“Does Size Matter”

Case Study on Sri Lankan Financial Sector Consolidation with emphasis on NDB and DFCC merger

ABSTRACT

The ‘bigger is better’ syndrome is more apparent than ever before in the Financial services

sector. We have seen an unprecedented push for consolidation in the belief that M&A (Mergers

& Acquisitions) gains can be achieved through expense reduction, increased market power,

increase the resilience of the system, reduced earnings volatility and to drive economies of scale

and above all to create a stable financial sector.

The recent flurry of M&A discussions and deals in the NBFI (Non-Banking Financial

Institutions) stands witness to this. The main catalyst generally behind M&A activity is

competition, which is generally fuelled by market forces, deregulation and technology, but the

recent excitement has been driven mainly by Government policy and less by the industry. The

regulator however cannot be blamed if the industry takes a back seat with little debate and allows

the Central Bank to be in the driving seat.The reality is that in most countries, the financial

services sector is at the mercy of public policy guidelines, central bank strategy and economic

incentives Therefore, the regulator is generally expected to regulate in a manner that the benefits

exceed the cost of doing it.In general, M&A is nothing new for the global banking industry. For

example the US banking industry has been consolidating for more than 10 years, during which

the number of banks has reduced from 14,000 to around 9,000, leaving room in the regional

areas for more consolidation. Historically, financial institutions in Europe have pursued growth

by purchasing domestic competitors or buying into banks in other countries in business areas

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where they already excel.In Sri Lanka after many years the banking sector is set to consolidate

with the DFCC-NDB taking the lead. Some stakeholders of the two banks are optimistic because

the merged entity would effectively create a bank the size of Sampath Bank.However, many

stakeholders of both banks are still not too sure as to the purpose of this merger. Is it to have a

bigger development bank or to create a bigger commercial bank, eliminating the only

development bank in the country? Or is it to make borrowing from overseas markets easier and

cheaper?

Clearly, looking at the scenario only way banks can grow and have larger operations and better

cost-to-income ratios is through mergers and acquisitions, that is to merge or buy, or be bought

by, other banks in Sri Lanka or outside the country. Consolidation therefore around

fewer,stronger players, will ultimately play to our competitive advantage.

The oligopoly affect as feared by analysts is unfounded, because, if the consolidation process is

managed well, the potential opportunity to increase the resilience of the system, create a cost-

efficient banking system and better oversight by the Central Bank would be a big plus for the

banking sector.

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ECONOMIC LANDSCAPE OF SRI LANKA

The pearl of the Indian Ocean was trailing at the far end of “developing countries” of its

counterparts due to its long bloody conflict which left a heavy mark of poor economic, political

and social stability and growth. In the years following the end of civil conflict in 2009 an

acceleration of activity of economic growth, political stability with an overall revival of a healthy

heart beat to all its functional key areas was evident. Government policy has had the most

significant impact on influencing strategic planning; The effect of government policy is the most

obvious in Emerging Markets such as Sri Lanka (SL). Based on World Economic Forum Global

Competitive Report 2014-2015 sustaining the current momentum of development and growth

will require a continued focus on macroeconomic stability, high and sustained investment in

infrastructure and human capital, and continued progress in fiscal consolidation and debt

reduction.

Sri Lanka’s economic growth has been one of the fastest among Asia’s developing economies in

recent years, it made many notable advances in recent years, and appears to be on its way to

joining the ranks of upper middle income countries. After falling to 6.3 percent in 2012, real

GDP had an accelerated growth of 7.3 percent for 2013. Driven primarily by a pickup in services

activity there appears to be an ongoing shift toward higher value added industrial production, as

well as rapid expansion of services and supported by manufacturing and construction and also

benefiting from an increase in net exports. Per capita GDP took a climb from US$869 in 2000 to

US$3,256 in 2013. Macroeconomic performance has generally exceeded expectations. the

current account deficit improved from 6.7 percent of GDP in 2012 to 3.9 percent in 2013.

Inflation declined falling to 4.7 percent at the end of 2013 and to 3.2 percent year-on-year in

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May 2014, Fiscal consolidation has continued, combined with declining imports and continued

inflow of remittances and services receipts, has bolstered the balance of payments. Together with

issuance of external debt, this has allowed the Central Bank of Sri Lanka to accumulate

international reserves. Monetary policy has been accommodative, but private credit growth has

been slow.

While goods exports have decreased as a share of GDP, services receipts have increased and now

rival the garment industry as a source of foreign exchange earnings. The most visible aspect of

this is growth in tourism—which more than doubled in dollar terms between 2011 and 2013—in

tandem with transportation services, supported by significant investment in port Export- Import

facilities. Rapid growth (albeit from a small base) is also visible in information technology and

accounting services. Inward remittances have also risen as a comparatively well-educated Sri

Lankan work force increases its overseas presence. Net remittances as a share of GDP have

increased to about 8.4 percent of GDP in 2013, compared with 6.4 percent a decade earlier—

equivalent to a rise from about one-quarter the value of total goods exports in 2003 to nearly

two-thirds by 2013. Further, growth in the garment industry and higher value added, but that

rising competition and labor scarcity might also give rise to shifting some operations to lower-

cost locations. Further diversification of goods and services exports would rest on continued

macroeconomic stability, improvements to the investment environment and a predictable policy

environment. In this context, Foreign Direct Investment (FDI) flows might also gain from such

structural improvements, and that available evidence suggest greater gains to productivity and

growth from equity and FDI flows than from debt financed investment.

