NDB’s Rajendra Theagarajah is Aiming to Shake Up Banking

By Shamindra Kulamannage.

Published on July 22, 2015 with No Comments

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NDB, a storied but slow commercial bank, is trying to acquire rival Seylan. If it happens the deal will create the island’s third largest private commercial bank and more importantly jolt placid bank boards and chief executives to consider their response.

Banking has been a cosseted industry. Their chief executives, all of whom preach the virtues of consolidation, have resisted those very elemental forces. They have however had to deal with an elevated risk in the institutional framework, so far.

Banking policy setter and regulator in Sri Lanka, the Central Bank announced plans to coerce consolidation in the financial sector in January 2014. But applause for the courageous move had to be reserved because government policy then was the biggest source of banking risks. In addition to policy formulation and supervision of banks, the central bank’s monetary board – which also oversees the island’s largest pensions fund- sought to control bank boards. Dealing with an overbearing regulator exerting pressure at bank boards significantly distracted chief executives from implementing strategy.

That type of regulatory conflicts of interest and institutional risk are now lower.

For decades bank chiefs have had to reassure anxious foreign counterparts’ that their balance sheets aren’t missing any zeros at the end and are regrettably; tiny. Besides the embarrassment, there are a number of disadvantages to being a small financial Agenda Bank Consolidation institution. In a world of declining margins; scale, more than anything else, is an indomitable advantage. Large banks can compete across borders, finance massive projects without concentrating risks, lend long term because large balance sheets are diversification friendly and be ruthlessly cost efficient.

Bank chiefs have long known that to deliver exceptional shareholder returns they need scale that organic growth alone will take too long to deliver.

Details are sketchy – and limited to speculation –about NDB’s reported Seylan bid and neither bank has made an announcement, perhaps because it’s premature. Ultimately the price will determine the success of any takeover; will NDB’s board be willing to back the price and Seylan’s major shareholders led by Ishara Nanayakkara (controlling 23.4% of voting stock) think it a good enough offer?

Seylan’s shares are trading around 1.5 times their book value (Rs102.8 on 24th June 2015). The stock is up 60% in the 12 months to end May 2015 outperforming the market, which rose 11% in the same period. Seylan shares’ recent rise could be due in part to growing speculation of its takeover.
rt3Price is always contentious. However NDB’s board must understand that takeovers happen in four waves determined by business confidence. The first wave is when an economy is in poor shape. Desperation on the part of sellers and bargain pricing, for buyers, drives a limited amount of mergers and acquisitions (M&A). Business confidence here is now higher than levels needed for such distressed deals.

Seylan, despite its high dud loans, is unlikely to be offered at a bargain. At 1.5 times book value Seylan’s stock is trading at the high end of the share’s own past price to book value band of 1.25-1.57 times. Bad loans while still high are declining rapidly. A chunk of the non-performing provisions are on account of two large loans and there is an expectation these may not turn out to be complete duds after all. Seylan expects to open 75 new branches of which 25 will be opened in 2015. New bank branches will weigh down profit growth but they will be an asset for a merged NDB-Seylan. NDB has 83 branches to Seylan’s 157.

In the second wave, an improving economy and cheaper finance will drive deals. Sri Lanka is in this second stage of the M&A cycle. Typically chief executives will be cautious and most deals will be regarded risky, scaring away all but the most confident buyers. NDB’s Rajendra Theagarajah no doubt is confident. In March 2015 NDB purchased an 8.7% of Seylan at Rs106 a share. In June 2015 NDB raised Rs10 billon in debt, ‘to stimulate the envisaged growth during the next 1-2 years,’ according to Theagarajah.

In mergers however it’s book value –the value of the bank’s assets minus its liabilities – that is the basis for a negotiation. Internationally a well-run bank can command two times its book value in a takeover.

Bank balance sheets here have improved in the last year, although private sector credit growth has been weak. State borrowing to finance infrastructure has made up for weak private sector demand in the second half of 2014. Lower bad loans related to gold backed lending and the lag effect of revising deposit interest rates downwards contributed to improved financial performance in the March quarter 2015.

However only Commercial Bank – trading at two times book value commands a high premium here. DFCC,
Sampath and HNB trade at a 1.1, 1.2 and 1.3 times their book value. Seylan’s book value tops Rs25 billion including its non-voting stock and holdings by board controlled share trusts. How much a takeover will cost depends on how many of Seylan’s existing voting shareholders will continue to hold stock in the combined entity.

rt2Running a bank is no mean task. The competing demands of shareholders who supply the capital, regulators who introduce and tweak compliance rules, customers who are now extremely flighty and the challenges of shifting economic conditions all weigh heavily.

The logic that bankers recognise but fail to act on is overwhelming. There have been two reasons for this. The first was the regulatory conflicts of interest that are possibly now behind us. The other is the timidity of chief executives. Their response has been a facade of fierce competition to shield the vulnerabilities and their jittery leadership.

