When everything is moving along, banks are fantastically profitable. In banking, this success breeds customer trust, importantly, from depositors. Banks weather economic peaks and troughs better than most businesses, because their assets are diversified, including lending to a diverse array of industries and safe harbour investments like government securities. Trouble in one area can be offset by gains in other assets, unless, of course, every area of the economy is impacted by crises, like Sri Lanka is now experiencing.

Non-performing loans at banks are forecast to rise and the foreign currency government commercial debt they hold faces a haircut. As a result of these, banks also face liquidity challenges.

HNB’s Chief Operations Officer Dilshan Rodrigo and accounting firm EY Sri Lanka’s Managing Partner Manil Jayesinghe joined Echelon’s Reboot Everything Festival to discuss the impacts of the economic crisis on banks and how they might begin to navigate out.

Among their proposals is the establishment of a ‘bad-bank’ to take over the sector’s non-performing assets. Once legally feasible, a ‘bad-bank’ will remove the assets from the balance sheets and free up capital that the bank can then use to back new lending. Excerpts of the interview …

We’ve got a crisis in Sri Lanka, which is a balance of payments crisis and debt repayment crisis. We have a political crisis, we have a humanitarian crisis, and potentially some trouble at the banks. Can you tell us how the current economic challenges are impacting the banking sector?

Dilshan: It has been a journey for the last three years. We had a constitutional crisis, followed by the Easter Sunday bombs and then a global pandemic. Over this time, the banks played a big role in supporting businesses. Some time ago almost 20% of our lending portfolio was on moratorium because the borrowers couldn’t repay the loans on schedule. By early this year, only around 2.5% of our loans were still in a repayment moratorium, which means that many businesses were able to emerge from these crises.

What we now face is a very different challenge. With the current economic crisis, when interest rates spiked and the exchange rate depreciated by 80% in a few months followed by inflation, all these are taking a toll.

We are watching to see how businesses will cope, and how many will need to be supported again. There was a recent Central Bank circular to banks requesting us to support businesses on a case-by-case basis.

Then there is the risk of impairment. Impairments on a large scale can have an impact on capital adequacy. So the banks have two immediate impacts which have to be managed. There are also challenges in the stock market, the real estate market, and the condominium sector, and these have compounded impacts on our impairments. Besides the tourism sector, the construction industry, and the transport sector are badly hit. Some companies, particularly in agriculture and trading are limping back.

So we are in challenging times and there will be consequences if this is not arrested early.

Manil, you’ve worked with a lot of banks, in the accounting, auditing and consulting work you do. Now, any banker looking at their balance sheet and income statement would find several of those numbers to be challenging for them. Can you tell us in terms of balance sheets and income statements, where will the banks now find the biggest challenges?

Manil: There are three things that will challenge the banks. One is the asset quality. Loans to stressed industries will automatically affect the bank’s asset quality. It depends on how much each bank is exposed to sectors like transportation, condominiums and tourism.

Sri Lanka has always been an import-driven economy. Our exports are equivalent to 15% of GDP. When you restrict imports, as we have done, there are knock-on effects in the whole system. This impact is difficult to quantify. Prior to the current economic crisis around 4.5% of bank lending portfolios were non-performing. Fitch Ratings recently forecast this will rise to about 10%. You can see how fast asset quality is forecast to deteriorate. However, I think it can be managed by banks working closely with borrowers.

The bigger challenge here is Sri Lanka getting hammered on all fronts. Interest rates are rising, inflation has hit triple-digits for some goods and services and the exchange rate has depreciated by 80%. Never in the past have all these things taken place, at such severity, during the same time.

Recall Sri Lanka was emerging out of two previous economic shocks the Easter bombing, and the global pandemic. During those crises, banks kept the economy moving, because the government lacked the wherewithal to support the industry and they got the banks to support it.

So the lending book is one part of the assets. Banks manage their asset portfolio by extending credit and investing the excess funds usually in treasury bills, treasury bonds, International Sovereign Bonds (ISBs) as well as the Sri Lanka Development Bonds (SLDBs). There’s a challenge with these assets because of the current economic scenario.

