1. Transforming Public Sector Banks Session II: Good Public Banks/Bad Public banks Presentation by Mr. A.S. Jayawardena Governor Central Bank of Sri Lanka

2. Introduction 1.“Good” and “Bad” public (or even private) banks in competitive situations need careful definition. 2.Public perception is that good banks earn financial profits; the profits grow over time; their capital is strengthened; they expand their business; their business is conducted prudently 3.Public sector banks are also expected to undertake social obligations, not usually borne by private sector banks. 4.They are also subject to government patronage, and tend to be bureaucratic and inflexible. 5.Financial profitability important for deposit raising banks.

3. 2. The Background 1832 -Ceylon Savings Bank (CSB) 1885 -Post Office Savings Bank (POSB) 1931 -State Mortgage Bank (SMB) 1939 -Bank of Ceylon – nationalised 1961 (BOC) 1944 -Agricultural & Industrial Credit Corporation (AICC) 1955 -Development Finance Corporation (DFCC) 1961 -Peoples Bank (PB) 1971 - National Savings Bank (NSB) – CSB + POSB 1979 -National Development Bank (NDB) 1995 -Regional Development Banks (5) merging 17 Regional Rural Development Banks (RDB)

4. 3. Commercial Bank Expansion: BOC and PB, Two public sector commercial banks expanded strongly since 1970s 1970 19802002 Branches Public Private 148 17 432 55 606 368 Employment Public Private 4510 n.a. 16,772 n.a. 19,626 14,409 Assets (Rs. Mn.) Public Private 2,338 784 18 620 7,981 386,032 401,994 Deposits (Rs. Mn.) Public Private 1,752 642 13,348 3,943 278,503 294,725 Loans (Rs. Mn.) Public Private 1,064 484 12,070 4,930 167,326 216,600

5. 4. Assets of Financial Institutions Commercial banks (50%) and investment (development) banks (11%) dominate. BOC and PB account for 29% along with NSB (9%) and SMIB (1%, public sector banks account for 52% of financial system assets – 55% of GDP. By 1980, public sector bank’s share was over 80 percent. Despite declining share, public sector banks accounted for two-thirds of loans by 1990. 5. Capital Ratios and Non-performing Loans Non-performing loans of public commercial banks continuously and consistently higher than that of private domestic banks, much higher than that of foreign banks. Average interest spread between borrowing and lending rates around 6 percentage points in the State banks. Other commercial banks tended to follow in setting interest rates, while engaging on non-interest rate competition. High interest rates discouraged investment.

6. Table 2: Assests of Financial Institutions InstitutionRs.Bn.% Central Bank of Sri Lanka30414.6 Institutions Supervised by the Central Bank Deposit-Taking Institutions1,224 62.8 Licensed Commercial Banks94249.6 State Banks46628.5 Domestic Private Bank35614.9 Local Branches of Foreign Banks1206.2 Licensed Specialised Banks24111.4 Registered Finance Companies411.8 Other Institutions35114.7 Employees’ Provident Fund31512.9 Primary Dealers221.1 Leasing Establishments150.7 Group Total1,57477.5 Institutions not Supervised by the Central Bank Deposit-Taking Institutions201.0 Co-operative Rural Banks150.8 Thrift and Credit Co-operative Societies50.2 Contractual Savings Institutions1225.6 Approved Private Provident Funds462.3 Employees’ Trust Fund411.8 Insurance Institutions351.6 Other Specialised Financial Institutions281.3 Merchant Banks160.8 HDFC Sri Lanka Bank50.2 Venture Capital Companies30.1 Unit Trusts40.1 Group Total1707.9 Total Assets2,050100.0

7. Table 3: Sri Lanka: Reported Capital Ratios and Loan Quality in Banks, 1996-2001 (In percent) 199619971998199920002001Est. Core capital ratio(min.4 percent) 1/ State commercial banks10.18.08.23.72.3-0.4 Private domestic banks10.210.110.19.910.39.4 Foreign banks13.315.514.215.614.116.1 All commercial banks10.59.79.77.87.34.8 Specialized banks------19.618.528.4… Risk-weighted total capital ratio(min. 9 per cent) State commercial banks10.710.58.68.84.30.1 Private domestic banks11.811.012.512.211.410.4 Foreign banks13.813.113.912.512.516.0 All commercial banks11.511.010.710.68.37.8 Specialized banks………18.217.323.4 NPLs/Total advances State commercial banks18.920.219.518.315.418.2 Private domestic banks12.012.413.415.914.915.7 Foreign banks8.310.412.710.712.713.2 All commercial banks15.416.416.616.615.016.9 Total advances (percent annual growth) State commercial banks…9.713.011.919.310.3 Private domestic banks…23.022.820.820.713.8 Foreign banks…6.7-0.315.3-1.6-5.7 All commercial banks…13.214.415.417.410.1

8. 6. Banking Reforms 1. Recapitalisation of Public Commercial Banks 1993 – Rs. 24 billion – 30 year non-redeemable bonds at 12% interest. Banks issue shares to government. 1996 – Rs. 19 billion – 12 year non-redeemable bonds at 14% interest. Helped meet capital adequacy – not liquidity – Implicit dividend to government deducted from interest. Memoranda of Understanding to ensure loan recoveries, improving return on assets and equity, commercial accounting and Boards held accountable. Introduce limited private management. 2. Reform of Investment and Regional Banks DFCC and NDB privatised. RRDBs consolidated into 5 RDBs 3. Improve Loan Recoveries

9. 7. Banking Reforms (continued) Recapitalisation did not succeed because of inadequate commitment to reform –weak loan recoveries –continuation of bad loans –failure to achieve targets –inability to reduce costs by reducing staff –continued use of the banks for government finance eg. security, loss making public enterprises. –trade union negativism Major Structural Reforms contemplated. –PB to be restructured into two – a savings and a commercial bank –BOC to be commercialised –Dispose of non-performing loans to an Asset Management Company –Private sector participation –Explicit subsidisation of social obligations –Rationalisation of excess employment –Good corporate governance.

10. 8.Strengths of Public Banks 1. Historically significant pioneering role - in mobilising savings – confidence and goodwill - in deepening the financial system. 2. Developing indigenous entrepreneur class, local enterprise, small and medium sector, as well as good bankers. 3. Success of branch expansion evaluated by the private banks. More balanced development of rural areas. 4. Large size enables domestic and international expansion – Implicit government backing. 9. Weaknesses of Public Banks 1. Government ownership brings government regulation - inflexible operations - pressure for direction of credit - pressure for employment expansion. 2. Difficulty of loan recoveries due to political pressure. 3. Lack of performance oriented incentives. 4. Negative trade union pressure. 5. Breakdown of financial discipline as they are perceived as “too big to fail”.

11. 10.Good Public Sector Banks - Must be financially viable - Operating on a level playing field with private banks - Social obligations to be identified and public be informed - Adopt good corporate governance principles, which are accounted for, to the owners and depositors - Pay special attention to credit evaluation and loan recoveries - Flexibility in operation and freedom from government regulation - Should annually justify why they should remain under public ownership.