Liberalizingthefinancialsectori si lanka

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Liberalizingthefinancialsectori si lanka

  1. 1. Liberalizing the Financial Sector in Sri Lanka Issues and ConcernsIntroduction For over a decade or so there has been some talk in various quarters aboutrestructuring the two state-owned banks in Sri Lanka namely, the Peoples Bank andthe Bank of Ceylon and if necessary even privatizing them. The PresidentialCommission on Banking and Finance after a thorough examination of the evidenceplaced before it on the performance of these banks found that there were a number ofshortcomings in their operations and stressed that they should be run on commercialprinciples and that commercialization should be accompanied by re-organization ofthe banks with changes in their managerial structure. However, it ruled outprivatization or peoplization of the banks in the immediate future (Report of theBanking and Finance Commission, SP No. XXIII of 1993).For restructuring the banks, the Commission suggested two options: one was to trimthem down into organizations focusing their efforts exclusively on debt recoveryoperations while the continuing profitable and viable businesses could be transferredto two new successor institutions to be established. The other was for the presentbanks to make a fresh start retaining the profitable businesses while recoveryoperations will be taken over by a new institution.The Central Bank a few years later in 1996 observed that while Sri Lanka has gone along way in its financial reform programs, further progress needs to be madeparticularly with a view to reduce financial intermediation costs…. and to improvethe commercial viability of the two state banks which account for nearly two-thirdsof the total assets of the banking system (Central Bank of SL, Annual Report, 1996). 1
  2. 2. As at the end of December 2001, their total deposits stood at Rs.127 billion whichwas a quarter of the deposits of the total banking sector while advances amounted toRs.100 billion. Of the 901 bank branch offices in the country, 598 or 66% belonged tothe two state-owned banks (325 to the Peoples Bank and 273 to the Bank of Ceylon).The Peoples Bank had over 4 million account holders many of them small accountholders from the rural sector. Furthermore, while the informal sector still controlsmore than 60% of the loans given to consumers, of the balance 40% the two statebanks control a formidable 60% even after 25 years of competition from foreign anddomestic private banks.According to the Central Bank, intermediation costs in the financial markets (whichconsist of financial costs and administrative costs) had gone up mainly due to the highintermediation costs of the two state banks which enjoyed oligopoly powers in themarket. Some of the factors that contributed to the high intermediation costs of statebanks have been identified as a) the large branch network of these banks; b) the highdegree of their non-performing loans; and c) large administration costs and overheadsof these banks. The last one is revealed by the fact that administrative costs of state-owned banks as a percentage of their total income were 4 to 7 percent higher thanthose of private banks in 1989. They were 37% and 40% for Bank of Ceylon and thePeoples Bank respectively as against 33% for the private banks. It is rather unlikelythat these percentages to have come down since then. The high administrative costsof state-owned banks was ascribed by the Banking and Finance Commission to highlevels of staffing, generous remuneration and benefit packages and the excessivenumber of security personnel employed and hence high employee-related expenses.This resulted in their annual cost per employee to be much higher than that of anemployee in private banks (Finance and Banking Commission, 1992). Because of theoligopoly powers that the state banks enjoy in the market, they are able to maintainhigh lending rates. This, in turn, allows other banks also to keep their lending rateshigh and thereby enjoy “windfall gains”. This situation continues to-date.Commercial banks are currently enjoying the benefits of interest rate cuts by the 2
  3. 3. Central Bank. While they have cut down interest rates paid on deposits they have onlymarginally reduced interest rates charged on their loans and advances. As a result, theinterest rate spreads have widened enabling them to record high profits. Furthermore,due to structural rigidities of the state-owned banks, monetary policy instruments,particularly interest rates tend to remain rigid. Since high lending rates had adverseeffects on private investment and economic growth, the Central Bank was of theopinion that such high lending rates need to be eliminated. To achieve this, the Bankrecommended the privatization of the state-owned banks (with restructuring themwithin state ownership as the second best option).The Institute of Policy Studies (IPS) referred to the large pockets of inefficiency in thestate-owned banking sector that contributed to the high cost of borrowing and highinterest rate spreads (IPS, 1999). It also drew attention to the relatively high ratio ofnon-performing loans (or bad debts or “troubled loans”) of the state-owned banks totheir total loans and advances. These loans were estimated at Rs.35 million andformed around 20.2% of total loans and advances in these banks compared to 12.7%and 13.7% in foreign and domestic private banks respectively. In view of this, theInstitute urged vigilance and close supervision of the activities of these banks by themonetary authorities (IPS, 1999).The World Bank, in the meantime, has been consistently urging the Government torestructure these banks, if privatization is not feasible. The demand for restructuringthe state-owned banks was first put forward as a condition for IMF aid disbursementunder the Enhanced Structural Adjustment Facility (ESAF) in the early 1990s. ThePolicy Framework Paper (1992-95) prepared by the Sri Lankan authorities with theWB-IMF Staff in 1992, for instance, stated that “the Government of Sri Lanka willcontinue to implement measures to restructure and commercialize the two state-owned banks with the aim of enhancing their autonomy and efficiency”. It indicatedan aggressive privatization strategy which included, among others, the privatization of 3