The third factor, which stems from these two, is the liquidity issue. Sometimes you can prevent a degree of losses in your loan book and investment portfolio, but that’s at the expense of liquidity. The question will be how this equation is going to be managed. When governments and banks grant moratoriums on loan repayments, that adds to the liquidity problem. Because under normal circumstances you’d expect loans to be repaid, and the money flows into the bank, which can then be re-lent, and there is the regulation of cash from going through. When you give moratoriums, whether, on lending or the investment side, it will impact bank liquidity.

I feel the high inflation will hit bank deposits too. Now, this is my own opinion; a good part of bank deposits come from retirement savings. When inflation hits high levels, say 100%, which is the case with food and transportation inflation, so a retired person may have to tap into their capital, faced with such rising costs. So liquidity is going to be a critical factor in terms of foreign currency as well as domestic currency.

Dilshan you have three challenges on the balance sheet, that is loan impairments in your lending portfolio, your investment portfolio and your liquidity. How are banks going to strategize around these?

Dilshan: All these three areas require a granular focus. Start with the investment portfolios. As you know, banks have invested in dollar government securities. When I last checked, the ISBs were trading at a significant discount. So the bigger banks would have a hole in the balance sheet because there is a portion, which is not going to be immediately realisable.

The local investors have factored in that we are not going to fully realise the dollar portion of these assets. It’s very important, I think, that we get at least rupees in lieu of the dollars and that commitment needs to be clear so that we can then understand and quantify the impact on the balance sheet and manage our liquidity accordingly. That is one important aspect to be addressed.

There are always challenges in terms of impairment, how are you going to account for it? If you’re going to take a conservative or prudent view, how would you present that in your financial statements? and how much would that impact your capital levels? Not to mention your credit ratings and rankings, all that can be impacted.

Then you have the impairment discussion. Impairment too is a granular review. You need to understand where the impairment is coming from, which sectors or segments. Many banks today have at least 30% of their portfolio as loans to the SME sector. SMEs are considered the engine of growth and a good 80% or 90% of the businesses in the country would be what we categorise as SMEs and micro-SMEs. These are the lifeblood of the economy, if you don’t support them, this can have a huge impact on the typical person’s living standards.

So it’s important we look at each business and see how we can go the extra mile, to make sure the banks are supporting an economic revival. In the past, we may have restructured the loans based on their forecast cash-flows. Now we look at what else we can do.

But banks realised there is a stressed portfolio, and that has to be addressed. There will be a time to start thinking about packaging those stressed portfolios to see how we can get rid of them by securitizing and finding a buyer for them. There have been instances following the East Asian crisis 30 years ago, where many companies came from overseas to buy the securitised stressed portfolios off the banks. Now, how do you build it to enable that environment to happen? That’s a very important question.

We also have too many banks. Consolidation needs to become part of the solution. Recapitalization is another thing we need to think about doing. These are all around the question of impairment.

The third area is liquidity. Liquidity is about confidence. How do we regain that confidence for exporters to bring their money here, and for the remittances to come in. How do you address the structural issues, so that people want to take advantage of the bargains we have right now? Everything is a bargain; the real estate market is a bargain, the stock market is a bargain, your interest rates on your deposits are a bargain and the government securities are a bargain. This is a good time to attract funds into the country and that will create a virtuous cycle. If we do that we can kill the informal market, and there’ll be more money flowing through the formal sectors, and this can address the liquidity issue for the country.

We also have too many banks. Consolidation needs to become part of the solution. Recapitalization is another thing we need to think about doing. These are all around the question of impairment

Banks are tightly regulated because they use a lot of depositor money compared to shareholder money, which is very unusual unless you are a bank. The central bank has recently loosened some of the regulations applying to banks. What’s the impact of this?

Manil: I think they are in the process of reducing some of the capital buffers. In good times the banks have created some capital buffers. Now the central bank, which regulates the industry, is being tolerant of some of those buffers.

You have to understand something about banking. For a bank to grow its balance sheet it needs capital; that’s the formula that it operates with. What happens is banks accumulate that capital in some form through retained earnings. When you’re profitable, you add that capital which allows you to grow your balance sheet. That’s basically how banks operate.

