Understanding role of banks in economy

WHAT SRI LANKA NEEDS IS FOUR STRONG BANKS WITH AN ASSET BASE EXCEEDING RS.2 TRILLION EACH BY 2025, TO GET US TO AN OVER US $ 100 BILLION GROSS DOMESTIC PRODUCT ECONOMY

By Dinesh Weerakkody 

Two leading ministers, Industries and Health Minister Dr. Ramesh Pathirana and Justice Minister Dr. Wijeyadasa Rajapakshe, on Sunday lambasted the banking sector for half-hearted support to the struggling micro, small and medium entrepreneurs (MSMEs), thereby endangering a quicker recovery in the economy following multiple crises.
Dr. Pathirana on Sunday urged enterprises to take a stand against unfair banking practices and to continue lobbying for their interests regardless of political affiliations.

Speaking at an awareness conference organised by the Ceylon Federation of MSMEs on ‘Business debt and finance management’, on the sidelines of Industry Expo 2024, Dr. Pathirana insisted the need for businesses to create conversations and pressure policymakers to address their concerns. 

Dr. Pathirana warned that the banks might channel most of the funds from international credit lines to their wealthy clients, calling for vigilance and protest against such practices. 

“We learn that the banks are trying to push most of the funding facilities to their already rich clients from the loans extended by the international agencies like the World Bank and Asian Development Bank,” Dr. Pathirana alleged. 
He also pointed out that promoting fair banking practices is essential to drive economic development in Sri Lanka. Separately at the same conference, in a scathing critique of the banking system, Dr. Rajapakshe criticised the policymakers for their failure to establish a credible economic policy to support enterprises and entrepreneurs. 
In practice, no bank can survive, if it alienates its customers. As with all businesses, it’s a balancing act. In general, the government policies have been designed to limit bank failures and the panic they can ignite. Therefore, the safety and soundness of banks are paramount, growing all banks to such levels of safety and soundness should be the deliverable, not just a handful of systemically important banks. The recent pronouncements on a development bank in Sri Lanka, limited to serving the needs of the MSMEs, should be pursued with vigour. 

True role of banks 

Banks play a pivotal role serving as the backbone that the entire financial system rests on. Their primary role is to safeguard depositors and to disburse loans. Banks however, as the primary supplier of credit, as the minister highlighted, have a crucial role in stabilising the economy and supporting their customers. Banks in general accept deposits and provide loans and derive a profit from the difference in the interest rates paid and charged to depositors and borrowers, respectively. This process performed by banks of taking in funds from a depositor and then lending them out to a borrower is known as financial intermediation. 

Through financial intermediation, certain assets are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money or surplus savings (savers) and then lend to those who do not have enough money to carry out a desired activity (borrowers). Banking thrives on the financial intermediation abilities of financial institutions that allow them to lend money and receive money on deposit. The bank is the most important financial intermediary in the economy, as it connects surplus and deficit economic agents.  

Way forward 

Banks are vital institutions in any society as they significantly contribute to the development of an economy through facilitation of business. Banks also create money and facilitate the growth of savings in the economy and are instruments of the government’s monetary strategy, among many others. The most important service provided by a bank is the provision of credit.  Credit fuels economic activity by allowing businesses to invest beyond their cash on hand, households to purchase homes without saving the entire investment in advance and enables governments to smooth out their spending by mitigating the cyclical pattern of tax revenues and to invest in huge public infrastructure projects. Therefore, the key role for a financial institution is to facilitate investment and employment to sustain the long-term economic growth of the country. 

What Sri Lanka needs is four strong banks with an asset base exceeding Rs.2 trillion each by 2025, to get us to an over US $ 100 billion gross domestic product economy. Therefore, the government should push for bank consolidation, keeping in view synergies and the benefits of mergers, with the government role purely as that of a facilitator.  However, in certain institutions, there is certainly a need to get rid of board toxicity and the management capacity deterioration and investigate the vested lending. Therefore, in the final analysis, the President, as the Minister of Finance (which supervises the Central Bank and Securities and Exchange Commission (SEC)), has a great opportunity to drive the financial sector reform agenda, thereby giving a very strong signal to the financial markets that the government is ready to support genuine investor appetite and provide competitive businesses the freedom to create wealth and growth. Whilst the banks need to ensure that they demonstrate to their clients that they have their best interests at heart.

(Dinesh Weerakkody was Chairman of the largest two private sector commercial banks and a Director of a development bank)

(References: https://www.ft.lk/top-story/Ministerial-duo-deal-heavy-blow-to-banks/26-763434;

https://www.fitchratings.com/research/banks/fitch-places-13-sri-lankan-banks-on-rating-watch-negative-12-04-2022)