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A strong recovery in exports in the second half of 2013 and into 2014, combined with declining

imports and continued inflow of remittances and services receipts, has bolstered the balance of

payments. Cumulative export earnings of first 8 months of 2014 recorded an increase of 14.8%

YoY (Year on Year) to USD7,384.9 mn chiefly aided by textile and garment exports.

Agricultural exports which added c.25% to export earnings reported an increase of 15.6% YoY

in January-August 2014 while industrial exports which accounts to c.75% of export earnings

surged 13.8% YoY primarily backed by textile and garments exports which grew c.19% YoY

over the first 8 months to USD3,256.0 mn. Textile and garments exports contribution to total

export earnings stood at c.44% on a cumulative basis during the same period. Import expenditure

grew 4.6% YoY, at a slower pace than export earnings over the first 8 months of 2014 to

USD12,554.8 mn with the main import destinations reported as India, China, UAE, Singapore

and Japan. Intermediate goods which accounted for c.62% of cumulative import expenditure saw

an increase of c.9.8% YoY led by the fuel bill increase of c.20% YoY as a result of higher

thermal power generation due to adverse weather conditions. Consumer goods contributed 18%

to import expenditure denoting an increase of 9.0% YoY while expenditure on investment goods

which contributed 20% to expenditure saw a dip of 11.4% YoY over the same period. Sri Lanka

is well positioned to benefit from the global economic recovery and particularly stronger growth

in advanced economies. The trade deficit for the first 8 months contracted 7.1% to USD5,170.0

mn. As per the road map targets, trade balance as a percentage of GDP is expected to decline to

11.6% in 2014 and 8.4% by 2016.

While the current account deficit has decreased in recent years, it remains financed largely by

debt-creating inflows and central bank foreign exchange reserves are at the lower end of what is

considered adequate by standard metrics. The predominance of debt-creating inflows is reflected

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in a high debt component in gross reserves which is slowly improving along with the gradual

decline in external debt. To raise the reserve cushion, the authorities have absorbed foreign

exchange inflows. Supporting the accumulation of additional reserves, the need to maintain a

flexible exchange rate rises in order to effectively stabilize the exchange rate with CBSL’s

interventions. The gross official reserves nearly doubled from USD5.4 bn in 2009 to USD9.4 bn

as at end of August 2014. Thus reserves are now able to service 4.8 months of imports.

Since its introduction by the CBSL on January 23, 2001The de jure exchange rate arrangement is

free floating. The CBSL intervenes in the foreign exchange market to limit volatility in the

exchange rate. Since 2013, the LKR has stabilized within a 2 percent band against the U.S.

dollar. SL maintains an exchange system free of exchange restrictions on the making of

payments and transfers for current international transactions, except for the exchange restrictions

imposed by SL solely for the preservation of national or international security. The exchange rate

appears broadly in line with fundamentals, yet should be monitored in light of developments in

the balance of payments and inflation, and the commitment to flexibility maintained. The

External Balance Assessment points to a slight overvaluation of the rupee. According to the

external sustainability approach, only a smaller adjustment would be compatible with a

stabilization of the external debt/GDP position. Recent improvements in the trade and current

account balances notwithstanding, Sri Lanka remains vulnerable to external shocks. Medium-

term sustainability will depend on maintaining an outward orientation, diversification of the

export structure, and a judicious use of foreign borrowing—particularly given the rapid increase

in debt servicing costs that have accompanied the shift from bilateral concessional debt to new

loans on commercial terms. The Market Access Debt Sustainability Analysis (MAC-DSA)

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highlights the sensitivity of Sri Lanka’s debt sustainability to growth and foreign exchange

shocks.

The government has remained solidly committed to fiscal consolidation and reduction of public

debt as a mainstay of macroeconomic stability. Particularly if Sri Lanka is to maintain current

growth momentum and foster economic development and diversification, high and sustained

levels of public spending on infrastructure and human capital will be essential. Which evidently

is the government development strategy that focuses on six pillars: (i) macroeconomic stability;

(ii) spatial transformation (creating economic links through improved infrastructure; (iii) human

resources development; (iv) rural-centric development; (v) resilience to climate and external

shocks; and (vi) five hubs of development (knowledge, shipping, energy, aviation and

commercial hubs.

Sri Lanka has a parliamentary based election system with an executive presidency. The current

government United People’s Freedom Alliance (UPFA) has 2/3 majority in parliament and has

power in all the provincial councils except the Northern Province. The incumbent president H.E.

Mahinda Rajapaksha is serving his second term in house and most likely would stand for an

early presidential election next year to obtain a mandate for the 3rd term. The current government

is more of a socialist regime align more towards China and India rather than the West.

Sri Lanka traditionally follows a Non-Aligned Foreign Policy, since the end of the long standing

conflict, the country has pursued better relations with all major powers and seeks to strengthen

its diplomatic, economic and military ties with India, Bangladesh, Russia, United States, China,

Pakistan, Japan, Malaysia, South Korea and European Union. Sri Lanka has also forged close

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ties with the member states of the Association of Southeast Asian Nations (ASEAN), African

Union and Arab League.