  4. 4. the two state banks. More recently, this has been re-emphasized as clearly reflected inthe Poverty Reduction Strategy Paper (PRSP) of the Government, “Regaining SriLanka, May 2003” prepared in accordance with World Bank requirements forassistance under its Poverty Reduction Growth Facility (PRGF). The PRSP indicatesan aggressive privatization strategy which includes, among others, the privatization ofthe two state banks as well. With regard to reforming the financial system the PRSPaper states that “……in spite of some improvement, the soundness of the bankingsystem remains a cause for concern because of the weakness of the two state-ownedbanks. According to the PRSP, “……wide spreads between borrowing and lendingrates, a high share of non-performing loans, under-provisioning and a large number ofdirected credit programmers characterize the operations of the state-ownedcommercial banks”. As proportions of risk-weighted assets the capital base of theBank of Ceylon and the Peoples Bank in 1989 was estimated at 3.4% and 2.9%respectively. In 2001, the liabilities of the Peoples Bank exceeded its assets by Rs.6.3million and was, therefore, found to be unable to meet the minimum capital adequacyratio of 8% prescribed by the Central Bank. The two banks are thus claimed to begrossly under-capitalized.With the deregulation of markets and globalization, the turf on which the state-ownedbanks operate is becoming complex and they are forced to compete with not only theircounterparts but also with other non-commercial banks in the system. In the contextof increasing competition in the financial system, restructuring of the state banks hasbecome inevitable.The Government has already started a program of restructuring them by introducingprofessional management and setting-up independent boards, resolving the problemof non-performing assets, increasing compliance with prudential regulations andencouraging management to enhance operational efficiency. Capital adequacystandards consistent with international norms of 8% as proposed under the BasleAccords have been imposed on commercial banks. In addition, regulations on loan 4
  5. 5. classification, provisioning for bad and doubtful debts and single borrower limits have been enforced. Off-site and on-site surveillance of banks has been strengthened (Budget 1999). This reform program also envisages several other measures which include branch downsizing, financial and operational restructuring, setting of key targets for cash collection, reduced levels of non-performing loans and improved financial ratios. In addition, the PRS envisages converting the Peoples Bank into a public company and if possible divesting it as a single unit after splitting it into a savings bank and an asset management unit and divesting the commercial bank portion of it as judiciously as possible (Regaining Sri Lanka - 2003, p.45). It may be recalled here that this, in fact, was one of the recommendations of the Banking and Finance Commission for restructuring these banks. According to the Chairman of the Peoples Bank the options considered for its privatization, are the sale of a share to a single Sri Lankan buyer or a consortium or offering shares on the Colombo Stock Exchange (CSE) and if these fail, the last option was to be find a foreign investor (Jayatilake, DN of 24August, 2002). But, it is doubtful whether investors who would comply with the objectives of the Bank that aim at mainly rural banking can be found. But whatever the option chosen for the purpose of privatization, the Bank according to him is expected to put forward a set of rules and regulations that would ensure the rights of the Bank’s employees that would include job security, a guarantee that the organization would continue to be run as a banking institution and protection for the assets of the bank and a promise that its properties including some prime lands and buildings situated in the city of Colombo will not be sold-off. Privatization is widely associated with labour lay-offs and retrenchments.It can, therefore, be expected that employees will be hostile to privatization. Retrenchments resulting from privatization in World Bank literature are described as an adverse potential aspect of the policy. Hence, unions rarely form part of the negotiation process. 5
  6. 6. Not surprisingly, therefore, trade unions in Sri Lanka are up in arms accusing theGovernment “…..of using subtle strategies for undermining the strength of these banksin preparation for their privatization” (Regaining Sri Lanka: A Trade Union andWorkers Response, 2002, mimeo). The government, on the other hand, seems to befeeling that by privatizing these banks it will lose control over resources of these banksthat could be used effectively used in dispensing and providing soft loans for the ruralfolk. As privatization would halt the flow of credit to the needy and small borrowers inthe rural segment of the population the government has shown reluctance to privatizethem. It has thus been using concepts such as “commercialization” and“corporatization” to describe the restructuring process (Lakshman, ed. 1997).In this context, it has become a matter of serious concern for trade unions as well asothers interested in the subject (of restructuring the state-owned banks in Sri Lanka) toevaluate the degree to which these banks have been successful in achieving theirobjectives, ascertain the soundness or otherwise of their operation, examine the validityand acceptability of the arguments advanced for privatizing them, study the likelyconsequences of their privatization on production, employment, consumption andwelfare of workers and others and also think of possible alternative policy options toprivatization.Before doing so, however, it is felt that it would be useful and enlightening to get aclear understanding of the theoretical underpinnings and the empirical foundations forstate intervention in financial markets and the rationale advanced for liberalizing thefinancial sector including privatizing state-owned banks that has become a majorfeature in several countries since early 70s and more recently in China and thetransition economies of Europe.Background to Financial LiberalizationRationale for State Intervention in Financial Markets 6
