Problems in the sector began at the periphery, with distressed non-banks. The Central Bank admitted in its Master Consolidation Plan that a number of non-banks had faced liquidity problems due to ‘certain directors siphoning out funds’ — a fraudulent act punishable under the law.

The Central Bank has justified the move toward consolidation on several counts. First, the country is on a growth path that may see GDP hit US$100 billion soon, and banks should be strong enough to fund a large economy, mobilising funds both locally and globally. Second, many banks are still small and incapable of participating in global markets. Of the domestic banks, only five had assets over Rs 500 billion (US$4 billion). Of the non-banks, only ten had assets over Rs 20 billion (US$150 million).

‘Pre-emptive strategies’ were therefore thought to be needed to make the financial sector ‘strong and dynamic’. These strategies will increase bank capital requirements and consolidate non-banks through mergers and absorptions. Thus, the final outcome of the consolidation will be to make both banks and non-banks bigger in the belief that a few big but stable banks are better than a large number of unstable small banks. In this ‘big is better’ strategy, the Central Bank envisages to have at least five commercial banks with assets over Rs 1 trillion (US$8 billion), a few large non-banks, a large development bank and a strong regional presence by some local banks.

The Master Plan is mainly directed toward non-banks because of the apparent risk of contagion they would bring to the whole financial system. The rapid growth in this sector after the war has prompted these institutions to take high risks in lending to newly opened sectors in the economy. The total assets of both finance companies and leasing establishments stood at Rs 238 billion (US$2 billion) in 2007, and increased to Rs 718 billion (US$6 billion) by 2013.

Along with this, the gross non-performing asset (NPA) ratio, which improved from 9 per cent in 2009 to 5 per cent in 2011, started to reverse since then. At the end of 2013, it stood close to 7 per cent and was rising. But the provision coverage remained at about 55 per cent of NPA during this period. Thus, the Central Bank’s free licensing policy has now threatened to destabilise the entire financial system, prompting it to adopt these pre-emptive strategies.

The Central Bank’s consolidation plan has come under criticism on several counts.

The short timeframe of the mandatory implementation has been criticised as inadequate. The plan was announced on 14 January 2014 and non-bank finance companies were required to submit plans of merger or absorption before 31 March 2014. The Central Bank claims that all the non-bank finance companies have complied with this timeframe, but market sources indicate that the plans submitted were completed in haste. The processing of the plans submitted is to be completed by 30 June 2014 and actual merger or absorption to be carried out, in a majority of cases, by the end of 2014. The market still feels that this timeframe is too ambitious.

In addition, mandatory consolidation has inflicted stress on the affected non-banks as well as formal banks. Mergers and absorptions are not uncommon in the financial sector but they have to be done voluntarily under the watchful supervision of the regulator. Mandatory consolidation within a short period of time does not permit affected institutions to obtain the best price. For this reason, absorption is unlikely to resolve all of the internal problems of the non-banks.

It is also expected that underperforming non-banks will be absorbed by better commercial banks or viable non-banks. Given the weaknesses in these two sectors meant to absorb the laggards, the market has fears that the consolidation will simply destabilise the ‘good’ banks.

And the Central Bank’s strategic assumption that ‘big is better’ has come under criticism. Though it is easy to supervise big banks, it does not necessarily follow that bigness reduces risk. This is because big banks will be more likely to take unnecessary risks in the belief that they are ‘too big to fail’. If a big bank fails, the systemic cost is much more than the failure of a small bank or even a group of small banks, as big private losses are socialised as public debt.

The consequences of consolidation of the sector could be risky and, if not managed properly, could turn out to be worse than the problem it is trying to fix.

W.A. Wijewardena is a former Deputy Governor of the Central Bank of Sri Lanka.