China and Sri Lanka is expected to enter a golden era with its growing economic ties, The two

nations are anticipating more cooperation and closer ties in trade and economy to open its 21st

Century Maritime Silk Road initiative. China has emerged as the largest foreign direct investor,

accounting for one fourth of the inflows in 2013, according to Laskshman Abeywardhana, Sri

Lankan minister of investment promotion. Loans and investments from China have played a

significant role in post-war reconstruction. Direct investment from China is not only contributing

to foreign exchange reserve and job creation of the country, but also generating considerable

benefits through technology transfer and development. There are 14 Chinese companies

registered at the Board of Investment of Sri Lanka and has thus far generated more than 2, 500

local jobs. In efforts of turning the nation into a global maritime logistics center and a world-

class harbor and goods distribution center china has been the strongest ally in unraveling its

potetial to great ecomoic growth infrastucture. Chinese enterprises contracts all primary mega

infrastructure projects in Sri Lanka, like the Hambantota Port and Colombo South Harbor, as

well as proposed the construction of Norochcholai Coal Power Plant, carried out by China

Machinery Engineering Corporation, which is expected to meet 45 percent of the total demand of

the nation's power grid will change the dynamics of the Sri Lankan economy and accelarate its

future development further. Sri Lanka also hopes the proposed Sri Lanka-China Free Trade

Agreement (FTA) will help Sri Lanka to gain easier access to the Chinese market and gradually

reduce its trade deficit towards the world's second largest economy.

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The World Bank has been supporting Sri Lanka’s development for close to six decades, having

accompanied the country as it has grown to join the ranks of middle-income countries. As set out

in the Country Partnership Strategy (CPS) for FY13–16, the World Bank Group is supporting Sri

Lanka in addressing its long-term strategic and structural development challenges as it transitions

to middle-income country (MIC) status. Key elements of this transition include boosting

investment, including in human capital, realigning public spending and policy with the needs of a

middle income country, enhancing the role of the private sector, including the provision of an

appropriate environment for increasing productivity and exports, and ensuring inclusive growth.

The CPS set out to contribute to achieving these goals through three areas of engagement: (i)

facilitating sustained private and public investment; (ii) supporting structural shifts in the

economy; and (iii) improving living standards and social inclusion. World Bank portfolio in Sri

Lanka comprises of 15 projects, with a total net commitment value of $1.77 billion:

ADB’s Country Partnership Strategy (CPS) for Sri Lanka, approved in 2011 identifies three

pillars, (i) inclusive and sustainable economic growth, (ii) catalyzing private investment and

enhancing the effectiveness of public investment, and (iii) human resource and knowledge

development, as the focus of operations over the period 2012–16. ADB continues to focus on

transport, energy, water supply and waste water management, and irrigation sectors in

infrastructure development, and education sector. An allocation from 2014-2016 consists of $562

million from ordinary capital resources (OCR) and $437 million from the Asian Development

Fund (ADF).

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FINANCIAL SECTOR TO RIDE THE GROWTH WAVE

The financial services sector accounts for c.8% of the GDP and the Banking sector is the most

dominant player in the financial services industry with 24 (12 foreign & 12 local) Licensed

Commercial Banks (LCBs) with a total asset base of LKR5,022 bn (USD38.6 bn).

Sri Lanka’s banking sector is dominated by the two state banks, namely Bank of Ceylon and

People’s Bank which accounts for c.43% of the total asset base in the sector. Further out of the

private commercial banks’ market share, Commercial Bank (COMB) and Hatton National Bank

(HNB) accounts for c.40% (refer appendix I). During the recent past private sector banks has

increased their contributions with new technological innovations and more customized product

portfolios and attractive service models.

The banking sector which acts as a proxy to the economy enjoyed great success since the end of

the conflict where GDP grew +8% and private sector credit growth was +30%. However the

slowdown in economic activity, subdued credit demand and declining gold prices during second

half of 2012 and 2013 created some head mined for the banking industry.

Since December 2012, the Central Bank (CBSL) has eased monetary policy with its key policy

interest rates, the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate

(SLFR), being reduced by 125 and 175 bps, respectively to 6.5% and 8.0%, and the Statutory

Reserve Requirement (SRR) on Rupee deposit liabilities of commercial banks being reduced by

200 bps to 6%. However corresponding adjustment in market interest rates were rather slow

during that period.

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Private sector credit dried up significantly in 2013 where the spillover effect was seen in 1 st

quarter of 2014.

During second half of 2012 and 2013 industry lending rates have declined continuously inserting

greater pressure on the interest spreads. However normally the deposits rates are adjusted

downward more than the lending rates where by the private banks are holding on to a healthy

interest spread.

Despite pressure on interest spreads in the industry, private sector commercial banks recorded

healthy interest margins (refer appendix II), given timely re-pricing of their funding products

(primarily deposit products) and shift in the deposit mix towards low cost CASA deposits which

enabled them to reduce their funding costs at a faster pace than lending rates.

During 2011 and 2012 banking sector asset growth was c.20% and the loan growth has been

31% and 21% respectively. However the asset growth slowed down in 2013 to 16% largely due

to the lower credit demand and reduction in the value of pawning portfolios which impacted the

industry loan growth where it only grew to 10% in 2013. The lower credit demand can be

attributable to relatively higher interest rates and most of the corporates raising alternative

funding (debt) during 2013. Excluding pawning the advances portfolio grew 16% in 2013 largely

backed by Construction (26%), Trading (21%), Infrastructure (20%), Manufacturing (17%) and

Transport (11%). Notably consumption related lending activities contributed negatively to the

overall credit growth. The loan growth was slower than expected in 1Q2014 but we believe the

loan demand would pick up from 2H2014 led by SME followed by the corporate and finally the

retail sector in 2015E (refer appendix III).

