks. When huge state owned banks come together, to compete the private banks need to be bigger. That would push for private sector consolidation.
That is what we saw in Singapore and in other markets. The only way non-state owned players can really continue to compete at size is to consolidate. That drives growth. This the Government can control.
At the moment getting the banks on a compulsion to merge is difficult. In reality they can build the business organically and probably cheaper than they could buy the business. The way in which the banks are owned with shareholders with different interest makes it difficult to make quick deals without justifying to shareholders as to why they should sell.
"Keith Pogson maintains a very active role in driving the wider EY business in Frontier and Emerging markets and leads its Assurance practice for Banking & Capital markets globally (a $1.6 billion business), as well as being a regular thought leader in the financial services space. He previously led EY’s Financial Service Practice in Asia Pacific, a multi-disciplinary practice of approximately 2,800 professional staff specifically serving the Financial Services Industry. Pogson has been in the region for 18 years and has a deep knowledge of the issues faced both by companies and regulators in the region. Having more than 20 years of exposure to investment and commercial banking, and financial services, he has worked with many regulators and governments in the region on regulatory and market reform initiatives.Pogson has significant experience with financial institutions in Hong Kong, China, Korea, Macau, Thailand, Philippines, Korea, Indonesia, Vietnam, Mongolia, Malaysia and elsewhere, and has particular expertise in assisting companies make mergers and acquisitions and or strategies in Asian markets. Pogson has led substantial numbers of due diligences in the financial sector, particularly in the banking, asset management and securities arena.In addition to assisting the PBoC on the reform of the Chinese banking system, and similarly more recently the SBV in Vietnam, he was actively involved in the restructuring of the banking systems following the Asian crisis in Korea, Thailand, Malaysia, Taiwan and Indonesia.Pogson is a member of the Associate Institute of Chartered Accountants in England and Wales. He was also the President of the Hong Kong Institute Certified Public Accountant in 2012 and has been both Chairman and committee member for a number of the standard setting committees in Hong Kong as well as the Professional Conduct Committee of the Institute."Q: The CB is putting in efforts to ensure that the human capital is not impacted during and after the consolidation process. What are the HR issues Sri Lanka will be facing?A: People worry about jobs. But in my mind this is kind of a naive worry. If there is a ruthless bank that wants to have maximum efficiency, it might cut 25% of its people. In reality, in an economy that is growing at 7-8% GDP growth, I am certain the country does not have many bankers lying around with no job to do. There are plenty of opportunities for these professionals.
Institutions will not retrench since it will take years to merge banks. Even if there is a surplus of people, companies will work them out over time. I am certain that with the level of people who actually retire, and the level of people on the search for opportunities, this is not an issue.
Q: So you are saying that the financial sector professionals have nothing to worry about?A: Definitely not since I don’t think Sri Lanka has an oversupply of bankers in the country. People are overly concerned and worried but this is not the real concern. The real concern is creating a banking system that is fit for purpose for a successful Sri Lanka in the near future. That is a banking system that can support economic growth. It is a banking system that can support both large and small enterprises expanding. And it is a banking system which can help support the expansion of both, domestic credit as well as commercial credit.
Themes such as mortgages can be explored. How do you get exciting mortgages? I look out the window and I see construction all around. Who is going to buy all that? For that there is a need to grow domestic, commercial, and consumer credit. With the 15% rate offered, I am not surprised why there are not many mortgages in Sri Lanka. When you look at the long term good, it will allow people to purchase their own home. This will make people stay in Sri Lanka and address a big issue it is facing which is brain drain. If you give them the opportunity to people to buy their own home, they are more likely to stay.
The benefits of the consolidation are a lot more than bringing together bigger banks.
Q: You mentioned that having too many players is unhealthy. Could you elaborate on that with reference to Sri Lanka?A: Certainly. Sri Lanka has 58 NBFIs and that is far too many. The small institutions, do they have finances to invest in strong technology platforms that and serves customers effectively? Can they invest in the credit risk management processes, the support business, and also good for customers? Certainly not. For the size of the Sri Lankan economy, 58 is a big number.
In most developed economies the NBFIs hold a much smaller space and usually a lot more of the functions are actually done by banks. I am a huge supporter of microfinance. It can be run as a niche or as part of a banking system. But actually how you get that to work in the economy in an efficient way to serve customers and society? I am not sure if 58 is the right number.
Q: Do you think that the timeframe imposed by the CB to get the deals done is realistic?A: The honest answer is that politically one can ink deals and get people to sign agreements, but to actually integrate banks it takes years. I have been involved in a lot of them and the fastest ones I have seen took two years.
So it depends on what you call integration and it takes months of planning to actually integrate them. The best way is to pass an Act in parliament, an ordinance bill where they say Bank A and B should merge and the liabilities and assets of both the banks should come together. However, for that you still have to go to Parliament and go through the process. That will take some time since we are talking a larger number of institutions here.
My view on the timeframe is that it is very optimistic. But then again, if you don’t have a deadline, you don’t have action. Say you merge two banks. What will be the name? Usually it’s a trade-off in many instances. Bank A will say its head will be the Chief Executive and Bank B will be allowed to name the bank, or select the bank system that is to be used.
When there is a trade there is politics, and when there is politics there are processes, all of which takes time. Unless it is an acquisition, it is difficult. However, even in that case the handling of the brand is not simple.
Q: What can the regulators do to get the consolidation process right?A:First is making sure there is market alignment with demand. It is not just that the regulator wants to do it, but to also create incentives that make it interesting and essential for the bankers to do it. That is why I previously said that may be pushing the state banks to merge may actually create a market demand for the private sector to merge.
The second is that trying to get the banks to integrate with the NBFIs will not work since the business models are different. If the prices, control, salary structures of the bank are put on the NBFI, then the latter will go out of business. It will not work.
If attempted the other way around, which is by using the NBFI culture and structure in a bank, the regulator will lose a lot of sleep. Bringing the two together will have to be done very cautiously. I think the best model is to keep the two separate and to encourage horizontal integration in the NBFI market.
Q: How about the banks? What should they do to be better prepared? A: They should think about long term strategy and look at the big picture. The cost of technology is going to be high. The real winners for me are those that embrace forward looking technology. If I want to be a niche player, they need to start working on their strategy now.
What EY has discovered globally is that being everything to everybody doesn’t really work. You need something to focus on. Competition is going to come from strange places, such as from telcos, supermarkets, the internet and many others, so financial institutions need to be prepared and focused.
Q: What should finance companies be cautious about?A: Finance companies should be worrying about how they could survive and make money. There is lots of competition out there, so they need to be clear about their franchise.
The regulator is obviously focusing on them so they are required to have better internal controls. This costs money so the challenge is maintain profitability. The other is that of the segment has bad reputation, the ability to continue to bring in deposits, raise the finance and run the business will become difficult.
To have a successful business they need to build a brand that is trust worthy and therefore can raise finance that raises good systems and controls. I personally think that intersegment consolidation is a more effective strategy, where a few strong players will consolidate the weaker players.