Eight years into a liquidity crisis, listed sub-prime lender The Finance’s strategy of funding more lending from asset sales and lower-cost deposits bore results in June 2016, when its loan interest income exceeded deposit costs; for the first time in 23 quarters, it managed to report a net interest income, published accounts showed.
Since 2009, The Finance Company (TFC) was not making enough interest income from lending to pay its deposit costs. In other words, it reported negative net interest income, or gross losses. Lending firms charge operating costs, provisions for future loan losses and other overheads to net interest income.
In The Finance’s case, the negative net interest income was equivalent to the company reporting a gross loss, driven further into the red by its other costs and overheads. Negative interest margins are an extraordinary occurrence for lending firms. In the June 2016 quarter, The Finance turned a corner, making a minutely positive net interest margin of 0.06% or Rs11.2 million.
Despite margins turning a corner in the June 2016 quarter, The Finance still reported a net bottomline loss. Cautious provisioning and investments resulted in a Rs334 million loss in the June quarter, up 11% from a year earlier. Loan provisioning grew 28% to Rs130 million, and overheads and administrative costs grew 3% to Rs294 million. The Finance’s net book value, the company’s worth, eroded further to a negative Rs13 billion from negative Rs10.7 billion the previous year (the company was worth Rs4 billion in 2008, the last time it had a positive value).
Former Chief Executive Aruna Lekamge, who resigned in November 2015, did not expect margins to turn positive so soon. Last year (2015), he told Echelon that it could take 18 months or so for the company to report net interest income, or a gross profit, and another five to six years to clean up the balance sheet and return The Finance to bottomline net profits.
The Finance sustained negative interest margins for 23 consecutive quarters since the Ceylinco Group (which it was associated with) disintegrated following the collapse of Golden Key, a credit company, in 2008. The company reported negative net interest income because its loan book, its primary source of income, crumbled.
“The Finance’s problem was not run-on deposits, but its income generating loans falling overdue rapidly,” Tissa Ekanayaka, a former director of the company, says. In 2010, the Central Bank intervening to prevent run-on deposits converted 10% of The Finance’s deposits worth Rs2 billion into non-voting shares and raised another Rs1.6 billion via a public offer.
The private sector provident fund, EPF managed by the Central Bank was forced to invest in 5.1 million shares, which have lost 75% in value since to Rs41 million at end-March 2016. The Finance shares trading on the stock exchange fell to Rs8 during this period from Rs37 at end-March 2011.
Deposits help banks and finance companies generate loans. Profits are earned from interest charged from borrowers higher than what they owe depositors. Fee incomes are another source of income, but not a primary source. Not only did The Finance’s loan book disintegrate since the crisis broke, it also aggressively mobilised deposits, driving interest margins deeper into negative territory.
The company’s Rs19 billion pre-crisis loan book deteriorated rapidly to Rs7 billion in the three years to 2012. Its deposit base fell by a quarter to Rs21 billion. The Finance reported a 9% negative interest margin that year. In the two years to 2014, the loan book grew 14% to Rs8 billion, but deposits rose to Rs24 billion. Its annual report that year hailed high growth in deposits as a sign of growing public confidence, but this only pushed negative interest margins further into the red at 14%.
There were three reasons for the dramatic decline in The Finance’s net interest expense: first, interest income was spiked by the return on government securities the company had invested the Rs6 billion Central Bank loan on. Second, low-cost savings grew 12% that year, twice as fast as fixed deposit growth at 6%. Third, loans grew three times faster than the deposit base during the year
To help reduce negative interest expenses, in December 2014, the Central Bank granted a Rs6 billion low-cost loan to The Finance, mostly invested in government securities. That year, The Finance’s board finalised a five-year business plan (2014/15 to 2019/20) approved by the Central Bank detailing a strategy to revive the company with low-cost deposit mobilisation, converting non-yielding real estate into yielding assets or selling them to finance long -term business loans, and improving the collection of Rs3.8 billion worth of Ceylinco Group loans.
The business plan did not expect net interest income for at least two years and was uncertain when The Finance will return to profits. “(It) will require time, vigilance and dedication to solve,” S.H.A.M. Abeyratne, a former chairman of The Finance, said in the 2014/15 annual report.
The strategy bore results the following year. The net interest expense or gross loss fell 90% to Rs85 million from a year ago. Double-digit negative interest margins shrank to a negative 0.48%, still dismal compared to the non-bank finance company industry’s positive NIM of 12% and the banking sector’s 3.5%, but it was an encouraging trend for The Finance.