For chief executives an unwillingness to negotiate a merger from a weak position – more than any other – may have dissuaded such talk in the past. For bank leadership it’s been a double edged sword. They are damned if they merge on a weak balance sheet and damned if they don’t, because it denies scale in a market where the competition will now consolidate. Faced with a choice they remain paralysed.

Over the next few years, financial sector merger mania will kick in and probably drive up deal prices to heady levels. Partners in M&A deals at first may not even realize they are paying more, because by then the boom may have been legitimized; chief executives will feel it safe even though the deals are now expensive. The pressure for M&A will be immense because every other bank will now be negotiating one. The markets cheering them on will give chief executives a false sense of security. This is the heady third stage of M&A.

It’s easy to overpay during a merger because your own shares are often the currency of transactions. If a chief executive pays too much they are possibly overestimating the scale of synergy. Partners throwing furniture at each other because a frothy price was paid isn’t always evidence for a failed marriage. A failed deal is often one not delivering the benefits promised when the deal was struck.

Bosses do such deals, which are so bad they become the stuff of legends, during this frothy fourth phase. Sri Lankan bank bosses will soon find shareholder expectations for scale that only M&A brings, mounting. This is the fourth stage where dealmaker exuberance is at its most irrational.

A premium above book value will be justifiable because of the sweeping industry wide changes. Banks will soon have to boost their minimum capital to Rs10 billion. Smaller banks will have a tough time raising capital because their current businesses model may not be able to deploy the money. Secondly profit growth that came from the interest rate reset, capital gains on bond portfolios and lower gold loan impairment will all fizzle away in 2015.

Thirdly, rising dollar interest rates, perhaps by the fourth quarter of 2015, will challenge banks which have begun to rely substantially on foreign currency borrowings. In 2008 foreign currency borrowing represented 33% of total bank borrowing, by 2013 it was 65% and in 2014 it declined slightly to 60%. The challenge of rising foreign currency interest rates will be likely compounded by a weaker Sri Lankan Rupee.

rtThe fourth reason is the growing cost and complexity of regulatory compliance the introduction of BASEL 3 rules will impose. For small banks the added cost of compliance will be debilitating.

Because they deal in a product – money – that is now moved around electronically; Information Technology plays an important banking role. Electronic money can also be stolen electronically and technology thatkeeps cyber criminals out is costly. Only banks with scale will be able to afford these new costs that are now a necessary part of being in business.

There are synergies for an NDB Seylan combine around all these challenges. A large branch and ATM network has a direct correlation to achieving a higher portion of deposits in current and savings accounts (CASA), which cost less to a bank than those deposits in fixed deposits. NDB’s CASA ratio at 25% is far lower than most large commercial banks. A combined NDB-Seylan, which will have access to a larger branch and ATM network, may be able to improve CASA, which will help maintain higher margins. Sampath – 46%, HNB – 45% and Commercial Bank – 48% have high CASA Ratios, while Seylan has 39% of its deposits in current and savings accounts. Banks with CASA ratios above 45% all have over 220 or more branches.

Sri Lanka’s economy is largely lubricated by cash, in the hands of households and small businesses, and the potential to attract more of this in to official financial channels will fuel growth in the next decade. Seylan Bank has a strong SME and retail banking presence and a growing credit card market share. Stockbrokerage Asia Securities in a recent banking sector report highlighted Seylan’s attractiveness as a takeover target due to its high CASA and SME and retail banking strengths for DFCC or NDB.

Asia Securities also highlights that Seylan plans to reduce its current 7% non-performing loans to an industry average matching 3% in the next few years.

Reluctant bankers must understand the financial industry will change completely in the next decade as Sri Lanka progresses up the middle-income league tables. Nothing they have experienced in the past will prepare them for the pace of change, unless they have the vision. Its inconceivable Sri Lanka will have room for the inefficiency of 22 local banks and 12 foreign ones. A country’s financial infrastructure benefits from megabanks because they create more economic value, are safer and more profitable. On the other hand, a fragmented financial sector imposes high costs on borrowers; their inefficiency destroys economic value and leaves the financial system far more vulnerable to shocks.

Asian economies that have transitioned in to upper middle-income level have all seen massive bank consolidation. In Malaysia – where per capita income is $9000 – 54 banking institutions have consolidated in to 10 groups. Sri Lanka’s forecast $4000 per capita GDP in 2015 will cross the $7000 mark in five years. Thailand’s economy – where per capita GDP is touching $5500 – will see its banking sector shrink from 14 to five.

Investment banks will have started undermining commercial banks as monopoly financial intermediaries. Large corporations, an important section of borrowers now, will almost exclusively finance their operations through the capital market in the future. Investment bankers who structure products and arrange deals will make fat fees. Traditional commercial banks will be left in the lurch.

Disintermediation will force banks to look for alternatives in retail and SME banking, where both risks and margins are higher. As with any change those at the vanguard of this will become the new leaders in this disruptive decade for the financial sector.

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