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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 costefficient banking system and better oversight by the Central Bank would be a big plus for the
banking sector.

ECONOMIC LANDSCAPE OF SRI LANKA


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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 Lankas economic growth has been one of the fastest among Asias 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 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
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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 tourismwhich more than doubled in dollar terms between 2011 and 2013in
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 lowercost 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.
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
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exports which added c.25% to export earnings reported an increase of 15.6% YoY in JanuaryAugust 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
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 CBSLs
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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. Mediumterm sustainability will depend on maintaining an outward orientation, diversification of the
export structure, and a judicious use of foreign borrowingparticularly 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)
highlights the sensitivity of Sri Lankas 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
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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 Peoples 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
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
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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 worldclass 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.
The World Bank has been supporting Sri Lankas 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 FY1316, 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)
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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:
ADBs 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 201216. 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).

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 Lankas banking sector is dominated by the two state banks, namely Bank of Ceylon and
Peoples 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
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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.
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.
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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).
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
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(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 banks have considerably reduce the loan to value ratio
to 60-65% enabling a higher cushion against future gold price reductions (refer appendix V).
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

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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%).

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).

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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
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 worlds 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
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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)
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.

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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.
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.

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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
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.

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Nobody needs to force us into this. I think the comment is coming from an outsiders point of
view and we from inside the Banks can assure that if this happens it wouldnt 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 Banks
impending merger with NDB has been passed by the Cabinet, industry sources said. The reason
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 (DFIs), 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 Banks 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

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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
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

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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 DFCCs 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 DFIs, 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
the banks were free to make business decisions in most instances. Consequently both DFIs, 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 90s. 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 onlends 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

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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.
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

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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. NDBs 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),
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 Banks 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

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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.

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
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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.

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
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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

APPENDICES
Appendix I Banking market share

Appendix II Net interest margin of banks

Appendix III Bank loan growth

Appendix IV NPL ratio of banks

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Appendix V Gold exposure of banks

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Appendix VI Deposit growth of banks

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

Appendix XIII GDP growth rate

Appendix XIV Per capita GDP

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Appendix XV Trade deficit

Appendix XVI FDI flows

Appendix XVII Share price of NDB

Appendix XVIII Share price of DFCC

Appendix XIX NDB shareholders

Appendix XX DFCC shareholders

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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

Subsidiari
DFCC es

NDB

Name

Business

DFCC Vardhana Bank PLC


DFCC Consulting (Pvt) Limited
Lanka Industrial Estates Limited
Synapsys Limited

Commercial banking
Consultancy
Operating an industrial estate
Provide information
technology services and
IT enabled services
The principal activities of the
Company
are investment banking and
related
activities such as Corporate
Finance,
Debt Structuring and IPOs
Management of Unit Trust &
Private
Portfolio

Joint
Ventures

Acuity Partners (Pvt) Limited

Associates

National Asset Management


Limited

Subsidiaries NDB Capital Holdings PLC


Under NDB Capital Holdings
NDB Investment Bank Ltd
NDB Wealth Management Ltd
NDB Securities (Private) Ltd
NDB Capital Ltd
Development Holdings
(Private) Ltd

Associates

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Maldives Finance Leasing


Company (Private) Ltd
.

Share
Holding
99.17%
100%
51.15%
100%

50%

30%

Investment Banking

100%

Investment Banking
Wealth Management
Investment Advisory and
Securities Trading
Investment Banking

100%
0.996

Property Management
Leasing

0.996
78%
0.587

35%

Appendix XXIV Top Ten Sri Lankan Banks

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