This year is going to be challenging because that profit growth may not come because of the high levels of impairment on the loan portfolio, and write-downs on ISBs and SLDB holdings. Then the question arises whether the banks would have enough capital to grow their business, which in turn has an impact on the economy. If you don’t grow your assets on the balance sheet, that means you’re not growing your lending. If you’re not lending, who gets hit? It’s the businesses that will also not be able to grow. So, there is a cyclical effect in this whole equation.

One of the things the government did in the past was to reduce taxation, to some extent, so banks can build that capital buffer, and their retained earnings because when their tax goes down, retained earnings rise. But now the government is challenged because it has to raise taxes as one means to overcome this crisis. I’ve heard that a good part of the government’s tax comes from the banks. So how can the government reduce taxation on banks? This is an equation that will have to be balanced. You can squeeze the banks, but their capital will fall along with lending, which will impact the economy. On the other hand, if they don’t squeeze the banks, how are they going to bridge the government’s budget deficit?

In accounting, the issue here is how you classify these bonds. There are three ways of classifying these bonds. One is fair value through income. Fair value means you carry the value of the bond at the market price. If you’re doing that, this discount is already there

The government has suspended payments on its international bonds. The large Sri Lankan banks have substantial holdings of these ISBs. They also have dollar-denominated but locally issued securities called Sri Lanka development bonds. Banks have these on their balance sheets. Now, you’re an accountant, so how do you account for this?

Manil: Let’s take the two separately. The ISBs or the Eurobonds are freely available in the global marketplace. SLDBs are more captive and I believe 90% of them are held by domestic banks. Many of the domestic bank ISB holdings have been acquired in the secondary market, and not necessarily at the time of their original issuance.

From an accounting point of view you have to start reeling that discount in because if you hold the bond to maturity, it has to go back to $100 (face value). When you account for it like that, the issue of impairment comes up. But if you didn’t do that kind of accounting for the bonds, the impairment is automatically accounted for in the purchase price because you’re buying it at a discount in the first place.

But at some point, the government will likely come to an agreement with bondholders about a haircut. Once that agreement is struck it will be apparent the holders of those bonds are not going to get the face value on the bond at maturity. Will this accounting issue be an interim problem until such an agreement is reached with bondholders?

Manil: In accounting, the issue here is how you classify these bonds. There are three ways of classifying these bonds. One is fair value through income. Fair value means you carry the value of the bond at the market price. If you’re doing that, this discount is already there.

The other method is fair value through OCI, in which case you do the fair value, but the differential doesn’t hit the P&L, it hits the retained earnings. So your net assets are okay. The third one is the dangerous one, which is held to collect. In the held-to-collect model, you’re buying the bond, at say $30 on a face value $100 bond. In your accounting, you increase the carrying value of the bond from today till the maturity date, to go back to $100. This means you’re releasing that discount into the P&L. Now that’s where the haircut will have a major impact because banks are recognizing the income on one side. If you didn’t recognize the income, chances are the haircut will have a minimal impact, unless you subscribed to the bond when it was originally issued.

Even if banks subscribed to these bonds, when the pandemic broke out, there was approximately a 40% discount on these bonds. Now that discount has ballooned to about 70%. So even if banks purchased these bonds at a discount a couple of years ago, the market suggests a steeper haircut. How are banks approaching this?

Dilshan: People used to say that banks make large profits. But the return on assets is modest, about one and a half per cent or 2%. As a percentage of what you used to make as profits these impacts on impairment, both on the ISBs as well as SLDBs, are significant for banks.

Accounting impacts bank earnings, which in turn has a significant impact on capital adequacy. Like in business it’s not excusable for banks to have a couple of years of poor earnings, because we are custodians of large amounts of deposits. That’s why from a policy perspective it’s important to safeguard the banks and that requires swift action.

What do you mean by swift action?

