BEC 1370: Microeconomics Group Assignment II “INDUSTRIAL ANALYSIS” Group No: 202 1st Year Group: B3 Industry: Financial Service Activities and Auxiliary Financial Service This report was submitted to the Department of Business Economics, Faculty of Management Studies and Commerce, University of Sri Jayewardenepura, as a partial fulfilment of the requirement of BEC 1370: Microeconomic course. Department of Business Economics Faculty of Management Studies ad Commerce University of Sri Jayewardenepura Date of Submission: 15th December 2022 1 Declaration We certify that this report does not incorporate without acknowledgement, any material previously submitted for a course or a degree in any university / institution, and to the best of our acknowledge and belief it does not contain any material previously published or written by another person, except where reference is made in the text. Group Members S. No. Name CPM MC 1 Hettiarachchige Salani Keshala 22699 103108 2 Mayakaduwa Ge Sadeesha Nelumi 22700 103651 3 Haeshintikaa Suthagar 22701 103003 4 Wanninayaka Mudiyanselage Kavindu 22702 103341 22703 103696 Induwara Wanninayaka 5 Savinduni Hasanditha Dahanayake 2 Acknowledgement We are extremely grateful because we managed to complete our Microeconomics assignment within the given time by our lecturer Dr. Janaka Fernando and our tutorial lecturer Ms. S.G.U.S. Chandrarathne. This assignment cannot be completed without the effort and cooperation from our group members' CPM 22699, 22700, 22701, 22702 and 22703. Last but not least, we would like to express our deepest gratitude to our friends for the support and willingness in helping us to complete this assignment and contributing to our findings. 3 Table of Content List of Tables ............................................................................................................................ 5 List of Figures ........................................................................................................................... 5 Chapter 1 .................................................................................................................................. 6 Introduction .............................................................................................................................. 6 Banking Sector ......................................................................................................................... 7 Chapter 2 ................................................................................................................................ 10 Market Structure .................................................................................................................... 10 Oligopoly .............................................................................................................................. 10 Differentiated Oligopoly .................................................................................................... 10 Collusive Oligopoly ........................................................................................................... 11 Chapter 3 ................................................................................................................................ 13 Pricing Strategies of An Oligopoly Based Banking Industry ................................................ 13 Pricing strategies ................................................................................................................. 13 The Future of Bank Pricing Strategies ............................................................................. 16 Value-based pricing .......................................................................................................... 16 Chapter 4 ................................................................................................................................ 18 Cost, Revenue, Profit Behaviors in Banking Industry ..................................................... 18 COST.................................................................................................................................... 18 Interest Expenses ......................................................................................................... 18 Personnel Costs ............................................................................................................ 19 Other Costs................................................................................................................... 19 Fees And Commission Expenses ................................................................................. 20 Tax Expenses ............................................................................................................... 21 REVENUE ............................................................................................................................. 21 Net interest income ...................................................................................................... 23 Non-interest income ..................................................................................................... 23 PROFIT ................................................................................................................................. 24 Chapter 5 ................................................................................................................................ 26 New Trends in Financial Services Industry...................................................................... 26 Conclusion ........................................................................................................................... 27 References ............................................................................................................................... 