There were three reasons for the dramatic decline in The Finance’s net interest expense: First, interest income was spiked by the return on government securities the company had invested the Rs6 billion Central Bank loan on. Second, low-cost savings grew 12% that year, twice as fast as fixed deposit growth at 6%. Third, loans grew three times faster than the deposit base during the year.
But the positive decline in interest losses did not translate into declining bottomline losses for 2015/16. Instead, losses increased 27% from the previous year to Rs2.3 billion.
Provisioning for its pension fund’s Rs265 million investment in government debt though Entrust Securities (ESP), a primary dealer that has now failed, and a Rs500 million real estate parcel where a subsidiary’s ownership is unclear led to the loss. However, both provisions are likely to be reversed in the future, according to the company’s annual report. The Rs500 million provision concerns a parcel of land owned by TFC Homes, a subsidiary of The Finance.
According to the company’s auditors, legal ownership of this property and several others is fuzzy. The Finance’s board intends to sell the property, which will allow it to reverse the provision in the future.
The Finance holds stakes ranging from 20% or more in 26 companies of the former Ceylinco Group. According to auditors SJMS Associates, the financial statements of these companies are not available. Making sense of assets is difficult. Prudently, many of these assets have been left out of the books, along with loans written off or provided for.
The company has a large real estate base. Former Chairman Abeyratne boasts, “In addition to its normal business lending, in the areas of property development, housing construction, leasing of buildings and industrial properties, we have the largest number of land blocks owned by a single company”. The firm had land and real estate assets worth Rs2.9 billion at end-June 2016 in its books, down 55% from Rs6.5 billion in 2011 after provisioning for losses. The company has been able to sell down a third of this over the last two years alone. Dealing with property holdings has its peculiar challenges.
When to sell, however, is always a difficult question. The Finance facing a liquidity crisis has lost its bargaining powers, and some board members are worried that property sales will not fetch fair prices. Appreciating land prices results in gains to both the profit and loss statement and balance sheet, but for a company badly in need of cash, these assets are idle and useless, and The Finance has a lot of it – a little over 380,000sq.ft. of real estate.
The company has now decided to shift its 20,300sq.ft. headquarters from Duplication Road to Ceylinco House in Fort to free up the property to convert into a high-yielding asset, according to the 2015/16 annual report. It’s not clear exactly what the conversion entails, but it’s one of two things – an outright sale or leasing out to a developer.
For The Finance to take a Rs265 million hit just when it was engineering a turnaround because of alleged fraud committed by, ironically, a former Ceylinco Group company Entrust Securities is tough luck.
The Central Bank, having suspended Entrust Securities over alleged misappropriation in January 2016, appointed state-controlled National Savings Bank to restructure the company. The bank continues to manage investments. In the June 2016 quarter, Entrust assets amounted to Rs16.4 billion, making Rs96 million for the period.
“NSB-managed Entrust sends regular acknowledgments of rolling over funds with accrued interest. However, the acknowledged dues were not received when TFC sent letters of demand to NSB in April 2016. Accordingly, TFC is unable to ascertain when the amounts due from ESP would be received in cash. Hence, an impairment of 100%,” The Finance explained in a note to the 2015/16 financial statements.
The primary dealer is accused of selling government bonds twice and pulling out funds worth several billions, according to EconomyNext.com: Provident funds of the Central Bank, its regulator, have Rs400 million and electricity utility CEB Rs3 billion tied up with Entrust.
In September 2016, five directors of the company, Dharmapriya Bandara Dassanayake (chairman), Chanuka Ratwatte (managing director), Romesha Dushanthi Senarath (executive director), daughter of former President Mahinda Rajapaksa’s chief-of-staff Gamini Senerath, Sanjeewa Dayaratne and Niloshan Romelo Mendis (director), were arrested.
Entrust Securities came into being in 2009, after a Ceylinco Group company called Ceylinco Shriram changed its name. Entrust listed on the Colombo Stock Exchange in 2011, raising Rs300 million in a debenture issue the following year. Entrust Securities is part of a group of companies under Entrust Holdings, which also controls Multi Finance, a listed finance company. In 2013, Entrust was warned by the Central Bank for irregularities in its operations. The Sunday Times, a weekly newspaper, believes Entrust is controlled by the Ratwatte family. Chanuka Ratwatte’s brother Lohan is a Member of Parliament. The crime investigations unit of the Sri Lanka Police is investigating the alleged fraud.
