The Monetary Board in conjunction with the Central Bank is busy creating a policy to create systems whereby there is better transmission of monetary policy. The situation has become quite dire as the Central Bank seems to have lost control over interest rates. This is most evident in the Central Bank imposing regulation limiting the rate at which new deposits can be renewed[1].
The law states;
The maximum interest that may be offered or paid by a licensed bank on Sri Lanka Rupee deposits shall be based on the standing deposit facility (SDFR) or the Weighted Average Yield Rate (WAYR) of 364-days Treasury Bills (T-bill rate)
This cap though has not yet resulted in a lowering of lending rates. Banks have used the benefit of the intervention reducing the interest paid to the saver and kept lending rates higher than the benefit accrued. In other words, net interest margins have widened.
To quote the recent monetary policy statement[2];
However, all market lending rates, including the AWPR, are yet to show a downward adjustment commensurate to the decline observed in deposit interest rates.
The Average Weighted New Deposit Rate (AWNDR) declined by 266 bps from end April to 8.58% in July 2019 and the Average Weighted New Fixed Deposit Rate (AWNFDR)declined by 269 bps from end April to 8.88% in July 2019.
This is as Average Weighted Lending Rate declined by 25 bps to 14.22% in July 2019 from end April and Average Weighted New Lending Rate declined by 74 bps to 13.88% in July 2019 from end April. Average Weighted Prime Lending Rate (AWPLR) declined by 147 bps to 10.77% as at 16th August compared to 12.24% recorded at end April 2019.
Like Moving Averages
The figures quoted for average weighted rates behave in the manner a moving average would. The figures quoted for new deposits or lending would only have an impact in proportion to their weight in the existing stock.
These averages are what the Central Bank has strongly signaled that it is trying to improve.
Are Banks Profiteering?
It, however, isn’t fair in this context to label bankers as being profiteers. Banks have an existing liability stock, i.e. fixed deposits made in 2018 and earlier, and this holds steady their cost of funds.
The Average Weighted Deposit Rate (AWDR)for Aug 2019 (based on July data) declined by 24 bps from end April to 8.73%. Average Weighted Fixed Deposit Rate (AWFDR)for Aug 2019 (based on July data) declined by 41 bps from end April to 10.74%.
Banks in Sri Lanka only offer instruments with fixed rates of return. Old deposits will still have to pay the rate of return negotiated earlier until such time that they are up for renewal. This means that even if all competitors are by regulation limited from offering high rates it will take time for that to impact their cost of deposits.
Banks as Victims
Banks have also in the recent past been on the receiving end of multiple tax increases. In the opinion of many, this is because banks tend to be highly compliant with the law and as such prove an easy target.
This regulation on net interest margins and thereby profitability comes as the banks have to raise considerable amounts of capital to be BASEL compliant. The Central Bank has set very short time spans for BASEL compliance. It has also set intermediate capital requirements putting many institutions into immediate difficulty.
Savers will probably end up diverting funds to risky commercial paper made available through a weak and expensive offering of unit trusts. Their rates are not regulated. This will reduce the growth of deposits with the formal banking system.
Given better capital markets savers would opt for corporate debt. However, the CSE and the SEC seem determined to prevent any such option from developing.
Private Credit Growth Has Contracted
If total credit does not grow sufficiently and existing lending obligations are not repriced, then average weighted lending rates would not decline to the 200 bps target. This would happen even if the banks lend at rates agreeable to the regulator.
Here there is the opportunity to game the metric. Banks and the regulator can collude by charging high fees on the repricing of obligations. At the same time, they could bring down the interest rate.
To quote the recent monetary policy statement;
Private sector credit in absolute terms, declined marginally by Rs. 1.2 billion in July 2019. This is after a significant increase of Rs. 63.2 billion in June 2019
The cumulative increase during the first seven months of 2019 is Rs. 42.5 billion.
Year on year growth of credit further moderated to 7.7% in July 2019 in comparison to 8.7% in June 2019. This is the lowest growth rate witnessed since December 2014.
Both the governor and director for economic research, Dr. Y M Indraratna called for concern with the reduction in private credit growth.
Capital Limitations
Banks are now shy of raising capital. Capital market conditions are depressed[3]. The two major development banks NDB[4] and DFCC[5] both failed to raise capital this year. This was even as they were offered at significant discounts.
Regulatory uncertainty is being driven by the shotgun merger rhetoric[6] of the central bank. The treasury is compounding this by targeting the sector for increased taxation. This makes it difficult for firms to raise capital.
Without being able to increase capital the rate at which the balance sheet of the banks can grow is limited. This constrains banks from making new loans.
This is all compounded by the earlier mentioned unusual interpretation of timelines for BASEL compliance. These regulations are being done with the ulterior motive of forcing mergers.
The Capital Market Fix
The federal reserve has signaled and acted in a manner to extend historically low rates[7]. Sri Lanka has unusually high rates. This makes it a highly opportune time for banks to implement existing shelved plans. Namely securitization[8] and international loans by the state banks[9]. International loans are self explanatory.
Context
As earlier mentioned the situation is dire and therefore any fixes must be implemented quickly. The situations must also be plausible given the PESTAL factors of the country.
Government debt is now under better management with the active liability management act. This has resulted in the continual declining of rates on government securities[10]. Further the governor is actively using phrasing referencing inflation targeting at monetary policy announcements. Inflation is below even the lower bound of the 5 percent target.
