Liberalizingthefinancialsectori si lanka

Liberalizing the Financial Sector in Sri Lanka
Issues and Concerns

Introduction
For over a decade or so there has been some talk in various quarters about
restructuring the two state-owned banks in Sri Lanka namely, the Peoples Bank and
the Bank of Ceylon and if necessary even privatizing them. The Presidential
Commission on Banking and Finance after a thorough examination of the evidence
placed before it on the performance of these banks found that there were a number of
shortcomings in their operations and stressed that they should be run on commercial
principles and that commercialization should be accompanied by re-organization of
the banks with changes in their managerial structure. However, it ruled out
privatization or peoplization of the banks in the immediate future (Report of the
Banking and Finance Commission, SP No. XXIII of 1993).

For restructuring the banks, the Commission suggested two options: one was to trim
them down into organizations focusing their efforts exclusively on debt recovery
operations while the continuing profitable and viable businesses could be transferred
to two new successor institutions to be established. The other was for the present
banks to make a fresh start retaining the profitable businesses while recovery
operations will be taken over by a new institution.

The Central Bank a few years later in 1996 observed that while Sri Lanka has gone a
long way in its financial reform programs, further progress needs to be made
particularly with a view to reduce financial intermediation costs…. and to improve
the commercial viability of the two state banks which account for nearly two-thirds
of the total assets of the banking system (Central Bank of SL, Annual Report, 1996).

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As at the end of December 2001, their total deposits stood at Rs.127 billion which
was a quarter of the deposits of the total banking sector while advances amounted to
Rs.100 billion. Of the 901 bank branch offices in the country, 598 or 66% belonged to
the 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 account
holders from the rural sector. Furthermore, while the informal sector still controls
more than 60% of the loans given to consumers, of the balance 40% the two state
banks control a formidable 60% even after 25 years of competition from foreign and
domestic private banks.

According to the Central Bank, intermediation costs in the financial markets (which
consist of financial costs and administrative costs) had gone up mainly due to the high
intermediation costs of the two state banks which enjoyed oligopoly powers in the
market. Some of the factors that contributed to the high intermediation costs of state
banks have been identified as a) the large branch network of these banks; b) the high
degree of their non-performing loans; and c) large administration costs and overheads
of 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 than
those of private banks in 1989. They were 37% and 40% for Bank of Ceylon and the
Peoples Bank respectively as against 33% for the private banks. It is rather unlikely
that these percentages to have come down since then. The high administrative costs
of state-owned banks was ascribed by the Banking and Finance Commission to high
levels of staffing, generous remuneration and benefit packages and the excessive
number 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 an
employee in private banks (Finance and Banking Commission, 1992). Because of the
oligopoly powers that the state banks enjoy in the market, they are able to maintain
high lending rates. This, in turn, allows other banks also to keep their lending rates
high and thereby enjoy “windfall gains”. This situation continues to-date.
Commercial banks are currently enjoying the benefits of interest rate cuts by the

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Central Bank. While they have cut down interest rates paid on deposits they have only
marginally reduced interest rates charged on their loans and advances. As a result, the
interest 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 adverse
effects on private investment and economic growth, the Central Bank was of the
opinion that such high lending rates need to be eliminated. To achieve this, the Bank
recommended the privatization of the state-owned banks (with restructuring them
within state ownership as the second best option).

The Institute of Policy Studies (IPS) referred to the large pockets of inefficiency in the
state-owned banking sector that contributed to the high cost of borrowing and high
interest rate spreads (IPS, 1999). It also drew attention to the relatively high ratio of
non-performing loans (or bad debts or “troubled loans”) of the state-owned banks to
their total loans and advances. These loans were estimated at Rs.35 million and
formed 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, the
Institute urged vigilance and close supervision of the activities of these banks by the
monetary authorities (IPS, 1999).