The Finance is a complex problem to fix. With the Central Bank infusing Rs6 billion from public funds to bolster its assets, the company got too big to fail. The firm cannot afford to cut overheads and staff costs. According to Former The Finance Chairman S.H.A.M. Abeyratne, the company will continue to invest in human resource development, technology and improving processes to stay relevant in a “highly complex and competitive financing business environment in the country”.
The company employs 800 people in 60 branches. Two years ago, only 19 of these branches made profits. Last year, 48 of them had become profit centres. The new board appointed in November 2015 says it’s continuing to rationalise systems and procedures to develop skills and competencies by introducing a performance-based culture that recognises and rewards top performers.
In the latest annual report, The Finance’s new Managing Director Suranjith Gunawardena says the focus remains on bringing down the firm’s high cost of funds and improving margins. The Finance seems to have managed this in the first quarter of 2016/17. But Gunawardena harbors some concerns with optimism.
First, the market is experiencing a rise in interest rates, which could pressure margins as people opt for fixed deposits over savings on top of high borrowing rates pressurising the quality of loans. “There is a temporary downturn in the market, which may stabilise in the next couple of months,” he says.
The Finance was incorporated in 1940 and later became part of Ceylinco Group, controlled by Senator Justin Kotelawala, which included around 300 companies by 2008. Ceylinco Group was founded in the late 1930s by Hugh Weerasekere and Cyril E. S. Perera, who relinquished control over to Kotelawala in the 60s.
The Ceylinco crisis began under Kotelawala’s son Lalith, when the Golden Key Credit Card Company, an unregulated specialist credit card issuer, collapsed, unable to settle Rs26 billion in authorised customer deposits and later going into court-administered insolvency in order to implement an investor repayment schedule.
The adverse publicity on the group saw depositors rushing to withdraw their monies in several group financial institutions – listed Seylan Bank, Ceylinco Savings Bank, Ceylinco Finance and F&G Property Developers, to name a few. In many of these, the Central Bank stepped in, appointing management agents and directly appointing director boards to restructure the companies. Seylan Bank was turned around quickly and Ceylinco Insurance was insulated to a great extent because of stringent regulations. Both companies are doing well today. Some of the other financial institutions were liquidated or acquired by other companies who changed their names.
The Finance, considered the market leader in sub-prime lending at the time, was too big to fail, so the Central Bank took control of the board through various management agents. But fixing The Finance proved to be difficult. For one, the company had invested heavily in property, which couldn’t be liquidated fast enough. Second, companies in the Ceylinco Group stopped servicing their loans, and overnight The Finance was left with an Rs9 billion hole in the balance sheet with no money to pay depositors.
In March 2009, the Central Bank appointed state development bank Lankaputhra to restructure The Finance, only to be replaced two months later by another state entity, Merchant Bank of Sri Lanka (MBSL). Directors were replaced with Central Bank sanctions and powers of key management taken away. Both Lankaputhra and MBSL proved inept at the job, mostly because they were struggling with governance problems of their own: Lankaputhra was running up its non-performing loans with imprudent lending and MBSL’s then chairman Janaka Rathnayake was in a futile attempt to build his own business empire with the pieces of several Ceylinco finance companies that he was entrusted to restructure.
In 2011, the Central Bank replaced MBSL with an independent board headed by industrialist Preethi Jayawardena. That year, the company issued new shares, raising Rs1.6 billion and capitalised deposits worth Rs2 billion.
The board was changed again in 2014, headed by S.H.A.M. Abeyratne, which made the five-year business plan and secured the Rs6 billion lifeline from the Central Bank. In November 2015, the Central Bank overhauled the board once more, this time headed by P.J. Jayasinghe, a former deputy general manager of the largest bank in Sri Lanka, Bank of Ceylon.
None of the boards to date have been able to reverse The Finance’s deepening negative net book value. The Central Bank’s irresoluteness with the boards is not clear, but the financial systems regulator in a September 2016 statement committed to reviving The Finance and others like it who mainly struggle to recover bad loans due to legal complexities and non-cooperation of borrowers.
The Central Bank and Finance House Association, which represents the nonbank finance company industry and the government, plan to set up an independent entity, Financial Asset Management Company, which will take on the responsibility of managing and recovering bad loans.
Some East Asian countries have already had success with similar ventures. Indonesia, Malaysia, Korea and Thailand introduced asset management companies or AMCs, which look over bad debt amounting to 20%, 17%, 10% and 17.5%, respectively, of each country’s GDP in 1999 after the East Asian Economic crisis. By 2002, these AMCs had recovered between 34% (Indonesia) and 57% (Malaysia) of these debts.