  7. 7. State intervention in financial markets has been a key feature in developing countriesuntil the process of liberalizing them started in the mid-70s as part of the overall policyof economic liberalization introduced in many of these countries. State intervention infinancial markets was advocated by academicians and policy-makers alike in the 50sand 60s at the time when developing countries in their early stages of development wereattempting to accelerate their growth rates. The financial systems of these countries hatwere expected to meet the needs of private enterprises - by locating, securing andchanneling funds to them - were found to be under-developed for carrying out this taskeffectively and efficiently. Consequently, their capacity for financial intermediation,that is, the process of collecting the savings of the scattered economic units and makingthem available to other investing units in the economy was found to be weak. While thesaving capacity of these countries itself was low, the financial systems because of theirunderdeveloped nature failed to fully mobilize even these limited savings. The naturaloutcome of this was low domestic capital accumulation, a shortage of investible capitaland dependence on foreign capital inflows for development (Khatkhate, 1998).The simple Harrod-Domar growth model clearly demonstrates that it is the savings ratio(s) and the Incremental Capital-Output Ratio (ICOR or k in short) that determine thegrowth rate of a country. According to them, growth rate would be equal to savingsratio divided by the ICOR (g=s/k) where s is the proportion of GDP that is saved and kis ICOR that stands for the amount of additional capital required to increase total outputby one more unit and Since the ICOR in developing countries tends to be low andcannot be increased in the short run (in Sri Lanka, for instance, it is around 4.5 meaningthat 4.5 units of capital would be required to increase total output by an additional unit)the real economic growth rate of these countries tends to crucially depend on theamount of resources that can be mobilized as savings and the actual investment thattakes place. With low savings ratio (and assuming that there is limited or no inflow offoreign capital) and a static ICOR, shortage of capital acts as a serious constraint totheir economic growth. It was in this context that state intervention in financial markets 7
  8. 8. was advocated as a means of advancing financial intermediation in order to increase savings and investment and through them the growth potential of these countries. It is thus clear that the case for state intervention in financial markets was based on the presence of “market failures” that make it difficult for economic agents to take decisions to save and invest. In this context, state intervention took several forms including lowering of interest rates below market clearing levels, making financial institutions pay more attention to social concerns than profit maximization, directed credit (to priority sectors) rather than market-driven credit and so on. But it is claimed that experience in many countries that followed a policy of intervention in these markets revealed that such intervention retarded financial intermediation rather than advancing it. By forcing financial institutions to pay low and often negative real interest rates, such intervention is said to reduce private financial savings and thereby limit the availability of finance for capital accumulation. This forced academicians and policy- makers who initially advocated state intervention to revise their policy stand and conclude that liberalization of financial systems from the shackles of government regulations was the appropriate policy to promote financial intermediation (Khathkhate, ibid).The Case for Financial Liberalization In the early 70’s two economists McKinnon (1973) and Shaw (1973) challenged the traditional view that low interest rates stimulate investment and growth and proved that such policies instead distort domestic capital markets and depress both savings and investment which they described as “financial repression”. Their strong and convincing arguments influenced subsequent policy changes in several countries leading to liberalization of their financial sectors. Since then many industrial and developing countries have liberalized their financial systems. This took the form of easing or lifting central bank interest rate ceilings (or deregulation of interest rates), 8
  9. 9. lowering of compulsory reserve requirements, introduction of competition throughwidening the franchise for new domestic and foreign banks, introduction of indirectmonetary policy measures and the scaling back of interference in the allocation ofcredit.It was argued that financial liberalization by increasing competition in the field offinancial intermediation would improve operational efficiency of banking and lowercosts of financial intermediation, on the one hand, and raise savings ratio, increaseavailability of credit and investment ratio, on the other. These in turn, are expected tohelp the rate of growth of the economy to increase as depicted in the Flow Chart below.Many developing countries have implemented more or less far-reaching programs offinancial liberalization in the 70s and 80s. The general objectives of these reforms havebeen to mobilize domestic savings and promote real capital formation by increasingdomestic investment or attracting foreign capital and improving efficiency in the use offinancial resources (Konrad Adenuer Stiftung, 1994).As against this positive view about financial liberalization, some argue that financialliberalization has increased financial fragility as evidenced by the marked increase infinancial crises in industrial as well as developing countries. The Brazilian Crisis of1991, the Economic Crisis of Mexico in 1994, the East Asian Currency Crisis of 1997-98, the Russian Crisis of 1998, and the Argentine Crisis of 2001 are illustrative of this.In many cases, banking problems emerged shortly after the financial sector wasderegulated. According to Khathkhate the experience of countries which introducedfinancial liberalization and sustained them were not only varied but also often quitedifferent from what the theory suggests. After a careful analysis of the experience ofvarious countries he came to the conclusion that the success of policy reforms dependson a number of factors, of which he considers the following to be important(Khathkhate, ibid): 9