The World Bank, in the meantime, has been consistently urging the Government to
restructure these banks, if privatization is not feasible. The demand for restructuring
the state-owned banks was first put forward as a condition for IMF aid disbursement
under the Enhanced Structural Adjustment Facility (ESAF) in the early 1990s. The
Policy Framework Paper (1992-95) prepared by the Sri Lankan authorities with the
WB-IMF Staff in 1992, for instance, stated that “the Government of Sri Lanka will
continue to implement measures to restructure and commercialize the two state-
owned banks with the aim of enhancing their autonomy and efficiency”. It indicated
an aggressive privatization strategy which included, among others, the privatization of

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the two state banks. More recently, this has been re-emphasized as clearly reflected in
the Poverty Reduction Strategy Paper (PRSP) of the Government, “Regaining Sri

Lanka, May 2003” prepared in accordance with World Bank requirements for
assistance under its Poverty Reduction Growth Facility (PRGF). The PRSP indicates
an aggressive privatization strategy which includes, among others, the privatization of
the two state banks as well. With regard to reforming the financial system the PRS
Paper states that “……in spite of some improvement, the soundness of the banking
system remains a cause for concern because of the weakness of the two state-owned
banks. According to the PRSP, “……wide spreads between borrowing and lending
rates, a high share of non-performing loans, under-provisioning and a large number of
directed credit programmers characterize the operations of the state-owned
commercial banks”. As proportions of risk-weighted assets the capital base of the
Bank 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.6.3
million and was, therefore, found to be unable to meet the minimum capital adequacy
ratio of 8% prescribed by the Central Bank. The two banks are thus claimed to be
grossly under-capitalized.

With the deregulation of markets and globalization, the turf on which the state-owned
banks operate is becoming complex and they are forced to compete with not only their
counterparts but also with other non-commercial banks in the system. In the context
of increasing competition in the financial system, restructuring of the state banks has
become inevitable.

The Government has already started a program of restructuring them by introducing
professional management and setting-up independent boards, resolving the problem
of non-performing assets, increasing compliance with prudential regulations and
encouraging management to enhance operational efficiency. Capital adequacy
standards consistent with international norms of 8% as proposed under the Basle
Accords have been imposed on commercial banks. In addition, regulations on loan

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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.

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Not surprisingly, therefore, trade unions in Sri Lanka are up in arms accusing the
Government “…..of using subtle strategies for undermining the strength of these banks
in preparation for their privatization” (Regaining Sri Lanka: A Trade Union and
Workers Response, 2002, mimeo). The government, on the other hand, seems to be
feeling that by privatizing these banks it will lose control over resources of these banks
that could be used effectively used in dispensing and providing soft loans for the rural
folk. As privatization would halt the flow of credit to the needy and small borrowers in
the rural segment of the population the government has shown reluctance to privatize
them. 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 as
others interested in the subject (of restructuring the state-owned banks in Sri Lanka) to
evaluate the degree to which these banks have been successful in achieving their
objectives, ascertain the soundness or otherwise of their operation, examine the validity
and acceptability of the arguments advanced for privatizing them, study the likely
consequences of their privatization on production, employment, consumption and
welfare of workers and others and also think of possible alternative policy options to
privatization.

Before doing so, however, it is felt that it would be useful and enlightening to get a
clear understanding of the theoretical underpinnings and the empirical foundations for
state intervention in financial markets and the rationale advanced for liberalizing the
financial sector including privatizing state-owned banks that has become a major
feature in several countries since early 70s and more recently in China and the
transition economies of Europe.

Background to Financial Liberalization
Rationale for State Intervention in Financial Markets

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State intervention in financial markets has been a key feature in developing countries
until the process of liberalizing them started in the mid-70s as part of the overall policy
of economic liberalization introduced in many of these countries. State intervention in
financial markets was advocated by academicians and policy-makers alike in the 50s
and 60s at the time when developing countries in their early stages of development were
attempting to accelerate their growth rates. The financial systems of these countries hat
were expected to meet the needs of private enterprises - by locating, securing and
channeling funds to them - were found to be under-developed for carrying out this task
effectively and efficiently. Consequently, their capacity for financial intermediation,
that is, the process of collecting the savings of the scattered economic units and making
them available to other investing units in the economy was found to be weak. While the
saving capacity of these countries itself was low, the financial systems because of their
underdeveloped nature failed to fully mobilize even these limited savings. The natural
outcome of this was low domestic capital accumulation, a shortage of investible capital
and 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 the
growth rate of a country. According to them, growth rate would be equal to savings
ratio divided by the ICOR (g=s/k) where s is the proportion of GDP that is saved and k
is ICOR that stands for the amount of additional capital required to increase total output
by one more unit and Since the ICOR in developing countries tends to be low and
cannot be increased in the short run (in Sri Lanka, for instance, it is around 4.5 meaning
that 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 the
amount of resources that can be mobilized as savings and the actual investment that
takes place. With low savings ratio (and assuming that there is limited or no inflow of
foreign capital) and a static ICOR, shortage of capital acts as a serious constraint to
their economic growth. It was in this context that state intervention in financial markets

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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),

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lowering of compulsory reserve requirements, introduction of competition through
widening the franchise for new domestic and foreign banks, introduction of indirect
monetary policy measures and the scaling back of interference in the allocation of
credit.

