Sri Lanka’s banks eye market-driven consolidation

The coming year looks set to bring further consolidation to Sri Lanka’s financial sector, with market forces expected to drive the trend, in lieu of the government-led policy of the previous administration.

Last year saw the industry regulator, the Central Bank of Sri Lanka (CBSL), take steps to bolster the sector’s operating environment by promoting consolidation amongst the country’s banks and non-banking financial institutions (NBFIs).

Measured progress

Unveiled in January 2014, the central bank’s blueprint for consolidation required larger lenders to identify potential partners – with a particular focus on smaller NBFIs – and initiate mergers and acquisitions (M&A), setting deadlines for each step of the process. The CBSL had targeted a sector of around 20 NBFIs upon completion, roughly one-third of the 58 operating when the master plan was published.

The roadmap also outlined higher minimum capital requirements for commercial and specialised banks, with a focus on the adoption of risk management best practices.

Progress thus far has been fair, with seven NBFIs completing some form of consolidation as of the end of last year; however, most of the benchmarks set out in the plan have yet to be achieved.

A planned merger between DFCC Bank and National Development Bank (NDB), agreed to in early 2014, was called off in May, and most other consolidation has been limited to small NBFIs or subsidiaries of larger banking groups.

Change of tack

After presidential elections early this year, state pressure for lenders to consolidate was largely replaced by market momentum – an approach favoured by many analysts – with the victory of the United National Party in the August parliamentary elections expected to reinforce this more hands-off approach.

Officials from the CBSL told local media in May that the consolidation process would be part of the new administration’s long-term economic policy, to be carried out in a more systematic manner.

Many industry players agree that while consolidation is needed, the sector will be better served if market forces dictate the process. In particular, market-driven consolidation could help avoid accumulation of weak assets amongst non-banking institutions forced to merge. However, others in the industry see a place for guided consolidation, especially if the interests of stakeholders are not being protected by the market.

The not-so-invisible hand

Signs that market forces are already at work are in evidence, with DFCC Bank and DFCC Vardhana Bank announcing plans in May to combine their operations. The news came just one week after the lenders called off the planned merger with NDB.

Indeed, a sector update from ratings agency Fitch, issued in the first quarter, found that Sri Lanka’s larger and more mature banks were better placed to leverage opportunities, with their established franchises granting them a competitive advantage over smaller or newer rivals.

Fitch urged medium-sized banks in the sector to find a niche or clear competitive advantage to reinforce their position in the market, though smaller lenders would likely continue to face challenges in sustaining and developing their franchises, the report noted.

Good standing

Sound growth metrics and healthy levels of reserves have already earned the financial industry a solid position in Sri Lanka’s economy, with Fitch reaffirming its stable outlook for the banking sector in early July, in line with its sovereign rating.

According to Fitch, the sector’s credit profile is unlikely to deteriorate materially despite the possibility of downside pressure on asset quality and profitability, though significant capital impairment risks or a broader deterioration in the country’s macroeconomic position could warrant negative rating actions. The agency also maintained its previous ratings on nine of the country’s banks.

Financial sector consolidation is expected to further improve the credit profile of Sri Lanka’s financial institutions, Fitch noted, strengthening franchises and reducing supervisory burdens. Consolidation would be beneficial to the sector in the long term, while being credit neutral in the short to medium term, the report found.

Although the in-coming government is expected to formulate a new policy to encourage M&A activity early next year, the new initiative is likely to be more laissez-faire than its 2014 predecessor.

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