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At the outset overall banking sector asset quality was dragged down due to the collapse in global

gold prices, resultant impact on the pawning portfolios and the slower than expected overall loan

growth. The absolute Non Performing Loan (NPL) quantum increased LKR74.0 bn and out of

which c.75% was pawning (“Over the counter lending where gold would act as a collateral”)

related advances. The specific provision coverage declined to 33% from 41% due to lower

amount of additional provisioning for new NPLs which was largely gold backed loans. However

we believe stabilizing gold prices and higher precautions on pawning related advances would

bring down the NPL ratio to c.4.5% in 2014 (refer appendix IV).

However gold prices in the world market has declined considerably during 2013 where it has

fallen c.28% (declined c.35% from its high of USD1,790.0) in 2013. Declining gold prices

reduces the collateral value of gold loans, but the impact would not be reflected immediately in

the income statement. Impact would be realized in the income statement when the collateral

(gold) of the defaulted loans are sold at the auction at lower prices. However sentimental value

of jewellery may reduce the customer default rates in pawning as they would not be refinanced

even when the gold prices decline.

During 2012 banks have given out c.80-85% (loan/value) of the gold value as pawning loans

(which would act as a buffer if gold prices decline). However steep fall in gold prices has

resulted in loan value dropping beyond the collateral value which has posted a bad loan risk to

the banks which has relatively high exposure in to pawning. During 2013 the system lost

c.LKR100.0 bn in value on gold loans and almost all the banks have taken a decision to auction

the gold and cut their losses. Further the bank’s have considerably reduce the loan to value ratio

to 60-65% enabling a higher cushion against future gold price reductions (refer appendix V).

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Deposits continued to be the main funding source in the banking sector accounting for c.70%.

The gap was bridged largely through borrowings (which grew 26% YoY) where the larger

increase was evident in foreign borrowings. Despite the reducing deposit rates funds continued to

flow to the banking system recoding a growth of 16% in deposits during 2013. Further with the

higher interest rates a deterioration in the CASA mix (absolute CASA base was maintained) in

2013 were seen (refer appendix VI and VII).

The banking sector reported a profit after tax of LKR74.6 bn (down 9%) for 2013. The net

interest margin declined from 4.1% to 3.5% in 2013, due to the increase in the share of high cost

term deposits in total deposits, the moderation in credit growth and the increase in low yielding

assets. However, there was no significant increase in the operating expenses. Excluding the state

banks the profit after tax decreased c.5.7% in 2013. Consequent to these developments, all the

profitability indicators such as net interest margin (NIM), return on assets (ROA) and return on

equity (ROE), declined during the year.

Banking sector remained very liquid in 2013 given the lower credit demand and growing

deposits & borrowings. The liquid asset ratio (statutory minimum of 20%) improved to 38% in

2013 as against 31% in 2012. The excess funds were mainly invested in treasury bills, bonds and

development bonds.

Banking sector remains well capitalized (refer appendix VIII) as at end 2013 where the Tier I

CAR is at 13.7% (regulatory limit 5%) whilst the total CAR is at 16.3% (regulatory limit 10%).

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TOWARDS A STRONGER FINANCIAL SYSTEM

“At present our country has 58 Finance Companies, out of which only 20 have an asset base over

Rs. 20 billion. Some of them are owned by banks. Therefore, I propose that any finance company

which is a subsidiary company owned by a main company, be absorbed by the main company to

consolidate their operations. I also propose that banks, which have finance companies to

consolidate their operations by acquiring the finance companies within the group to further

strengthen the banks. In support of this initiative, I propose to give qualifying payment status for

acquisition expenditure of banks or companies, if they have acquired any finance company. As a

part of financial sector strengthening, I propose to encourage development banks to merge and I

also propose to improve the Credit Information Bureau to facilitate both banks and customers”

(Quoted from Budget Speech 2014).

Based on the 2014 budget proposal the CBSL on 17th January published a document titled

“Master Plan on Consolidation of the Financial Sector” which articulated clear guidelines on

the consolidation process. Further CBSL conducted a special seminar and explained

Chairmen/CEOs of Banking and Non-Banking Finance Institutions (NBFIs) and Bank Auditors

the need/rationale and components of the Consolidation. Banks were advised to look in to the

consolidation process by obtaining specialized consultations from IT, Legal, Tax and HR

services and to have close relationship with CBSL to make the consolidation process smooth and

professional. CBSL also held discussions with leading consulting firms with regard to the

provision of consultancy services in respect of valuations, accounting and other services. CBSL

also appointed a special unit including the assistant governor to be in line with the banks and

subsequently the banks and NBFIs agreed to submit the preliminary proposals on consolidation

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effort by 31st March 2014. As per the CBSL the main objective of the consolidation process is to

create a stronger, more resilient and a better positioned financial system to support the future

economic growth of the country.

“Soludo (2004) iterate all over the world and given the internationalization of finance,

size has become an important ingredient or success in the globalizing world”. The last

few years have witnessed the creation of the world’s banking group through mergers and

acquisitions. The trend has been influenced by factors such as prospects of cost-savings

due to economies of scale as well as more efficient allocation of resources; enhanced

efficiency in resource allocation; and risk reduction arising from improved management.

In the United States of America, there had been over 7,000 cases of bank mergers since

1980, while the same trend occurred in the United Kingdom and other European

countries. Specifically, in the period 1997-1998, 203 bank mergers and acquisitions took

place in the Euro area. In many emerging markets, including Argentina, Brazil and

Korea, consolidation has also become prominent, as banks strive to become more

competitive and resilient to shocks as well as reposition their operations to cope with the

challenges of the increasingly globalized banking systems. In Korea, for example, the

system was left with only 8 commercial banks with about 4,500 branches after

consolidation.