It was argued that financial liberalization by increasing competition in the field of
financial intermediation would improve operational efficiency of banking and lower
costs of financial intermediation, on the one hand, and raise savings ratio, increase
availability of credit and investment ratio, on the other. These in turn, are expected to
help 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 of
financial liberalization in the 70s and 80s. The general objectives of these reforms have
been to mobilize domestic savings and promote real capital formation by increasing
domestic investment or attracting foreign capital and improving efficiency in the use of
financial resources (Konrad Adenuer Stiftung, 1994).

As against this positive view about financial liberalization, some argue that financial
liberalization has increased financial fragility as evidenced by the marked increase in
financial crises in industrial as well as developing countries. The Brazilian Crisis of
1991, 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 was
deregulated. According to Khathkhate the experience of countries which introduced
financial liberalization and sustained them were not only varied but also often quite
different from what the theory suggests. After a careful analysis of the experience of
various countries he came to the conclusion that the success of policy reforms depends
on a number of factors, of which he considers the following to be important
(Khathkhate, ibid):

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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

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liberalization was that it would enable developing countries to stimulate domestic
savings and thus reduce excessive dependence on foreign capital inflow.

FINANCIAL LIBERALIZATION AND ECONOMIC
GROWTH

HIGHER INVESTMENT RATIO

IMPROVED AVAILABILITY OF CREDIT

Lower required
reserve ratio

HIGHER SAVING RATIO

Higher and positive real Higher rates of
interest on deposits interest on
loans

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FINANCIAL IMPROVED HIGHER

LIBERALIZATION ALLOCATION INVESTMENT
Ratio
OF CREDIT
EFFICIENCY

Increased
Competition
IMPROVED OPERATIONAL
EFFICIENCY OF BANKING

LOWER COSTS OF FINANCIAL
INTERMEDIATION

v)

To understand the contribution of state sector banks in Sri Lanka, in the growth
and prosperity of the rural sector and the economy in general, it is necessary to
look at the banking scenario

prior to the commencement of state banking. At the time of independence, the Sri
Lankan banking system was dominated by 9 foreign banks (holding over 60 % of
banking sector assets) and just 2 local banks. These banks almost exclusively
catered to the domestic requirements of the plantation industry, import/export

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trade and related activities. Out of the 45 bank branches operating at the time in
the country, a considerable number were either located in Colombo or in other
principal cities. The semi-urban and rural population - comprising peasants,
farmers, craftsmen, petty traders and workers – was almost totally left-out of
banking services or inadequately served by the system. The banking density was
low with a branch for approximately 274,000 people (CB, 1998). The activities of
the existing banks were practically confined to the major cities. It was the
informal financial sector consisting of money lenders, traders, landlords, pawn-
brokers etc. that served the financial needs of the rural sector. The major
economic activity of the majority of people in this country namely, paddy
cultivation was mainly financed by the informal financial sector at exorbitant
interest rates making paddy cultivation a costly affair. Market penetration by the
formal financial sector institutions was extremely limited.

With the establishment of the Central Bank in 1950, the financial sector began to
expand rapidly in terms of institutions, instruments, variety of services offered and
geographical coverage. Several steps were taken in the early 60s to make banking
services available to hitherto neglected sectors. The Bank of Ceylon established in
1939 was expected to assist the indigenous entrepreneurs and business community
who had been marginalized by the foreign banks and had had been forced to
depend on foreign money-lenders – Nattukkottai Chettiars and Afghans - for
credit. But contrary to these expectations, the bank had been following a pattern of
lending policies which was not very different from that of the foreign banks in the
country. In an attempt to make banking services available to the large majority of
the people in the country and to meet the credit needs of the hitherto neglected
rural sector the government in 1961 nationalized the Bank of Ceylon, the
country’s largest commercial bank and the only indigenous bank. The Peoples
Bank was established in the same year. The mandate of the Bank was to “develop
the cooperative movement of Ceylon, rural banking and agricultural credit by
furnishing financial and other assistance to cooperative societies, approved

