Why an NDB – NTB merger will shake up banking

Banks are better capitalized and in greater shape than ever before. So the first banks to now raise the game and achieve real efficiency improvements through a merger will delight shareholders and customers alike while sending a healthy jolt of fear through competitors

By Echelon.

Published on April 02, 2013 with 1 Comment

ndb-ntb

Not all mergers or takeovers will create better banks. The notion, floated more than a decade ago here, that bank consolidations will lead to a more efficient financial system was misplaced. The malaise of dud loans, weak risk management, patchy coverage in rural provinces, inadequate capital, all required banks to compete fiercely to grow networks and improve processes as a first step for a more efficient financial system. 

Despite the fundamental nature of challenges facing the industry then, there were a number of attempts at consolidation. HNB tried a hostile takeover of Sampath Bank in 2000, Harry Jayawardena with HNB then tried a hostile takeover of Commercial Bank in 2005 and Commercial Bank explored a merger with NDB in 2007. They turned out to be hubris and a majority of shareholders were unconvinced they would be better off with stock in a combined entity and regulators were unconvinced consolidation would make the financial system more efficient.

In the last five years, however, the banking landscape has been turned on its head and it would be complacency and folly to ignore the benefits to shareholders and to the financial sector at large of consolidation. Banks are better capitalized, risk management systems robust, gross dud loans at all commercial banks are below 5% barring Seylan Bank, net interest margins are 4% – at their narrowest – and return on equity tops 15% at most healthy banks.

There are a number of advantages to those that have scale. Their larger networks make it possible to raise deposits more cheaply than can smaller banks and clout extends to better pricing for money raised in financial markets. They are able to maintain fat margins and when necessary offer keener lending rates. Scale also helps lower risks by diversifying assets and makes it possible for banks to offer a broader range of credit products and services on which fees can be charged.
For two banks to now explore a merger will send a healthy jolt of fear industry wide and NDB and NTB for a number of reasons are the best placed to do this.
Firstly, both banks have shareholders for whom circumstance or impatience can make a quantum leap in size attractive. At NTB, John Keells Holdings (JKH) together with group firms, as founding shareholders, invested 30% of equity but now has to reduce its holding to 15% to comply with new bank ownership rules from the regulator. Central Finance (CF), the other founding shareholder, has close to 20% equity interest which it also has to reduce to 15% to comply with the new rules. Promoting shareholders expect long – term returns and NTB – a relatively young bank –hasn’t yet provided these firms a return commensurate with the disproportionately large risk they took as promoters. Any sell down would force JKH and CF to accept less than optimal returns. An obvious avenue to comply with regulatory rules is for JKH and CF to hold a smaller stake in a much larger bank.

ndb ntb2One of NDB’s newer large shareholders and now its Deputy Chairman, Ashok Pathirage, controls nearly 9% of the bank and is famously impatient. NDB not having a controlling shareholder in the forefront of strategy has got it the wrong type of attention in the past like from illegal pyramid scheme operator Goldquest which at one time purchased its shares. Pathirage, although not controlling the bank, is already shaking things up there and has worked closely with JKH at his Softlogic-controlled ventures, making a collaboration success that much more likely. Now efficiency, not hubris can drive the process.
Secondly, consolidation – which the bank regulator, the Central Bank, says will be allowed so long as it’s not hostile – has the obvious cost benefit of eliminating one head office and some branches. Cost to income ratios of these banks reflect their current strategies. At NTB the ratio at 63% in 2011 is in part because the bank was rapidly opening new branches. Over the medium term it’s targeting a ratio below 50%. NDB’s ratio, already below 50%, is an indication that its branch network is well entrenched and profitable.
A combined NDB-NTB balance sheet of Rs283 billion would make it the fourth largest private commercial bank leaving it only 10% shy of third placed Sampath Bank and it will be almost as profitable. Sampath Bank reported Rs5 billion in profits for 2012 while a combination of NDB-NTB would put it at Rs4.8 billion, excluding the extraordinary contribution to NDB from its sale of Aviva Insurance shares to AIA. But a combined entity’s efficiency gains aren’t reflected by adding up numbers. Only the two entities themselves would be able to work out exactly how much these efficiency gains add up to, but it’s likely to run in to billions, which in a combined entity directly boosts the bottom line.
Like they can share strengths that scale brings in the future, currently they also share weaknesses. A luxury enjoyed by other banks with larger networks is that a greater share of their deposits are in current and savings accounts. Despite offering meaner deposit rates most other commercial banks maintain 45% or more of their deposits in current and savings accounts, making up the larger part of their low cost fund base.
ndb ntb1NDB and NTB’s problem is their low share of current and savings accounts in their deposit mix compared to other banks. A combined bigger bank will have easier access to financial markets to overcome this low cost funding challenge in the short term and greater heft to attract current and savings deposits as opposed to more expensive fixed deposits in the long term.
Thirdly, the banks share a remarkably similar culture and business outlook. Their combined focus on middle markets, SMEs, and corporates won’t require a reset in the minds of their customers or potential ones about a merged outfit. As Sri Lanka progresses through middle income status big industrial companies will find it easier and cheaper to raise money directly from the capital markets and banks will be forced to focus more on their fee activities and the retail and small business segments where demand for credit will continue to grow. NDB’s development banking pedigree has endeared small business to it and on the fee income side its investment banking unit is unsurpassed. NTB has strong retail franchise offering credit cards and personal loans which it is now extending to a wider segment in the market.
Everyone wants a piece of retail and small business action and successful banks in the future will be ones that have scale to cater to these two segments and investment banking units to serve large corporations. Lending to large businesses at low rates will be unattractive and matter less.