“Based on Abeywickrama (2010) through M & A, banks will be able to deliver several

services to customers under the universal banking concept and also bring down the cost

of transaction such as overheads, capital expenditure”. (Abeywickrama, 2010)

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So far, the Central Bank has approved 29 proposals of 7 Banks and 22 NBFIs to proceed with

their merger/acquisition processes while further consolidation plans of 7 NBFIs and One Bank

are being finalized.

Asian Finance Ltd and TKS Finance Ltd., Capital Alliance Finance PLC and Cargills Bank Ltd.,

Commercial Credit and Finance PLC and Trade Finance and Investments PLC, Bartleet Finance

PLC and Orient Finance PLC, Prime Grameen Micro Finance Ltd and Hatton National Bank

PLC, and Senkadagala Finance PLC and Newest Capital Ltd, have made public announcements

of agreed consolidation arrangements

The Monetary Board approved the merger of TPG Global LLC, a US - based global private

investment firm, which through its subsidiary, has committed a significant capital infusion to

Union Bank of Colombo PLC.

Mergers of DFCC Bank, DFCC Vardhana Bank PLC and the National Development Bank PLC,

as well as Merchant Bank of Sri Lanka PLC, MBSL Savings Bank Ltd., and MCSL Financial

Services Ltd., aim to complete their merger processes by last quarter of this year.

The Panel of Audit Firms continued to assist in transaction management, by advising Banks and

NBFIs on transactions as well as on the smooth transition, the Central Bank said. The Central

Bank said it is closely monitoring the progress made by banks and NBFIs which are earmarked

for consolidation and the timelines indicated in the consolidation plans with a view to

expeditiously drive the financial sector consolidation programme.

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By releasing a statement on 10 January 2014 to Colombo Stock exchange The Boards of

Directors of DFCC Bank (DFCC) and National Development Bank PLC (NDB) announced:

“The Boards of DFCC and NDB wish to emphasize there have been no definite decisions on any

aspect of such consolidation and that final decisions would be dependent, amongst others, on

arrangements being agreed keeping paramount the interests of customers, employees (which in

the case of DFCC include those of DFCC Vardhana Bank PLC) and other stakeholders of the

banks. Moreover, consolidation of the two entities will be dependent on regulatory approvals and

possibly, the passage of facilitative legislation. “

In March 2014, NDB and DFCC Bank entered into a memorandum of understanding in order to

proceed with their merger process. The banks submitted their broad plans on consolidation by

adhering to the already given time line of 31/03/2014. Audit firms that have been appointed by

the CBSL to carry out due diligence and valuation of the banks submitted their reports to

facilitate the broad level discussions held between the banks and CBSL.

According to Mr. Arjun Fernando, Chief Executive Officer (CEO) of DFCC Bank there is still a

lot of preliminary work need to be done at present stage and the two banks are working together

with the utmost cooperation to make this merger smooth and success.

Mr. Arjun Fernando was appointed as the CEO of DFCC bank in 2013, He is a career banker

with 27 years of experience with HSBC in Sri Lanka, Bangladesh and Hong Kong and has

served in senior managerial positions in Corporate Banking, Trade Finance, Retail Banking and

Operations. Mr. Fernando was the Chief Operating Officer of HSBC Sri Lanka from 2005 to

2007 and Chief Technology and Services Officer of HSBC Bangladesh since October 2007 till

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his appointment as CEO of DFCC. According to Mr. Arjun Fernando, chief executive of DFCC

bank there is still a lot of preliminary work need to be done at present stage and the two banks

are working together with the utmost cooperation to make this merger smooth and success.

Mr Rajendra Theagarajah who is a veteran banker with a wealth of experience in the Banking

and financial services sector with over 29 years in banking both locally and overseas. Prior to

his appointment as Director / CEO of National Development Bank PLC (NDB) in 2013 , he

served as CEO/ Managing Director at Hatton National Bank PLC for 9 years is very positive

about the development in merger progress with DFCC in fact 2013/2014 annual report also has

been named “Size Matters”

Making a statement to newspapers Mr Theagarajah denied the claim that the proposed merger is

a forced one.

“Nobody needs to force us into this. I think the comment is coming from an outsider’s point of

view and we from inside the Banks can assure that if this happens it wouldn’t be forced on us,”

Theagarajah said in response.

In July 2014 NDB and DFCC jointly announced that they have hired Boston Consulting Group

of India to be the advisor for the banks on the amalgamation process. According to the top

sources of Central Bank, DFCC and NDB the management structure of the new merged bank,

has also not yet been decided. (Ceylon Today, August 2014).

Since DFCC is formed by a special act of parliament Amendments allowing DFCC Bank’s

impending merger with NDB has been passed by the Cabinet, industry sources said. The reason

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is because the DFCC was founded under a special Act while the NDB was established under the

Banking Act. Reports say.

“These amendments will facilitate DFCC to become a company, thereby aiding the merger with

NDB, This will be similar to the parliamentary approval which was sought to enable NDB to get

incorporated under the Companies Act, to facilitate the merger with NDB Bank some years ago”

In October 2014, Central Bank issued Guidelines on Tax Incentives to Promote Financial Sector

Consolidation. This makes the cost of acquisition/merger(purchase consideration, professional

fees, documentation fees, expenditure incurred on IT systems, human resource related costs,

advertising costs and infusion of capital) as a qualifying payment and on the claimability of any

unabsorbed input credit in terms of the Inland Revenue Act and the Value Added Tax (VAT).