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societies, cultivation committees and other persons” which was a long-felt need
in the country (Karunatillake1968). Its objectives were to cup-lift the rural poor by
providing banking facilities for the agricultural and cooperative sectors and small
and medium industry and the majority of Sri Lankans who hitherto had neither
access to the foreign banks nor any knowledge of banking.

The two state banks were expected to provide development finance to the small
and medium enterprise sector within which the agricultural sector dominates. In a
bid to further develop the financial system, the government introduced several
new regulations pertaining to financial sector activities under the Finance Act of
1961. The entry of new foreign Banks was stopped and a ban was imposed on the
opening of new accounts by Sri Lankans in the existing ones, the objective being
to localize and expand the banking system with state support and direct
participation (the above restrictions were lifted in 1978 and 1968 respectively).
These timely measures of the government helped to boost the domestic banking

True to the expectations of the government, the two state banks brought in a
fundamental change in commercial banking in Sri Lanka and also marked the
beginning of the dominance of state banks in the banking sector. The two banks
by establishing a network of branches throughout the Island, took banking
services even to remote rural areas. The Bank of Ceylon helped to build-up the Sri
Lankan Business community by providing it with bank credit to engage in
business activity in various fields such as trade, agriculture, industry, transport etc.
The government used these two banks to direct investment to all parts of the
economy. They, in fact, functioned as social banks while carrying on commercial
banking activities. Besides serving as the tools for directing resources to the
desired sectors and at the desired cost they also served as important means of
mobilizing rural savings as well as monetizing the rural economy. When the
Government increased its direct involvement and investment in the economy in
the 70s, the two state-owned

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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 Tamil
offered 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 serves
the needs of the “small man”. Pawning that was started in 1963 became a popular
mode of credit as it provided the fastest means to obtain loans. Many farmers during
cultivation seasons made use of this facility to obtain credit and they redeemed the
jewelry after harvest. This proved to be an easy method of obtaining short term
credit for low income groups as it did not require much paper work for the grant of a
loan. The increase of pawning advances of the Bank from Rs.3.4 million to Rs.12.5
billion at the end of December 2001 proves that this was a popular mode of
borrowing among people. It also has become one of the main growth and profit
sectors of the bank. The bank also helped to monetize the rural sector and to
mobilize rural savings. The savings deposits mobilized from the rural sector
amounting to Rs.127 billion is claimed to have far exceeded the lending in these

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areas and the surplus is transferred to the International Divisions of the Banks which
are 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 went
developmental and substantial loans came to be pumped into the weaker sections of
the economy and society. The Bank of Ceylon had 14 subsidized credit lines and the
Peoples 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

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available today to the needy from these banks. Rural agriculture too got an
encouraging boost through their operation in the rural areas. The establishment of
state banks was a significant step in the process of public control over the
principal institutions that mobilize people’s savings and channel them towards
productive purposes. They have become the instruments of social banking in the
country.

Criticisms against the banks
1) As the two banks are structured on British banking model, it is said that they
have 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, Sunday
Times August 30, 2003). Under the Grameen Bank Scheme lending was done on a
peer-group basis to poor people who were precluded from the normal banking
channels due to the fact that they had no collateral security and were generally
classified as high risk borrowers. Credit facilities under the Grameen Bank
Scheme were extended to the unemployed and under-employed men and women
for creating self-employment opportunities. It may be said that in the absence of
such a scheme in Sri Lanka, the formal sector has not been able to adequately
penetrate the financial market resulting in the informal financial sector dominating
the economy as revealed by the Consumer Finance and Socio-Economic Survey of
1996/97. According to this survey 56.9% of the population is being served by the
non-institutional sector while it was 60.2% in 1986/87. This reveals that the
percentage of people who enjoy bank credit is still low.