The treasury has strongly signaled its conscientiousness of public debt. Foreign denominated debt has remained constant to GDP over the period. The external debt stock[11] as at end 2018 was USD 52.3 billion which is 58.7 percent of GDP compared to the previous year’s USD 51.6 billion which was 58.6 percent of GDP.
Objective
The objective of this strategy would be to free up the balance sheets of the banking system to make new loans. This would be a scenario wherein the banks and the regulator win. Further given the tax structure it would be beneficial for banks to make more money from fees than they do in the spread of lending and borrowing.
Securitization
Securitization is the process of parceling future revenue streams and selling them. Securitization became more well known outside the world of finance following the 2008 global financial collapse and the notoriety of mortgage-backed securities.
In a Local Context
Given the nature of our capital markets, securitization to third parties is not an immediate possibility. However, most major banks own finance companies. Notably Peoples bank owns Peoples Leasing Company and Bank of Ceylon owns Merchant Bank of Sri Lanka.
These two institutions can take on the loans of their subsidiaries to the extent that they optimize their figures against the regulatory capital requirements. It would be wise to ignore the internal political implications between top management and those subsidiary companies. This is because if you had space to lend at lower margins the Central Bank has signaled that it would force you to do so.
Why Finance Companies?
To quote Indian Finance Minister Nirmala Sitharaman in her budget speech[12];
“Non-banking financial companies play an increasingly important role in India’s financial system”
Though our Central Bank may not want to admit it, the NBFI sector is the lifeline to the SMEs. This is where credit growth for the expansion of GDP can be most effectively stimulated.
Politicized programs like Enterprise Sri Lanka which offer interest rate subsidy through considerable bureaucracy do not work in the long run. Worse still are the bailout programs to predatory microfinance companies[13]. It would be far more effective if the treasury acted to free up the balance sheet of lenders on the basis of a track record of promoting enterprise.
How Banks would Lend otherwise
The banking system is reflective of power in society. To whom loans are disbursed and at what rate are for the most part decided within those institutions. These assessments can have self-fulfilling impacts on credit worthiness. In certain instances, it is easier for some people to get lifestyle loans that they are unlikely to payback than it is for businesses with strong track records to borrow to expand.
That is because banks may collateralize a Colombo home and not so one in Kandy. This invariably has an impact on liquidity for the Colombo residential market over Kandy.
Bob Hope said;
A bank is a place that will lend you money if you can prove that you don’t need it.
Prime borrowers are the people who get the Average Weighted Prime Lending Rate. This rate has dropped the most according to the monetary policy data. This is because these borrowers have bargaining power with the banks.
Banks if forced to lend on a short term time horizon will probably do so by helping big companies refinance their negative cash flow positions. This would also help reduce their immediate default risk allowing management to postpone any difficult questions. Some large corporates have quite sizable negative cash positions.
This would not Result in investment
Given above are the cash flows of the three leading diversified holdings groups in the country. No one invests during election season. Note that Melstacorp’s investment figure for 2019 is linked to its takeover bid on John Keells and not really linked to new investment in the economy.
Big companies are in a position to plan their investments in line with government policy. They therefore wait to see who the government is going to be and what they plan to do. They do not want to be in a position where their investments go against government policy.
One may recall that supermarkets were targeted under the Rajapaksa government in order to help small retailers. One would also note that it was the sweetened beverage and food industry that was first to meet with the purported coup government[14].
It is currently very difficult to see what will happen politically. I myself did not think that Mahinda would select Gothabaya Rajapaksa and still feel something does not add. In such a context it is unlikely to see any large scale investment in the near future.
If the Central Bank is serious about the
output gap it should consider helping the Non-Bank Financial institutions. They
are the institutions capable of creating a boom in the SME sector.
[1]https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/laws/cdg/bsd_circular_letter_20190628.pdf
[2] https://t.co/eK4DfZ5oCC?amp=1
[3] http://www.dailynews.lk/2019/03/11/business/179837/aspi-falls-lowest-sept-2013
[4] https://cdn.cse.lk/cmt/uploadAnnounceFiles/7451545389632_386.pdf
[5] https://cdn.cse.lk/cmt/announcement_portal_prod/dfcc_3589040472812898.pdf
[6] http://www.sundaytimes.lk/190526/business-times/cb-gets-tough-with-licensed-finance-companies-350366.html
[7] https://www.theguardian.com/business/2019/jul/31/federal-reserve-cuts-interest-rates-by-025-its-first-in-a-decade
[8] http://www.sundaytimes.lk/180325/business-times/securitisation-bill-to-be-ready-by-next-year-287105.html
[9] https://www.businesstimes.com.sg/banking-finance/sri-lanka-state-banks-to-borrow-up-to-us1b-abroad-before-end-of-2018
[10] https://economynext.com/Sri_Lanka_s_Treasury_Bill_yields_continue_fall_across_maturities-3-15171.html
[11] http://www.dailynews.lk/2019/05/22/finance/186196/%E2%80%98marginal-increase-external-debt-stock%E2%80%99
[12] https://www.financialexpress.com/budget/budget-2019-why-nirmala-sithraman-says-nbfcs-need-parity-with-banks-on-tax-issues/1631755/
[13] http://www.sundaytimes.lk/190721/news/is-microfinance-model-failing-govt-absorbs-more-than-rs-1-25-b-in-unpaid-loans-359320.html
[14] http://bizenglish.adaderana.lk/sugar-tax-reduction-may-increase-sales-volumes-of-carbonated-soft-drinks/