Dilshan: If the challenge is in terms of earnings, and ultimately spilling onto the capital inadequacies, then the need for capitalization of banks could arise. The chain is as strong as its weakest link, so all it takes is one bank to be needing capital, which can have a knock-on impact on the entire banking sector

So recapitalisation of banks is something we need to think about. Consolidation of banks is another aspect. We have 25 banks, and dozens of non-bank financial institutions in this small economy. Now is the time for us to start acting on this. The enabling environment needs to be in place to support that.

Do you think shareholders will be willing to consider consolidation under stressed valuations now? Have valuations been a major bar towards consolidations in the past?

Dilshan: So it’s not business as usual anymore. I think shareholders have to realise that there will have to be some dilution. For foreign investors, Sri Lanka has an attractive valuation perspective with the rupee depreciation. So there can be foreign investments that can take stakes in some of these banks that are under stress.

Then we need to think about pooling the distressed assets into what we can call a ‘bad bank’, and packaging those loans in a securitization. Banks can get cash upfront for these securitizations, and the investor will take time to realise returns on those. A combination of these things need to be thought through and from a policymaker’s perspective, it’s important to create an enabling environment, for all of these things to happen.

We are discussing several things here; putting distressed assets into a bad bank, recapitalization, and about consolidation. Let’s unpack them. Let’s look at this concept of putting the banking sectors’ stressed bad loans into one entity, which is the so-called ‘bad bank’, to raise money against these assets. What are the challenges to doing that?

Manil: Banks need to release the cash from non-performing assets or stressed assets they now have. One option is to put the stressed assets into a vehicle and release the cash flow of that into the bank, so the bank can then get on with its business.

The second benefit of doing so is; let’s assume that each bank has 10% of its portfolio that is non-performing, which is what Fitch Ratings is forecasting it’s going to be. Now, the question is, if a bank has 10%, stressed assets, the bank’s resources are not entirely focused on that 10%, because it still has to run the rest of the business. So the bank may not have the necessary expertise and bandwidth to maximise the recoverability of those stressed assets. That’s why putting it into a specialised vehicle will be helpful, because 10% of portfolios from 10 banks will add 100%, that’s a large stressed portfolio. So you can have a team of experts focused on restructuring these.

The third factor is, that you are then packaging these stressed loans and offering them to specialist risk takers. There are, in the investment community, people who would want to take the risk for better returns. Whereas if it was within the bank, you’re taking a weighted average risk. So you’re allowing the investors to come into those vehicles, who have the risk appetite for that kind of operation. This ‘good bank’ and ‘bad bank’ scenario is probably the most efficient mechanism to release the cash flows to the banks. So they don’t need to go in the recapitalization route yet.

The banks then have to look at their portfolio of assets and identify the assets not meeting that threshold, recover your investment or return and try to move them out, realise the cash and redeploy it into better assets.

So whoever ends up purchasing these ‘bad bank’ assets, will try to realise them over time. Is that straightforward to do in a legal and regulatory sense?

Manil: You must have an enabling environment for this to happen. My view is, the limited success of securitisation here is because we don’t have the enabling legal environment to transfer the assets into another entity. There are legal contracts entered into when you obtain a loan. The question is whether those legal rights and obligations can be transferred to someone else. Currently, to my knowledge, I don’t think we have a smooth transition in that and that is one of the biggest hurdles that the banks face.

Dilshan: Because we need the consent of the customer for the transfer of an asset and the customer is not going to give you that consent automatically in an environment such as this.

Manil: And remember these are difficult customers anyway. So they will not willingly offer their consent. Banks will have to coerce them, which is the difficult part. If you had the enabling environment where you can transfer the legal rights to another party, and then those rights will be owned by that party, then I think it makes operations smoother. Without that enabling environment, this can’t work.

There is taxation that also has to be dealt with. When you transfer assets from one entity to another, and then those assets start earning money for the new entity, there will be tax implications. So all these have to be resolved to create a favourable environment for this to happen.

Is it likely that bank balance sheets will shrink in the next couple of years, simply because the environment isn’t accommodative of their current balance sheet size?      