2) Despite the many contributions of the state banks to the social and economic
development of the rural population, as described above, the Central Bank made
the following criticisms against them (CB, 1998):

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(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 s
tate 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

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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

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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 the
dictates of government policy on economic and social development, on the one
hand, and the necessity on the other, to act on commercial principles. This duality
in their role is one of the major factors that affect their performance. They are
used by the state as tools for implementing government policy on agriculture and
poverty alleviation with subsidized loans, refinancing and periodic debt
forgiveness. The Peoples Bank, for instance, played a key role in the Janasaviya
poverty alleviation program by providing small loans for both agricultural and
industrial activities and today it continues to play a similar role in the Samurdhi
program. The state-owned banks have also been used by the government to
provide concessional or priority loans to the tourist industry, tea exporters, tea
factory owners and garments manufacturers. While providing these loans they are
also expected to make profits. Thus, they are faced with a major contradiction in
their 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 to
government and government-related institutions amount to Rs.57.9 billion while
the government itself has directly taken Rs.17.9 billion. The two biggest
borrowers in the state corporation sector were the Ceylon Petroleum Corporation
which had outstanding loans amounting to Rs.8.7 billion and the Ceylon
Electricity Board Rs.9.0 billion. Around 25 mega borrowers owe the Peoples
Bank over Rs.12 billion. The volume of bad debts also includes money lent to
small-time agriculturists and loans granted on government directives including
money advanced for privatization of certain state corporations. Some claim that
politicians are mainly responsible for bulk of the bad debts. In their opinion, if the
state banks have suffered a set back the government and politicians too are

20

responsible for it. Besides, as NPAs are caused by bad management of business
enterprises by their owners who borrow money from state banks, the
presence of bad debts is not a sign of failure of banks but are, in fact, failure
of industrial and macro economic policies of the government. Therefore,
privatization may not be the best way to tackle the NPAs. They must be tackled
separately.

At the end of 2000, the Bank of Ceylon made provision for bad and doubtful debts
of Rs.21.3 million while the Peoples Bank’s provision was Rs.13.88 million. The
latter was further raised to Rs.14.66 million in 2001. Thus, if the amounts locked
up in NPAs are recovered, state sector banks will not suffer from any shortage of
capital 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? NPAs
are 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 Capital
Adequacy Ratio as noted before. Carrying NPAs on the bank portfolio requires
incurrence 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 of
Rs.36.0 million worth of NPAs in their portfolio. Since no interest is charged on
those advances, the banks lose interest incomes on them. At a rate of interest of
10% they lose an annual interest income of Rs.3.6 million. In addition, since the
NPAs form part of the gross profits, huge amounts are set apart for making
provisions for them every year thus reducing the actual profits of these banks.

Non-performing loans, however, are not unique to the state banks only. Private
sector banks too have substantial amounts of such loans and they too make
provisions 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

world and more particularly among the Asian countries, particularly after the
recent 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 saddled
with 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 60s
and 70s began to feel the heat of competition in the 80s and 90s when the
financial sector was liberalized and thrown open to the establishment of foreign
and private domestic banks. Financial liberalization in general is said to affect the
entire banking system. It increases competition among banks and non-banks and
also adds new instruments which could pose threats to traditional banking activity.
Consequently, banks that do not have proper control systems begin to face risks of
even becoming insolvent, a situation where capital is eroded. In the face of
competition from foreign and domestic private banks, the two state banks found
the systems and procedures designed for them some decades ago to fulfill the
needs of the time inadequate to meet the demands of the new situation created by
the process of financial liberalization. In response to this, they made heavy
investments in computerization but this did not help them to overcome the
bottlenecks to their efficient performance. Profits began to decline, bad loans

22

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

These should be taken into consideration when sensitive decisions like the
privatization of state-owned banks are taken. Furthermore, it should be
remembered that although globalization has become a universal phenomenon due
regard needs to be given to the local conditions and the distinct characteristics of a
traditional society like ours.