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MERGING ENTITIES: NDB AND DFCC

Development Finance Institutions (DFI’s), were created following World War II for the principal

purpose of rebuilding the war-devastated economies. These institutions were sponsored by

governments or donors for the provision of term financing for developmental projects. In the

words of Mr. William Diamond, the father of development banking, “by and large the principal

activity of the appraisal of investment proposals and the monitoring of investments after they are

made, became the core of the Development Bank’s work” Around. 60 percent of DFIs around

the world were owned by the governments of their respective countries. Another 25 percent were

privately owned, while the balance (15 percent) has a mixed ownership. Irrespective of

ownership, however, it is evident that all of the DFIs have received some form of assistance from

their governments. The justification for such assistance came on the basis that DFIs filled a void

created by a failure of the market and that they were an essential instrument in promoting and

financing development. This led to the paradoxical situation that although many of them were

privately owned and mandated to serve the private sector, they were viewed as quasigovernment

institutions and expected to behave in the public interest.

The negative effects of the close association with governments became pronounced in the case of

many DFIs, especially those that were owned by governments. The continued dependence of

these institutions on the government (1) for its resources for lending and (2) for subsidies to

maintain profitability of operations and increase portfolio infection ratios that arose from behest

lending not only created unhealthy market distortions but raised the question of the

appropriateness of the DFI model in the context of a liberalized global financial market. A

significant number of DFIs have failed to provide an acceptable return on the funds invested. The

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portfolio quality of some among them has deteriorated to such an extent that the viability of the

institutions is threatened. There are others whose continued profitability depends on

governmental subsidies of one kind or another. Institutions function in an ever-changing

dynamic macro environment. Globalization has increased the pace of such change. The success

or, at a minimum, the very survival of any institution depends on its ability to adapt to such

changes and to reinvent itself from time to time. Only a few DFIs have been able to do so, and

the DFCC & NDB are among those that have done so successfully.

DFCC Bank was established in 1955 through an act of parliament, and on the recommendation

of a World Bank mission. It was envisaged that DFCC would play the role of a DFI, providing

long term finance to industries and services to facilitate growth of the Sri Lankan economy .The

initial capital was subscribed to by Commonwealth Development Finance Company, and 9 other

domestic financial institutions. Whilst significant state support was anticipated (in terms of

funding) DFCC was created as a ‘private’ entity. With the exception of the Government director

(mandated by the act), the board members are appointed by shareholders. At present State

Owned Entities (SOE) hold approx 25% of DFCC’s equity. Other major shareholders are HNB

(12.22%), Employers provident Fund (9.19%), and Distilleries company of Sri Lanka (6.43%).

In general, the state adopted somewhat of a ‘hands off’ approach towards policy lending, through

the two main DFI’s, i.e. DFCC and NDB. Focus was achieved by restricting the scope of

activities of the institutions, whilst funding was directed to targeted areas by making available

particular lines of funding for designated sectors. Targeted sectors were awarded tax concessions

to encourage investments. This is in contrast to stipulating strict guidelines, capped interest rates

and minimum exposure levels, as was practiced in some countries. This effectively meant that

21 | P a g e

the banks were free to make business decisions in most instances. Consequently both DFI’s, have

enjoyed relatively higher levels of autonomy and operating freedom, compared to that enjoyed

by their counterparts in other similar developing economies. DFCC was also publicly listed on

the CSE in 1956, whilst NDB was listed in the early 90’s. As a result the performance and

financial health of both institutions have been relatively good, and have avoided bail outs and

recapitalizations, which are frequently associated with financial institutions with policy

mandates. The institutions have, over the years earned a satisfactory return on funds, helping

them to build equity. Primary source of funding for DFCC has been the multilateral agencies. In

most instances, these credit lines are lent by the agencies to the Government, who in turn on-

lends the funds to DFCC. However, even in instances where the bank is the direct borrower, the

Government continued to provide the guarantees. Foreign exchange risk is also taken up by the

state. The availability of these concessionary lines of credit are expected to reduce, especially

given the trends witnessed elsewhere. However, judging by the credit lines made available over

the last 4 -5 years, this issue, at least in the Sri Lankan context does not appear to be that acute as

yet. Nevertheless, competition, and the shift of development lending away from the traditional

model have necessitated change. Other activities of DFCC, in addition to its core of providing

project loans are Commercial Banking through DFCC Vardhana Bank ,leasing, investment

banking, consultancy, stock broking, fund management and venture capital. The bank also has

interest in the development and management of an industrial park (Lindel ), where it is a Joint

venture partner with the government. However, contribution by these activities, are not that

significant. Hence, revenues are still largely dependent on the riskier longer term project finance,

increasing the inherent risk of the institution.

22 | P a g e

In 2003, DFCC Bank expanded into commercial banking by acquiring a 94% stake in National

Mercantile Bank, which was subsequently rebranded as DFCC Vardhana Bank Limited . Today,

DFCC Bank and DVB form the DFCC Banking Business. Combining the expertise of a pioneer

development bank and the dynamism of a commercial bank, the entity offers a breadth of

seamless banking solutions.

NDB was established in 1979 as a state owned institution through an act of parliament to provide

project funding to the private sector along with DFCC. In addition, the bank was nominated by

the government as the apex refinance body to distribute credit lines obtained from multilateral

agencies to other participating financial institutions. In 1993 NDB was privatized with 61% of

the capital transferred to the private sector. At present state controlled entities (very much

passive investors) hold 21% stake in the bank, whilst other major shareholders include the

Employers Provident Fund (9.63%).NDB group has a well experienced and competent senior

management team, drawn from leading foreign and local banks and the commercial sector. The

senior management has been exposed to the best practices adopted in international banks and has

been implementing such practices at NDB. The senior management is complemented by a team

of skilled professionals, most of whom have multidisciplinary qualifications. Currently NDB is a

long term project lender. NDB’s larger customer exposures are concentrated on the top end

corporate.

