harry j and the commercial bank

a lot of interest has been aroused by the mr jayawardena's (btw his full name in don harold stassen jayawardena, a easily verifiable fact some newspapers got wrong) attempt to remove mr m.j.c.amarasuriya from his directorship (thus his chairmanship) of the commercial bank(combank) board. an extraordinary general meeting of shareholders requested by two of the main shareholders of combank, namely distilleries co of sri lanka(dcsl) and sri lanka insurance corporation(sli) (both controlled by jayawardena) will be held on 2^nd of november for that purpose. in fact because of the large number of shareholders who are expected attend, venue was changed from bank's auditorium to holiday inn.

before discussing the merits of the case i would like to point out some basic facts that are not considered in newspaper articles dealing with this issue. (please note that this is simplified for easy consumption )

how to get seriously rich.

since a main argument put forward by people opposed to jayawardana concerns his motivation, let us see what he has been doing in the past.

simple answer is he has been trying his best to get very rich. and the method he uses has been followed by lots of wise investors world over with spectaculars success. in fact if you are not a genius innovator or a big risk taker(as in venture capitalist etc. ), or a just plain lucky person and you do not want to do anything that is illegal, then this is the only method to get seriously rich.

method (simplified) consist of

1. secure a steady cash flow
2. take loan against the future cash flow
3. use the money to secure another steady cash flow
4. go to step 2

to take a example, from jayawardena's past, first he bought dcsl( step 1) (that almost monopoly spews out more than 1 billion in profit each year, with nothing much to do by way of reinvestment). then it's expected future cash flow made it possible for him to get loans (step 2) to buy sli, another cash cow(step 3). he has consistently followed these steps (as when he bought lanka bell (another cash cow) recently ).

control of combank will enable him to continue with this strategy. that is because he has bumped up against a problem when obtaining financing (that is step 2) for future deals because these deals are expected be large by sri lankan standards.

it is one thing to get 4 or 5 billion rupees against dcsl cash flow but something else to obtain the money needed to say, buy that ultimate cash cow the sri lanka telecom (probably about 40 billion or more) whenever the government sells it's remaining stake. while financing for this will be easily obtained by anyone with access to developed capital markets, sri lankan financial sector is so undeveloped that no private bank will be in a position to advance that kind of money. total assets(that is mostly loans to customers) of hnb the largest private bank(already more or less controlled by jayawardana) is only 153 billion in 2004. which means to get that kind of money (without breaching single borrower limits etc. that apply to banks), he has to get control of other available pools of money in sri lanka. and the prime target is combank.

what does a bank actually do.

banks take deposits from customers and pay interest for those deposits and then lend that money and receive interest from the borrowers. their profit is the difference(spread) between those two interest rates less costs (including regulatory costs) .

so, say a bank has 100 billion in deposits and it pays 12% on deposits( that is it pays 12b in interest). it has to park about 10% of deposits in central bank as a statutory requirement. so it has 90b to lend which it does say at 15%, then it will get 13.5b in interest. so it's profits before costs comes to 1.5b.

but that is what a bank is supposed to do.(of course they get income from other sources too. such as money market and foreign exchange dealings, other fees etc. but let's leave that aside for the moment)

but commercial bank is different. in most banks share capital and retained profits (called the shareholders' funds) is used up in various physical assets and such(buildings etc.), those assets mostly does not give a return. but in combank shareholders' funds exceeded any such requirement by 5.5b at the end of 2004. this excess is called free capital. why is this important.? because the free capital is well 'free', almost. since the dividends are paid as per 'par value' of shares(rs.10) and the net book value of a share was rs.172( at end 2004) cost of that 5.5b to the bank is negligible.

so if the bank lends that 5.5b at 15%, it will get 0.8b in interest. but since it doesn't have to pay anything for that money this is pure profit. in other words 5.5 b in free capital equals 50b in deposits.

this the main reason why combank has been able to make consistently good profits while other banks' profits go up and down with the sri lanka's interest rate volatility. for instance in 2001, a very bad year for banks combank made more profits than all the other local private banks combined. yes, it has a lower cost to income ratio than other banks but this is the main reason.

anybody who controls combank will be able to release this free capital with minimum fuss, after all it belongs to the shareholders.

shareholders should have the final say

this free capital and the fact that he will be able to draw loans from a larger pool in the future is probably why harry j is trying to get control of combank and not because of ' reasons(that) are personal and mala fide' as claimed by amarasuriya in his letter to the shareholders dated october 5^th .

most commentators object that according to law it's illegal to own more than 10% of a bank by one person or group acting in concert. while there is a rule like that, central bank has pointedly not acted. why ? maybe because these things are more flexible than people think and has been flexibly applied so far in sri lanka's banking history. do not expect central bank to act differently now.

second objection (which is also the justification for the above rule) is that a dominant shareholder will use depositors money for his own purposes, thus putting their money at more risk than necessary. but that is mere speculation and even professional bankers sometimes screw things up. central bank has done a good job as a regulator as far as commercial banks in sri lanka are concerned, there is no reasons to expect it will fail to do so in the future. if customers fear for their money, they should withdraw the deposits.

minority shareholders may fear that their interest will not be looked after, but if they do they can sell now. but comparison of dcsl share price and combank share price shows that though both have done phenomenally well in recent years dcsl has done much better.

silly unions at combank are threatening to strike on this. what could be more stupid and harmful to their bank? if hnb and comb are to merge in to one bank there will be some layoffs (in that case given that combank staff are more efficient by all measures, it's the hnb staff who should fear) but i don't think any such formal merger will take place.

another objection is that there will be less competition if a single group controlled both combank and hnb. that is not true because in sri lanka largest banks are the state controlled bank of ceylon and people's bank. if you want more competition best thing to do is to privatize those two.

in fact i believe most people object because they don't like jayawardana (he certainly doesn't fit the normal mold of the colombo elite) and what he stands for – capitalism. fact that they don't articulate this indicate that their objection has no validity in their own opinion nor should it deserve any consideration by us.

anyway shareholders own the bank so they should be allowed to decide what to do.

I don't know how the vote will go on 2^nd but i hope share holder rights will prevail.