28 4 List of Tables Table 1: Gross Domestic Product (GDP) at constant (2010) market prices .............................. 7 Table 2: Total assets of the financial system ............................................................................. 8 Table 3: Distribution of banks, bank branches and other banking outlets ................................. 8 Table 4: Exchange rates of Bank of Ceylon ............................................................................ 15 Table 5: Exchange rates of Sampath Bank .............................................................................. 15 Table 6: Exchange rates of People’s Bank .............................................................................. 16 Table 7: Interest expenses ........................................................................................................ 18 Table 8: Personnel Costs .......................................................................................................... 19 Table 9: Other expenses ........................................................................................................... 20 Table 10: Fees and Commission Expenses .............................................................................. 20 Table 11: Tax Expenses ........................................................................................................... 21 Table 12: Gross Income ........................................................................................................... 22 Table 13: Total Operating Income ........................................................................................... 22 Table 14: Interest Income ........................................................................................................ 23 Table 15: Non-interest income................................................................................................. 23 Table 16: Income Statement of People’s Bank ........................................................................ 24 List of Figures Figure 1: Contribution to gross domestic................................................................................... 6 Figure 2: Contribution to Gross Value Addition ....................................................................... 6 Figure 3: Rates for fixed deposits of ........................................................................................ 14 Figure 4: Rates for fixed deposits of Seylan Bank .................................................................. 14 Figure 5: Pricing approaches .................................................................................................. 16 Figure 6: Value based pricing steps ......................................................................................... 17 Figure 7: Total operating income, net interest income, non- interest income ......................... 22 Figure 8: Profit before tax ........................................................................................................ 25 Figure 9: Rise up of search interest in blockchain in 10 years ................................................ 26 5 Chapter 1 Introduction Sri Lanka is an emerging economy in South -East Asia with a population of 22.156 million in 2021. The service sector in Sri Lanka is the largest contribution to the Sri Lankan economy with a contribution of 58.3 percent of the national Gross Domestic Product (GDP) in 2021(Figure 1). Under this service sector, Financial and auxiliary services industry is comprised of savings, investing, pawning, insurance, loans, leasing and finance so on. This industry is made up of a wide range of financial firms including banks, insurance companies, lenders, finance companies, real estate firms etc. The financial services sector in Sri Lanka, was ranked at the fourth place and contributed roughly 14.53 percent to the service sector’s output (in 2021). As Table 1 shows, Financial and auxiliary services grew by 7.5 percent in 2021, compared to the growth of 10.9 percent in 2020. Figure 1: Contribution to gross domestic product Figure 2: Contribution to Gross Value Addition Source: (Annual Report 2021 of Central Bank,2022) Since there are many firms and institutions under the financial and auxiliary services industry, in this report we mainly look at the Banking Sector. 6 Table 2: Gross Domestic Product (GDP) at constant (2010) market prices Source: Annual Report – 2021 of Ministry of Finance Banking Sector The banking sector in Sri Lanka plays a major role in stabilizing the financial and economic conditions of the country. According to the Central Bank of Sri Lanka, the banking sector excluding the Central Bank, continued to dominate the financial sector accounting for 63.3 per cent of total assets as at the end of year 2021 (Table 2). According to the Table 3, by the end of 2021, the banking sector in Sri Lanka comprises 24 Licensed Commercial Banks including domestic and foreign banks and 06 Licensed Specialized Banks, with a network of over 3600 bank branches and banking outlets and around 6300 Automated Teller Machines (ATMs). 7 Table 3: Total assets of the financial system Source: Annual Report 2021 of Central Bank Table 4: Distribution of banks, bank branches and other banking outlets Source: Annual Report 2021 of Central Bank 8 This report is organized as follows. The next chapter presents market structure and justification and the third chapter focuses the pricing model with illustrations. The fourth chapter presents cost, revenue and profit behaviours of People’s Bank as a selected firm in the banking sector and the last chapter presents future trends of the financial industry and conclusion of the analysis. 