NDB has been working on transforming itself to a Universal Bank similar to the path followed

by ICICI, India. In this context, NDB has made several acquisitions, which include the local

banking operations of ABN AMRO (renamed NDB Bank) and the local operations of Zurich

Insurance (renamed Eagle Insurance). Further, NDB has subsidiaries in housing finance (in

association with IFC a multi lateral agencies and HDFC, the strongest housing bank in India),

23 | P a g e

stock brokering, investment banking (jointventure with Citi Bank) and DHPL a property

development company in collaboration with the EDB, but contributions from these entities at

present are relatively small. The strategy would involve the positioning of NDB as a high end

bank focusing on retail banking, Small and Medium Enterprises (SME) banking, corporate

banking, project & infrastructure financing, investment banking, leasing, housing finance,

investments advisory and securities trading, wealth management, property management and

bancassurance. They are delivered through the core banking activities of the Bank and the Group

companies. Further in keeping to the banks positioning as “A world class Sri Lankan” the bank

aspires to have the best systems and procedures, especially in the areas of service delivery and

risk management.

Consolidation of the financial sector as proposed by the Government of Sri Lanka (GOSL) in the

2014 budget and presented in Central Bank’s Road Map for 2014, is a policy initiative to reduce

systemic risk and create strong financial institutions with scale benefits. This move would steer

Sri Lanka towards the developmental goals set for 2016 and beyond. In this context, the

proposed amalgamation of DFCC Bank, DFCC Vardhana Bank PLC and National Development

Bank PLC is a timely move and a landmark event in the banking landscape with the country

positioning itself as a middle income economy. The effective management of challenges inherent

in a voluntary amalgamation of strong financial institutions would be a key factor in determining

the success of such effort. Much preliminary work needs to be done and the three banks are

collaborating in a spirit of unstinted co-operation. Priority in this exercise is to ensure that

stakeholders (shareholders, employees and customers) interests are well looked after and

protected.

24 | P a g e

WILL SIZE MATTER

Industry expert is in the view that NDB-DFCC consolidation will have no big impact on the big

five banks; in the short term, the size of the new bank would not in any way pose a threat to any

of the big banks except maybe the smaller ones. If preferential treatment is given to the new

entity like foreign currency borrowings and access to credit lines, the new entity could bring

down their cost of funds and help them to compete with the big five banks.

However, this may push down margins further. The DFCC, Vardhana, NDB merged entity

would also be under pressure to grow fast and may look to low yielding segments of the

economy and to fund SOEs to deliver double-digit growth. In the final analysis, the success of

the merged entity will depend largely on how they differentiate themselves from competitors and

on the integration and consolidation of human capital. The natural remedy here is to

communicate plans around organisational and leadership modifications as honestly, clearly and

most importantly as early as possible and also on rigorously assessing the quantitative and

qualitative elements of the transaction. However, time and again, history has shown that without

a productive integration of the merging entities, the benefits envisaged can never be realised. On

the other hand, less regulatory interference and greater market freedom to complete the

transaction would help the consolidation process to realise the full potential outcome for the

stakeholders and for the Lankan economy.

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REFERENCES

Abeywickrama, C. (2010). GREATER INCLUSION - THE WAY FORWARD FOR A STABLE AND SUSTAINABLE BANKING INDUSTRY. Retrieved from Association of Professional Bankers in Sri Lanka: www.apbsrilanka.org/articales/23.../11_Chandula_Abewicrama.pdf

Shih, M.S.H. (2003). AN INVESTIGATION INTO THE USE OF MERGERS AS A SOLUTION FOR THE ASIAN BANKING SECTOR CRISIS. The Quarterly Journal of Economics and Finance 43, 31-49

Soludo, P. C. (2004, July 06). CONSOLIDATING THE NIGERIAN BANKING INDUSTRY TO MEET THE DEVELOPMENT CHALLENGES OF THE 21ST CENTURY . CBN Headquarter, Abuja.

Sufian, F. (2004). THE EFFICIENCY EFFECTS OF BANK MERGERS AND ACQUISITIONS IN A DEVELOPING ECONOMY: EVIDENCE FROM MALAYSIA. International Journal of Applied Econometrics and Quantitative Studies, 53-74.

Diamond, William, ed. 1668. Development Finance Companies. Bombay: John Hopkins Press;

Reprinted, Vakil & Sons (Pvt) Ltd.

DFCC Bank ,Annual Report 2013/2014

NDB Bank Annual Repot 2013

Other Sri Lanka Commercial Bank Articles

http://www.weforum.org/reports/global-competitiveness-report-2014-2015 - GCI 2014-2015 report

http://www.cbsl.gov.lk/pics_n_docs/01_home/docs/macro_economic_chartpack_e.pdf?article=9241 - Sri Lanka: Macroeconomic Developments in Charts - September 2014