Manil: That is an obvious outcome. But I’m not sure if that’s good for the economy, because it means the economy is also shrinking with the bank balance sheets. I think there’s a balance that we have to achieve. That is by refocusing on bank lending because, to my knowledge, this situation has created opportunities. For example, the domestic industry has more opportunities, like agriculture or sustainable energy. There are areas that are growth-oriented.

We have a principle-based accounting environment. Accountants must provide a true and fair view. When do you look at the principles which ones are the most contentious to apply to the current situation?

Manil: One of the problems with impairment for banks, is they’re using, what is called the ‘expected loss model’. This means losses will originate in the future, and not in the past. Invariably, the past gives a good indication of what the future holds. However, today we are in a situation where the past has no relevance to the future.

Estimating some of these is challenging, but we will get better at it as we move along, because we still have to find the data, to make the projections.

Even the IMF team asked how we do the impairment for the banks. It is to be based on historical data because that’s all we have to work with at the moment. But to that, many banks and financial institutions add overlays. The overlays are to compensate for what’s happening today. It’s not only in Sri Lanka, worldwide, this is happening. No one could have predicted a war in Ukraine and the impact that has on the global economy. In some countries, we are seeing signs of a recession. These are things for which historical data isn’t so relevant for modelling. Most financial institutions are using what we call overlays, and those are estimates of what we believe this situation is likely to give rise to.

Dilshan: We need to be much better at forecasting and scenario planning, so that we start measuring the right things, and then monitoring and following through so that we get better and better at this.

The world is becoming more chaotic. But the better we are at being able to understand underlying assumptions, and how each of those pans out in our financials, the better we will be in terms of managing the future.

One of the challenges banks face in Sri Lanka is the high intermediation cost. So automation, and digitization, can reduce this cost of intermediation

If you try to forecast the future, in what ways do you think the banking sector in Sri Lanka will be different in three or four years, to what it is today?

Dilshan: I think the major area of change will be digitalization. Wider digitisation can eliminate many of the brick-and-mortar inefficiencies of the banking system, making it more affordable for everyone. The banks have adapted to doing more with less recently. Today, the majority of our staff work from home. So, do we need all this transport and other infrastructure? We have large numbers of ATMs and branches. We have to reinvent that. The future is going to be digital, wallets and cards.

Manil: One of the challenges banks face in Sri Lanka is the high intermediation cost. So automation, and digitization, can reduce this cost of intermediation. I recall several decades ago the intermediation cost was eight or nine percent; the intermediation cost being the difference between the borrowing (deposit) and lending rate at banks. Today intermediation has declined to about 3%, so it has fallen quite a bit. But it can be reduced further through digitization.

Covid and the current financial crisis have given further impetus to change. Today, if you want to borrow money you have to go to a brickand-mortar branch, and talk to the lending officer. But in most countries today, you can apply for a loan on an app. A good portion of retail banking will be made more efficient by digitization.

Banks will be challenged in the future by all types of other players. Now we have seen several players who are not raising deposits, they bring the capital and get into the lending business.

That’s the second trend.

The third, is a lot of rules introduced over the last several years have made banking challenging. Take for example the grey market foreign exchange. One reason for this is the rate difference, the other reason is the service. Today you will have to answer many questions before you can remit money through a bank. The banks have to meet anti-money laundering, KYC and a whole bunch of regulations. But anyone who goes to the bank will realise it’s not easy to do transactions.

There will have to be some degree of change so that banks can compete with what I call the grey market for financial services. Bank consolidation is difficult in our market due to challenges like the cultures and the merging of the teams. Worldwide mergers haven’t been that successful because of cultural issues. If you’re marrying two cultures, then there are issues about aspirations too, because two people in the same position will not be able to advance.

Dilshan: For mergers to succeed there have to be some unique synergies that must materialise. It cannot happen because one bank thinks it’s better than the other. If a bank approaches a merger because it thinks it has better quality management and better leadership, and you’re taking over a less efficient company to make it more efficient; history shows that approach doesn’t work.

That’s called the ‘the princess and the frog’ analogy where the princess thinks she can kiss the frog and turn it into a beautiful prince. You know, that doesn’t work. There are many frogs and very few princesses.