  10. 10. i) The country-specific institutional and macroeconomic policy context is an important factor that influences the outcome of financial liberalization measures (ii) Financial liberalization is more likely to succeed, if the financial system of the country concerned is sound. However, reforms very often have taken place in the context of widespread distortions in the financial systems such distortions themselves being a consequence of previous financial market interventionist policies by the government. These distortions render the banking system generally unsound with a large amount of non-performing assets which, in turn, affect the success of financial reform In countries with financial repression the real sectors of the economy tend to be weak. If financial repression is lifted without proper measures to remove the weaknesses in the real sectors, the net worth of financial institutions tend to fall and can hamper the effectiveness of financial reforms in correcting the financial sector. Furthermore, it is said that domestic and external financial liberalization to be successful, it should be underpinned by other reforms, including an accelerated commercialization of state-owned banks, establishment of effective supervision and reform of the accounting systems used by banks.iv) Some countries have privatized banks and insurance companies within a broader framework of restructuring the financial sector while some others have actively promoted the development of local stock markets and also encouraged the entry of foreign financial intermediaries into the domestic market (Khatkhate, 1998). Sri Lanka provides a good example for the latter. A further argument for financial 10
  11. 11. liberalization was that it would enable developing countries to stimulate domesticsavings and thus reduce excessive dependence on foreign capital inflow.FINANCIAL LIBERALIZATION AND ECONOMIC GROWTHHIGHER INVESTMENT RATIOIMPROVED AVAILABILITY OF CREDIT Lower required reserve ratioHIGHER SAVING RATIO Higher and positive real Higher rates of interest on deposits interest on loans 11
  12. 12. FINANCIAL IMPROVED HIGHERLIBERALIZATION ALLOCATION INVESTMENT Ratio OF CREDITEFFICIENCY Increased CompetitionIMPROVED OPERATIONALEFFICIENCY OF BANKINGLOWER COSTS OF FINANCIALINTERMEDIATION v)To understand the contribution of state sector banks in Sri Lanka, in the growthand prosperity of the rural sector and the economy in general, it is necessary tolook at the banking scenarioprior to the commencement of state banking. At the time of independence, the SriLankan banking system was dominated by 9 foreign banks (holding over 60 % ofbanking sector assets) and just 2 local banks. These banks almost exclusivelycatered to the domestic requirements of the plantation industry, import/export 12
  13. 13. trade and related activities. Out of the 45 bank branches operating at the time inthe country, a considerable number were either located in Colombo or in otherprincipal cities. The semi-urban and rural population - comprising peasants,farmers, craftsmen, petty traders and workers – was almost totally left-out ofbanking services or inadequately served by the system. The banking density waslow with a branch for approximately 274,000 people (CB, 1998). The activities ofthe existing banks were practically confined to the major cities. It was theinformal financial sector consisting of money lenders, traders, landlords, pawn-brokers etc. that served the financial needs of the rural sector. The majoreconomic activity of the majority of people in this country namely, paddycultivation was mainly financed by the informal financial sector at exorbitantinterest rates making paddy cultivation a costly affair. Market penetration by theformal financial sector institutions was extremely limited.With the establishment of the Central Bank in 1950, the financial sector began toexpand rapidly in terms of institutions, instruments, variety of services offered andgeographical coverage. Several steps were taken in the early 60s to make bankingservices available to hitherto neglected sectors. The Bank of Ceylon established in1939 was expected to assist the indigenous entrepreneurs and business communitywho had been marginalized by the foreign banks and had had been forced todepend on foreign money-lenders – Nattukkottai Chettiars and Afghans - forcredit. But contrary to these expectations, the bank had been following a pattern oflending policies which was not very different from that of the foreign banks in thecountry. In an attempt to make banking services available to the large majority ofthe people in the country and to meet the credit needs of the hitherto neglectedrural sector the government in 1961 nationalized the Bank of Ceylon, thecountry’s largest commercial bank and the only indigenous bank. The PeoplesBank was established in the same year. The mandate of the Bank was to “developthe cooperative movement of Ceylon, rural banking and agricultural credit byfurnishing financial and other assistance to cooperative societies, approved 13
  14. 14. societies, cultivation committees and other persons” which was a long-felt needin the country (Karunatillake1968). Its objectives were to cup-lift the rural poor byproviding banking facilities for the agricultural and cooperative sectors and smalland medium industry and the majority of Sri Lankans who hitherto had neitheraccess to the foreign banks nor any knowledge of banking.The two state banks were expected to provide development finance to the smalland medium enterprise sector within which the agricultural sector dominates. In abid to further develop the financial system, the government introduced severalnew regulations pertaining to financial sector activities under the Finance Act of1961. The entry of new foreign Banks was stopped and a ban was imposed on theopening of new accounts by Sri Lankans in the existing ones, the objective beingto localize and expand the banking system with state support and directparticipation (the above restrictions were lifted in 1978 and 1968 respectively).These timely measures of the government helped to boost the domestic bankingTrue to the expectations of the government, the two state banks brought in afundamental change in commercial banking in Sri Lanka and also marked thebeginning of the dominance of state banks in the banking sector. The two banksby establishing a network of branches throughout the Island, took bankingservices even to remote rural areas. The Bank of Ceylon helped to build-up the SriLankan Business community by providing it with bank credit to engage inbusiness activity in various fields such as trade, agriculture, industry, transport etc.The government used these two banks to direct investment to all parts of theeconomy. They, in fact, functioned as social banks while carrying on commercialbanking activities. Besides serving as the tools for directing resources to thedesired sectors and at the desired cost they also served as important means ofmobilizing rural savings as well as monetizing the rural economy. When theGovernment increased its direct involvement and investment in the economy inthe 70s, the two state-owned 14