The potential benefits of privatization of state banks should be judged on the basis
of the positive benefits it can bring to the poor of the country and not just the
overall profit. State sector banking, as explained here, has been a tool for fighting
rural poverty but privatization would probably further escalate the problems of the
poor and have an adverse impact on the poor as the elite banks will never come to
the 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 of
private commercial banking in their lending activities, they could not have played
the role they did in contributing to the social and economic development of the
rural masses. Furthermore, the need for such institutions in a country like Sri
Lanka, where nearly 40% of the people are still living below the official poverty
line, cannot be exaggerated. Approximately, 2.2 million people are known to be
members in the Samurdhi program. This means that poverty is still a widespread
phenomenon in the country. In view of this, state-owned banks still have a role to
play in alleviating poverty and channeling financial resources to the rural sector.
In this context, China’s experience with financial sector liberalization is worth
noting. While it contributed to the country’s high savings ratio and its rapid
monetization, it fell short as a mechanism for channeling resources to the most
productive sectors of the economy. The state banks in Sri Lanka have been
performing exactly this task of channeling funds to the sectors and economic
activities where it was most needed. Even in the East Asian economies such as
South Korea, Taiwan, Thailand, Indonesia, etc. the state-owned banks have played
the leading role in their growth efforts. The privatization of state-owned banks

24

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 is
not the only way to deal with the problems of the state-owned banks. As with
other options, there can be costs and benefits in privatization which have to be
necessarily taken into consideration in deciding on restructuring of state-owned
banks.

The high administration costs of these banks referred to earlier were perhaps
unavoidable in the context of spreading banking activities country-wide and
performing numerous functions on behalf of the government. In the seventies, for
instance, the government asked the Bank of Ceylon to open a branch in every
Agrarian Service Centre, a sub-office to provide credit to agriculture. There were
390 such sub-offices. They had necessary manpower even though most of them
were uneconomic with total loans exceeding total deposits. Although the number
was gradually reduced to 22 by 1995, the additional staff recruited to them had to
be retained and redeployed in other work (The Island, May 18, 1997). The
administrative costs of the banks are likely to come down with consolidation of
banking and with better internal security. Similarly, high intermediation costs are
the result of high inflation, heavy government borrowing to finance budget
deficits 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 policy
of 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

1997 2059 690
1998 118 312
1999 2055 -8538
2000 701 -1840
2001 893 308

According to statistics shown in Table 1 above, the Peoples Bank suffered their
biggest loss in the year 1999. But this was partly because of Rs.24.0 million worth
of loans being identified as non-performing loans in that year. Half of these loans
were supposed to have been given to just four Sri Lankan citizens. Despite this in
2001, both state banks were able to earn small profits.

It is said that in recent times even the World Bank’s evangelical faith in
privatization is waning. There has been talk of a change taking place within the
Bank itself with the emergence of Post-Washington Consensus (PWC). The PWC is
shifting to a more realistic policy framework in which aspects of real world (for
example, 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 at
least regulation to accompany privatization. In the case of Sri Lanka, however,
competition is already assured by the presence of a large number of foreign and
domestic private commercial banks and other non-commercial banking institutions
which compete with state banks for market share and what is required here is proper
regulation of the lending activities of state-owned banks rather than their outright
privatization.

The problems currently faced by the state banks, therefore, by no means are
insurmountable. While it is true that there is inefficiency and corruption in the
management of the state banks but it certainly is not due to state ownership but
mismanagement through politicization of the administration of these banks.
This managerial problem can only be rectified by the state itself by making the two
banks fully autonomous and the corporate management made accountable to the

26

state (Fernando,R, Sunday Times, August 20,2000). With more efficient
management the problems of these banks can be overcome and what is necessary is
to create the right environment for autonomy in their operations and the strict
requirement of accountability. It should be remembered that privatization in itself
may not lead to sound financial management and operational efficiency as revealed
by the failure of some leading Finance Companies and the Pramuka Bank in Sri
Lanka. 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 of
operation. Furthermore, the market mechanism is not necessarily less corrupt or
more efficient than the state is as corruption is just as visible in contracting and
service provision in the private sector as well.

It is understood that according to an agreement between the government and the
Board of Directors of the Bank, the Bank has been allowed to engage in normal
banking operations aimed at improving the underlying capital deficiency in the
longer term despite its current financial deficiencies. The Board of Directors is
currently involved in implementing a Strategic Plan and monitoring progress to
achieve the profit targets under the Plan. It is known that this restructuring process
is 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 state
banks. Such a decision should wait until the results of the current efforts to revive
these 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

(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

(17) Central Bank of Sri Lanka., 1998. Economic Progress of Independent Sri
Lanka, Colombo. SriLanka.

(18) ------------------------. Annual Report 1966

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