Annual Report 2013 -Central Bank of Sri Lanka

26 | P a g e

24.2%

19.7%

12.4%10.2%

7.4%

4.3% 4.1% 3.4% 2.7%1.3% 0.7%

6.0%

2.5%0.6% 0.5%

2.6%

3.5%

4.1% 4.1%

2.8%

4.7%

3.5%

5.0%

5.7%

3.8%4.1%

BOC* Peoples* COMB HNB SAMP SEYB NDB DFCC NTB PABC UBC

050

100150200250300350400450500550600650700750800850

LKR bn

Gross loans & advances - 2012 Gross loans & advances - 2013

6% YoY

4% YoY

13% YoY

17% YoY

26% YoY

8% YoY

11% YoY

19% YoY14% YoY

5% YoY23% YoY

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

BOC* Peoples* COMB HNB SAMP SEYB NDB DFCC NTB PABC UBC

Gross NPL Net NPL

12.7%

19.5%

0.7%

8.8%

12.8%

6.9%

0.6%

2.4% 1.9%

3.5%

8.0%

BOC* Peoples* COMB HNB SAMP SEYB NDB DFCC NTB PABC UBC0

100

200

300

400

500

600

700

800

900

LKR bn

Deposits - 2012 Deposits - 2013

22% YoY

11% YoY

15% YoY

13% YoY

24% YoY

14% YoY

11% YoY

21% YoY29% YoY

12% YoY23% YoY

APPENDICES

Appendix I – Banking market share Appendix II – Net interest margin of banks

Appendix III – Bank loan growth Appendix IV – NPL ratio of banks

Appendix V – Gold exposure of banks Appendix VI – Deposit growth of banks

27 | P a g e

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

BOC* Peoples* COMB HNB SAMP SEYB NDB DFCC NTB PABC UBC

Tier I CAR Tier II CAR

Tier II Regulatory Limit

40% 40%

45%

40%38%

35%

25%

17%

27% 26%

19%

6.0

7.0

8.0

9.0

10.0

11.0

12.0

13.0

14.0

15.0

16.0

17.0

Dec

-10

Feb

-11

Ap

r-11

Jun

-11

Au

g-11

Oct

-11

Dec

-11

Feb

-12

Ap

r-12

Jun

-12

Au

g-12

Oct

-12

Dec

-12

Feb

-13

Ap

r-13

Jun

-13

Au

g-13

Oct

-13

Dec

-13

Feb

-14

Ap

r-14

Jun

-14

Au

g-14

%

AWPLR Commercial Bank AWLR

0

5

10

15

20

25

30

Jan-06

Apr-0

6Ju

l-06

Oct-0

6Jan

-07Ap

r-07

Jul-0

7Oc

t-07

Jan-08

Apr-0

8Ju

l-08

Oct-0

8Jan

-09Ap

r-09

Jul-0

9Oc

t-09

Jan-10

Apr-1

0Ju

l-10

Oct-1

0Jan

-11Ap

r-11

Jul-1

1Oc

t-11

Jan-12

Apr-1

2Ju

l-12

Oct-1

2Jan

-13Ap

r-13

Jul-1

3Oc

t-13

Jan-14

Apr-1

4Ju

l-14

%

P to P Annual Ave.

90

95

100

105

110

115

120

125

130

135

140

Jan-

04

Jun-

04

Nov

-04

Apr

-05

Sep-

05

Feb-

06

Jul-

06

Dec

-06

May

-07

Oct

-07

Mar

-08

Aug

-08

Jan-

09

Jun-

09

Nov

-09

Apr

-10

Sep-

10

Feb-

11

Jul-

11

Dec

-11

May

-12

Oct

-12

Mar

-13

Aug

-13

Jan-

14

Jun-

14

LKR

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13

Private Sector Credit (YoY Growth)

Appendix VII – CASA mix of banks Appendix VIII – Capital adequacy of banks

Appendix IX – Sri Lankan inflation Appendix X – Sri Lankan interest rates

Appendix XI – Sri Lankan credit growth Appendix XII – USD exchange rate

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0

50

100

150

200

250

300

10/28/2009 10/28/2010 10/28/2011 10/28/2012 10/28/2013 10/28/20140

50

100

150

200

250

300

10/28/2009 10/28/2010 10/28/2011 10/28/2012 10/28/2013 10/28/2014

Appendix XIII – GDP growth rate Appendix XIV – Per capita GDP

Appendix XV – Trade deficit Appendix XVI – FDI flows

Appendix XVII – Share price of NDB Appendix XVIII – Share price of DFCC

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Appendix XIX – NDB shareholders Appendix XX – DFCC shareholders

Appendix XXI – NDB 10 Year Summery

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Appendix XXII – DFCC 10 Year Summery

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Appendix XXIII – Group Strutures of DFCC & NDB

    Name BusinessShare Holding

DFCC Subsidiaries DFCC Vardhana Bank PLC Commercial banking 99.17%  DFCC Consulting (Pvt) Limited Consultancy 100%  Lanka Industrial Estates Limited Operating an industrial estate 51.15%  Synapsys Limited Provide information 100%  technology services and    IT enabled services  

 Joint Ventures Acuity Partners (Pvt) Limited

The principal activities of the Company 50%

are investment banking and related

activities such as Corporate Finance,

Debt Structuring and IPO’s

AssociatesNational Asset Management Limited

Management of Unit Trust & Private 30%

Portfolio    NDB Subsidiaries NDB Capital Holdings PLC Investment Banking 100%  Under NDB Capital Holdings    NDB Investment Bank Ltd Investment Banking 100%  NDB Wealth Management Ltd Wealth Management 0.996

  NDB Securities (Private) LtdInvestment Advisory and Securities Trading 0.996

  NDB Capital Ltd Investment Banking 78% Development Holdings (Private) Ltd Property Management 0.587

AssociatesMaldives Finance Leasing Company (Private) Ltd Leasing 35%

  .    

Appendix XXIV – Top Ten Sri Lankan Banks

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