  15. 15. Banks became the tool by which resources could be directed to the desired sectors. With the support of the state banks and other financial institutions established during this period, the Central Bank introduced various credit allocation methods such as loans at preferential or subsidized rates for priority sectors, provided re-financed credit under various Schemes, gave credit guarantees and set up credit ceilings/floors on lending by development finance institutions. In addition, interest rates were maintained at below market clearing levels based on the arguments that maintaining low interest rates would encourage investment and hence economic growth and keep the interest cost of growing public debt low. Another factor that supported the low interest rate policy was the skepticism about the sensitivity of savings to high interest rates in view of the low levels of income of the Sri Lankan people (Fernando, 1978). These policies helped to develop local businesses, both private and semi-government.The Peoples Bank by conducting its banking business in Sinhalala and Tamiloffered the benefits of banking to the rural majority. It services small businessmen,the professionals and low income groups in rural and urban areas. In short, it servesthe needs of the “small man”. Pawning that was started in 1963 became a popularmode of credit as it provided the fastest means to obtain loans. Many farmers duringcultivation seasons made use of this facility to obtain credit and they redeemed thejewelry after harvest. This proved to be an easy method of obtaining short termcredit for low income groups as it did not require much paper work for the grant of aloan. The increase of pawning advances of the Bank from Rs.3.4 million to Rs.12.5billion at the end of December 2001 proves that this was a popular mode ofborrowing among people. It also has become one of the main growth and profitsectors of the bank. The bank also helped to monetize the rural sector and tomobilize rural savings. The savings deposits mobilized from the rural sectoramounting to Rs.127 billion is claimed to have far exceeded the lending in these 15
  16. 16. areas and the surplus is transferred to the International Divisions of the Banks whichare then used for lending in the urban areas for lending for commercial activities.Under the United Left Front government between 1970 and 1977 both banks wentdevelopmental and substantial loans came to be pumped into the weaker sections ofthe economy and society. The Bank of Ceylon had 14 subsidized credit lines and thePeoples Bank 18 (Sunday Times of August 20, 2000). Various schemes of the Central Bank for channeling credit to the agricultural and industrial sectors and particularly the rural sector, to which reference has already been made, were implemented through the country-wide network of Peoples Bank branches. They, in fact, became development banks as they pumped in subsidized loans to the weaker sections of the economy and society. The massive injection of money into the lower strata of society for almost 40 years has helped to raise the living standard of a large section of population and made economic activities possible at the lower levels. Today the two banks occupy a predominant position in Sri Lanka’s banking system and account for 60% of bank deposits and bank credit. But their relative share has declined gradually. Furthermore, it would not be wrong to say that the setting-up of bank branches outside the city of Colombo by other banks and to some extent by the Bank of Ceylon as well was motivated by the desire of the Peoples Bank in expanding into the rural areas. The state banks have ensured the right to have access to credit on reasonable terms to a wide spectrum of people. In this sense, it may be confidently stated that these banks have achieved the prime objectives for which they were established or that they have achieved much more than what was originally expected of them. Today they occupy a prominent position in Sri Lanka’s banking system accounting for about some 60% of bank deposits as well as bank credit. Because of the operation of the state banks the hard-earned savings of the common people have been brought into the mainstream of the banking system. Similarly, bank credit is 16
  17. 17. available today to the needy from these banks. Rural agriculture too got anencouraging boost through their operation in the rural areas. The establishment ofstate banks was a significant step in the process of public control over theprincipal institutions that mobilize people’s savings and channel them towardsproductive purposes. They have become the instruments of social banking in thecountry.Criticisms against the banks1) As the two banks are structured on British banking model, it is said that theyhave not been able to reach the real grass root level people (who form around 40%of the population) like the Grameen Bank did in Bangladesh (Fernando, SundayTimes August 30, 2003). Under the Grameen Bank Scheme lending was done on apeer-group basis to poor people who were precluded from the normal bankingchannels due to the fact that they had no collateral security and were generallyclassified as high risk borrowers. Credit facilities under the Grameen BankScheme were extended to the unemployed and under-employed men and womenfor creating self-employment opportunities. It may be said that in the absence ofsuch a scheme in Sri Lanka, the formal sector has not been able to adequatelypenetrate the financial market resulting in the informal financial sector dominatingthe economy as revealed by the Consumer Finance and Socio-Economic Survey of1996/97. According to this survey 56.9% of the population is being served by thenon-institutional sector while it was 60.2% in 1986/87. This reveals that thepercentage of people who enjoy bank credit is still low.2) Despite the many contributions of the state banks to the social and economicdevelopment of the rural population, as described above, the Central Bank madethe following criticisms against them (CB, 1998): 17
  18. 18. (i) branch expansion of these banks was sometimes based on social & political considerations rather than on strict commercial criteria; (ii) considerable amounts of credit was provided to public corporations which were not economically sound; (iii) credit was also extended to borrowers who were politically influential but not creditworthy; (iv) state-owned banks became the means of providing political patronage & expanding employment; (v) with no competition from other banks prior to 1978 these banks had no motive for maintaining efficiency or introducing innovations; and (vi) large amounts of losses resulted from the default of government- directed loans. (3) The state banks today are burdened with large volumes of non-performing loans and advances (NPAs) to which a multitude of factors have contributed. They may be classified as internal and external factors. Among the internal factors the most important one is inadequate management controls and poor credit decisions. Both banks have been involved in extending microfinance, the Peoples Bank from its very inception and the Bank of Ceylon since 1973. It is important to note that these loans were extended not by any internal decisions of the banks themselves but in accordance with government directives. As of May30, 2001, the Bank of Ceylon had 100,241 outstanding loans in the range of Rs.5, 000 - 50,000 with a total value of Rs.1, 831 million. The average recovery rate on these loan balances was 70%. By the end of 2,001 the Bank had to write-off micro credit amounting to Rs.271 million which formed about 18