Sri Lanka’s economy is still 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 the greater financial sector growth in the next decade. NDB and NTB’s retail customer focus, and higher service standards stand out among local banks. They also aren’t weighed down by obstructionist trade unions as are the state banks and large private sector ones, so a merger won’t be a bitter pill. Prudent hiring by the two in the past might reduce the need for redundancies except of underperformers in senior positions.
Fourthly, Sri Lankan commercial banks, barring NDB and NTB, have inefficient and outdated operating models. Layers of bureaucracy compete for funds: branches and regions with head office, corporate with retail, leasing with mortgages.
NDB and NTB have a centralised structure organised around business units typically for corporate, retail, leasing, credit cards and treasury etc. It’s similar to foreign bank structures where branches are mere service points for customers while all fund allocation, credit approvals, operations and risk management are centrally-managed allowing the bank to set different risk profiles, capital allocations, margins and service propositions for each of the businesses. In local banks decision making is decentralised; branch managers and regional managers all dabble in evaluating credit and allocating funds.
The NDB and NTB model eliminates needless layers and frees frontline managers to focus on customers. They will derive more savings in a combined entity and result in a cost structure and efficiency that cannot be matched by any other local commercial bank. It may take years before any one of the others will be able to axe enough layers and re-skill staff to create such a ruthlessly efficient operating model. While the competition figures how to drive more efficiency from their existing models – and concludes that centralisation is the next logical step – NDB and NTB have a window to go one up.
This is another reason for consolidation, exploiting the window of opportunity that NDB and NTB’s unique operating model now offers. Soon others will replicate this model closing that brief window of opportunity. An early move, on the other hand, will leave the rest in a spin. Only HNB’s Rienzie Wijetilleke went beyond the rhetoric, getting in to bruising takeover battles in his attempt to deliver superior shareholder returns. Unfortunately for banking he is no longer in the industry. The dinosaurs that dominated banking for the last three decades – pushed out by a ten-year regulator-imposed limit for directorships – somehow guided banking though bleak times when government dominated the economy and inconsistent policy and raging war made for sputtering economic growth.
A new leadership now occupies the corner offices and boardrooms at banks. Instead of spending their time fire fighting the new leadership will be expected to deepen the availability of financial services and provide attractive returns for investors who have been patient for years.
There is a happy confluence of complementarity and overlaps to exploit for NDB and NTB between their businesses. It need not be a merger triggered by the weakness of either bank, but propelled by the potential strength of the marriage.
It’s easy to take heart in the satisfactory ROEs and smooth running strategic plans. After all, there are no complaints about the achievement so far or doubts about the future. But this is a relative measure against everybody else and past performance. That thinking won’t result in a quantum leap.
Other obstacles include the reluctance of managers who would rather implement board endorsed strategic plans and the possibility that consolidation has to be designed in ways to soothe individual egos compromising the benefit to shareholders. But it’s now finally time for a banking sector shakedown. NDB and NTB have the best shot at it.

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  1. Already top heavy NTB will have to get rid of 75% of senior managers in order to achieve said benefits of such a merger.

    Higher remuneration packages of NTB seniors and industry standard packages of NDB employees will have a mismatch and HR issues.

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