  19. 19. 27% of its total micro credit portfolio at that date. By end of August 2001, it incurred a net loss of Rs.43.7 million in microfinance activities. The Peoples Bank had 114,200 outstanding microfinance loans.(4) The lending policies of the Peoples Bank from its very inception have been guided by the desire to increase production and its policies all along had been oriented more towards development finance which other banks were unwilling to undertake. But the criticism against the bank in this respect is that it failed to take adequate measures that would minimize losses arising from such defaults. Several external factors also contributed to the accumulation of the large volume of non-performing loans in these banks and the important ones among them are as follows: i) relaxing commercial criteria in assessing projects for lending and postponing recovery procedures due to political pressures; ii) in the face of increasing demand for credit after implementation of the second phase of liberalization of the economy in 1979 both banks relaxed their standards relating to the creditworthiness of borrowers in their lending activities in an attempt to hold on to market share; iii) loss of a large number of their experienced staff to the local offices of new foreign banks opened in the country after financial liberalization and the expanding domestic private banks; iv) failure of state banks to properly monitor the end-use of funds lent out; v) both banks in their capacity as state institutions undertook financing exceptionally risky projects which they would not have accommodated on strict commercial criteria; vi) these banks were directed by governments to lend to various unviable public sector enterprises;vii) disruptions caused to loan recoveries by the civil disturbances of 1983 and 1987-89; and 19
  20. 20. viii) legal and other procedural delays experienced in the recovery of loans It is clear from the above that both state banks have been constrained by thedictates of government policy on economic and social development, on the onehand, and the necessity on the other, to act on commercial principles. This dualityin their role is one of the major factors that affect their performance. They areused by the state as tools for implementing government policy on agriculture andpoverty alleviation with subsidized loans, refinancing and periodic debtforgiveness. The Peoples Bank, for instance, played a key role in the Janasaviyapoverty alleviation program by providing small loans for both agricultural andindustrial activities and today it continues to play a similar role in the Samurdhiprogram. The state-owned banks have also been used by the government toprovide concessional or priority loans to the tourist industry, tea exporters, teafactory owners and garments manufacturers. While providing these loans they arealso expected to make profits. Thus, they are faced with a major contradiction intheir operations.It is claimed that 25 large defaulters are responsible for 40% to 50% of the non-performing loans amounting to Rs.10 to 12 billion. The lending of state banks togovernment and government-related institutions amount to Rs.57.9 billion whilethe government itself has directly taken Rs.17.9 billion. The two biggestborrowers in the state corporation sector were the Ceylon Petroleum Corporationwhich had outstanding loans amounting to Rs.8.7 billion and the CeylonElectricity Board Rs.9.0 billion. Around 25 mega borrowers owe the PeoplesBank over Rs.12 billion. The volume of bad debts also includes money lent tosmall-time agriculturists and loans granted on government directives includingmoney advanced for privatization of certain state corporations. Some claim thatpoliticians are mainly responsible for bulk of the bad debts. In their opinion, if thestate banks have suffered a set back the government and politicians too are 20
  21. 21. responsible for it. Besides, as NPAs are caused by bad management of businessenterprises by their owners who borrow money from state banks, thepresence of bad debts is not a sign of failure of banks but are, in fact, failureof industrial and macro economic policies of the government. Therefore,privatization may not be the best way to tackle the NPAs. They must be tackledseparately.At the end of 2000, the Bank of Ceylon made provision for bad and doubtful debtsof Rs.21.3 million while the Peoples Bank’s provision was Rs.13.88 million. Thelatter was further raised to Rs.14.66 million in 2001. Thus, if the amounts lockedup in NPAs are recovered, state sector banks will not suffer from any shortage ofcapital and will be wealthier than other banks. The question to be asked then is,are genuine attempts are being made to recover these loans and advances? NPAsare a drag on profitability of state banks because besides provisioning for them,the banks are also required to meet the cost of funding these unproductive efforts.They also affect the earning capacity of assets thereby impairing the CapitalAdequacy Ratio as noted before. Carrying NPAs on the bank portfolio requiresincurrence of cost of capital adequacy and cost of funds blocked in NPAs.According to available statistics, in the year 2000 both state banks had a total ofRs.36.0 million worth of NPAs in their portfolio. Since no interest is charged onthose advances, the banks lose interest incomes on them. At a rate of interest of10% they lose an annual interest income of Rs.3.6 million. In addition, since theNPAs form part of the gross profits, huge amounts are set apart for makingprovisions for them every year thus reducing the actual profits of these banks.Non-performing loans, however, are not unique to the state banks only. Privatesector banks too have substantial amounts of such loans and they too makeprovisions for them. Such provisioning is an accepted practice among banks. Non-performing loans are quite common today in the banking systems all over the 21
  22. 22. world and more particularly among the Asian countries, particularly after therecent Asian Currency Crisis as shown in Table 2:Table 2: Non-Performing Loans among Banks in the Asian Region (as % of total loans and advances) Country Year (2000) Japan 27.0 China 40.0 Indonesia 60.0 Taiwan 20.0 Phillipines 32.0 Thailand 45.0 S.Korea 21.0 SOURCE: FAR EASTERN ECONOMIC REVIEW, JUNE 13, 2002.Some estimates show that Asia’s banks (excluding China and Japan) are saddledwith nearly $ 200 billion worth of non-performing loans.The two state banks in Sri Lanka that played a major role in the market in the 60sand 70s began to feel the heat of competition in the 80s and 90s when thefinancial sector was liberalized and thrown open to the establishment of foreignand private domestic banks. Financial liberalization in general is said to affect theentire banking system. It increases competition among banks and non-banks andalso adds new instruments which could pose threats to traditional banking activity.Consequently, banks that do not have proper control systems begin to face risks ofeven becoming insolvent, a situation where capital is eroded. In the face ofcompetition from foreign and domestic private banks, the two state banks foundthe systems and procedures designed for them some decades ago to fulfill theneeds of the time inadequate to meet the demands of the new situation created bythe process of financial liberalization. In response to this, they made heavyinvestments in computerization but this did not help them to overcome thebottlenecks to their efficient performance. Profits began to decline, bad loans 22
  23. 23. increased in number and value, their capital base remained low and they also suffered from a paucity of technically skilled staff. Despite the various problems faced by them due recognition should be given to the fact that these banks responded positively to the forces of deregulation and globalization. Competition from over 20 other commercial banks operating in the country during the last 15 years has not been able to prevent the state banks from playing a dominating role in the banking field. They have continued to make profits until 1988 as shown in Table 1. In this regard, reference needs to be made to certain advantages they enjoy over the other banks in the system. The following are worthy of mention here:1. the massive branch network of these banks in semi-urban and rural areas enabled them to access easily to sustained resources at cheaper rates; 2. the highly educated workforce of these banks had the ability to learn any skill required for the efficient performance of their duties; 3. they had built-up high credibility and customer confidence over time; and 4. they also have the opportunity of redeploying their excess staff to the hitherto neglected aspects of marketing and personal selling. Given this background, is privatization the best way to solve the problems of State-owned banks in Sri Lanka? It is said that privatization generally attracts over-optimistic expectations. In the present case, privatization may be expected to improve the performance of these banks in the narrowest sense of increasing their level of profit. Beyond increasing profits in the above sense, the impact of privatization is rather sketchy. It must also be noted that privatization may not be the only way to increase profits. Furthermore, the state banks also have other objectives which may be divergent and conflicting with the objective of profit-making. In the Sri Lankan context, we need to consider the unique historical background of our public/private sector establishments and the distinct role that they have played in rural development. 23
  24. 24. These should be taken into consideration when sensitive decisions like theprivatization of state-owned banks are taken. Furthermore, it should beremembered that although globalization has become a universal phenomenon dueregard needs to be given to the local conditions and the distinct characteristics of atraditional society like ours.The potential benefits of privatization of state banks should be judged on the basisof the positive benefits it can bring to the poor of the country and not just theoverall profit. State sector banking, as explained here, has been a tool for fightingrural poverty but privatization would probably further escalate the problems of thepoor and have an adverse impact on the poor as the elite banks will never come tothe rural areas or look after the poor people who have to battle for their survival.It should also be remembered that if the state banks had adhered to strict norms ofprivate commercial banking in their lending activities, they could not have playedthe role they did in contributing to the social and economic development of therural masses. Furthermore, the need for such institutions in a country like SriLanka, where nearly 40% of the people are still living below the official povertyline, cannot be exaggerated. Approximately, 2.2 million people are known to bemembers in the Samurdhi program. This means that poverty is still a widespreadphenomenon in the country. In view of this, state-owned banks still have a role toplay in alleviating poverty and channeling financial resources to the rural sector.In this context, China’s experience with financial sector liberalization is worthnoting. While it contributed to the country’s high savings ratio and its rapidmonetization, it fell short as a mechanism for channeling resources to the mostproductive sectors of the economy. The state banks in Sri Lanka have beenperforming exactly this task of channeling funds to the sectors and economicactivities where it was most needed. Even in the East Asian economies such asSouth Korea, Taiwan, Thailand, Indonesia, etc. the state-owned banks have playedthe leading role in their growth efforts. The privatization of state-owned banks 24
  25. 25. ignoring this reality is likely to lead to social tensions and disruptions in the socio-economic fabric of the country. Besides, it should be noted that privatization isnot the only way to deal with the problems of the state-owned banks. As withother options, there can be costs and benefits in privatization which have to benecessarily taken into consideration in deciding on restructuring of state-ownedbanks.The high administration costs of these banks referred to earlier were perhapsunavoidable in the context of spreading banking activities country-wide andperforming numerous functions on behalf of the government. In the seventies, forinstance, the government asked the Bank of Ceylon to open a branch in everyAgrarian Service Centre, a sub-office to provide credit to agriculture. There were390 such sub-offices. They had necessary manpower even though most of themwere uneconomic with total loans exceeding total deposits. Although the numberwas gradually reduced to 22 by 1995, the additional staff recruited to them had tobe retained and redeployed in other work (The Island, May 18, 1997). Theadministrative costs of the banks are likely to come down with consolidation ofbanking and with better internal security. Similarly, high intermediation costs arethe result of high inflation, heavy government borrowing to finance budgetdeficits and tight monetary policy pursued for a long time by the Central Bank.With low rates if inflation, reduced budget deficits and lower interest rate policyof the Central Bank the intermediation costs are likely to come down.Table 1: Post-Tax Profits/Losses of State-owned Banks (Rs./Million) Year Bank of Ceylon Peoples Bank 1991 780 - 1992 755 767 1993 1723 640 1994 2090 853 1995 2732 119 1996 2462 529 25
  26. 26. 1997 2059 690 1998 118 312 1999 2055 -8538 2000 701 -1840 2001 893 308According to statistics shown in Table 1 above, the Peoples Bank suffered theirbiggest loss in the year 1999. But this was partly because of Rs.24.0 million worthof loans being identified as non-performing loans in that year. Half of these loanswere supposed to have been given to just four Sri Lankan citizens. Despite this in2001, both state banks were able to earn small profits.It is said that in recent times even the World Bank’s evangelical faith inprivatization is waning. There has been talk of a change taking place within theBank itself with the emergence of Post-Washington Consensus (PWC). The PWC isshifting to a more realistic policy framework in which aspects of real world (forexample, market imperfections) are taken into account when privatizing state-owned institutions. It admits that when it comes to privatization competition may,in fact, be more important than ownership (Kate B, 2001). PWC also calls for atleast regulation to accompany privatization. In the case of Sri Lanka, however,competition is already assured by the presence of a large number of foreign anddomestic private commercial banks and other non-commercial banking institutionswhich compete with state banks for market share and what is required here is properregulation of the lending activities of state-owned banks rather than their outrightprivatization.The problems currently faced by the state banks, therefore, by no means areinsurmountable. While it is true that there is inefficiency and corruption in themanagement of the state banks but it certainly is not due to state ownership butmismanagement through politicization of the administration of these banks.This managerial problem can only be rectified by the state itself by making the twobanks fully autonomous and the corporate management made accountable to the 26
  27. 27. state (Fernando,R, Sunday Times, August 20,2000). With more efficientmanagement the problems of these banks can be overcome and what is necessary isto create the right environment for autonomy in their operations and the strictrequirement of accountability. It should be remembered that privatization in itselfmay not lead to sound financial management and operational efficiency as revealedby the failure of some leading Finance Companies and the Pramuka Bank in SriLanka. There are also examples of failure of private banks from other countries.Domestic private banks and foreign banks too incur losses and sometimes go out ofoperation. Furthermore, the market mechanism is not necessarily less corrupt ormore efficient than the state is as corruption is just as visible in contracting andservice provision in the private sector as well.It is understood that according to an agreement between the government and theBoard of Directors of the Bank, the Bank has been allowed to engage in normalbanking operations aimed at improving the underlying capital deficiency in thelonger term despite its current financial deficiencies. The Board of Directors iscurrently involved in implementing a Strategic Plan and monitoring progress toachieve the profit targets under the Plan. It is known that this restructuring processis going on according to schedule and that the Bank is well on the path to recovery.In view of the above, there seems to be no great hurry for privatizing the statebanks. Such a decision should wait until the results of the current efforts to revivethese banks are known.REFERENCES (1) Lakshman, W.D.1992. Dilemmas of Development, Fifty years of Economic Change in Sri Lanka’s, Sri Lanka Association of Economists (SLAE) Colombo. (2) Report of the Presidential Commission on Banking and Finance, Sessional Paper No. XIII. 1993. 27
  28. 28. (3) Institute of Policy Studies, State of the Economy for 1999.(4) Government of Sri Lanka: Vision and Strategy for Accelerated Development, May 2003.(5) Khathkhate, D, “Timing and Sequence of Financial Sector Reforms.” Workshop on Macroeconomic Management and Policy Analysis, Economic Development Institute (EDI) and Central Bank of Sri Lanka, Colombo, Sri Lanka, May 1998.(6) McKinnon, R. 1973. Money and Capital in Economic Development, The Brookings Institute. Washington D.C.(7) Shaw, 1973. Financial Deepening in Economic Development, Oxford University Press(8) Konrad Adenuer Stiftung, 1994. The Role of Central Banking, Report of a Conference held in Colombo.(9) Karunatillake, HNS. 1968. Banking and Financial Institutions in Ceylon. Central Bank of Sri Lanka, Colombo(10) Central Bank of Sri Lanka, 1988. Economic Progress of independent Sri Lanka, 1948-1998. Central Bank of Sri Lanka, Colombo.(11) Fernando, Daily News, August 30, 2003.(12) Asian Development Bank, Commercialization of Microfinance in Sri Lanka, Manila, Philippines, 2002.(13) Kate, Bayliss. 2000. “The World Bank and Privatization: a flawed development tool”. PSIRU, University of Greenwich, London(14) Tilakasiri S.L. and M.L.M. Mansoor. “Commercial Banking: Emerging Issues”, Peoples Bank Economic Review, January/March 2001.(15) Sri Lanka’s Poverty Reduction Strategy: People’s Response to Regaining Sri Lanka and Need Assessments, June 2003 (mimeo).(16) Khathkhate, D. “Timing and Sequence of Financial Sector Reforms: Evidence and Rationale”. Paper presented at the Workshop on Macroeconomic Management and Policy Analysis, Economic Development Institute (World Bank) and the Economic Research Department of the Central Bank of Sri Lanka, Colombo, Sri Lanka, 4-14, May 1998. 28
  29. 29. (17) Central Bank of Sri Lanka., 1998. Economic Progress of Independent Sri Lanka, Colombo. SriLanka.(18) ------------------------. Annual Report 1966 29

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