9 Chapter 2 Market Structure In economics, market structure refers to how various industries are classified and differentiated based on the degree and nature of competition for goods and services. It is founded on the characteristics that influence the behavior and outcomes of businesses operating in a particular market. There are four distinct market structures. Perfect competition, market competition, oligopoly, and monopoly are the four types of competition. The number of buyers and sellers, ability to negotiate, degree of concentration, degree of product differentiation, and ease or difficulty of entering and exiting the market are all factors that influence market structure. Oligopoly What is Oligopoly? Oligopolistic markets are characterized by a small number of suppliers. They can be found in all countries and in a wide range of industries. Some oligopoly markets are highly competitive, while others are significantly less so, or appear to be. Nowadays, in many countries, the banking sector is clearly an oligopoly in the sense that a few large banks control a significant portion of the banking business. Differentiated Oligopoly In an oligopoly, the products sold are differentiated. Barriers to entry, paying attention to rival firms' behavior, producing differentiated products, and price setter are key features of an oligopoly market. Why financial industries fall under oligopoly market structure • Due to economies of scale, financial services and auxiliary services fall into an oligopoly market structure to increase production efficiency. • A large capital investment is required to enter the financial industry, particularly the banking sector. • Patented manufacturing processes, as well as regulated standards and acts • Retention of existing service providers' brand loyalty 10 Collusive Oligopoly Oligopolists agree formally or informally to limit competition among themselves in collusive oligopoly. They may agree not to poach each other's market, set output quotas, fix prices, limit product promotion or development, or agree not to set output quotas. Cartel agreements, price leadership models, and so on. Interbank markets are an essential component of the financial system; banks lend to one another to allocate liquidity in the economy. Despite the interbank market's potential benefits, we propose a novel cost. Our argument is based on the simple observation that banks compete in one market for lending to businesses while lending to each other in another (interbank) market. We develop a stylized model to investigate how strategic spillovers between these two markets can result in inefficient resource allocation and provide a role for government regulation. The model produces an unexpected result: in certain regions of the parameter space, an interbank market can facilitate bank collusion, and regulations limiting interbank trade can implement the planner's solution. Collusion occurs when two competing banks have sufficient resources to make business loans. In this state of the world, one bank (call it bank B) makes a loan to another bank (call it bank A), and as a result, bank B lacks the funds to compete with bank A. If these two banks are the only ones in the area, bank A effectively becomes a monopolist, reaping monopolistic profits by rationing loan supply. The interbank loan from bank B to bank A is a credible promise not to compete. Bank B gains from this commitment by receiving a higher interest rate on the interbank loan, which represents a portion of bank A's monopolistic profits. Without an interbank market, both banks would compete and earn no profits, which is the allocation that a social planner would prefer. If banks are permitted to trade on the interbank market, the decentralized solution may become inefficient. The paper's main conclusion is that interbank trading allows banks to collude. Even when there are benefits to interbank trade because of liquidity sharing, the welfare loss from collusion can outweigh the benefit. We extend the model to allow banks to enter the business loan market endogenously. Banks make this strategic decision based on anticipated profits from entry. These profits are 11 determined by the other bank's decision to enter the market, liquidity shocks, and the presence of the interbank market. Cartel model A cartel is a formal agreement formed by a group of producers of a good or service to regulate supply in order to regulate or manipulate prices. In other words, a cartel is a group of otherwise independent businesses or countries that act as if they are a single producer and thus can set prices for the goods and services they produce and provide without competition. Banking cartels exist in countries such as Australia, the United Kingdom, and Poland, as examples. 12 Chapter 3 Pricing Strategies of An Oligopoly Based Banking Industry Pricing is currently more important for all banks than ever before. It plays a central role in customer satisfaction and profitability. Mainly due to changes in customer preferences and cost changes pricing has taken a lot of our attention. Sometimes it acts as a challenge to the banking industry and at the same time, it can be an opportunity. Pricing strategies Cost-plus pricing strategies mean adding the average total amount and adding a fixed market to earn the desired profit. Commercial banks use a different brand as well as costing labor to enhance profit. Internet banking facilities, ATM card charges, SMS alert charges, and cheque return charges in banks are provided to customers at different price rates. They can’t do major price changes in the banking industry as they are in an Oligopoly key structure but they tend to use the tactics mentioned above. Price skimming strategy is also seen in commercial banks when they build new products. Price skimming strategy influences profit maximization in any industry. It helps the overall profitability of the organization as well as the return on the individual product. Banks do consider the level of different prices in different products of their competitors and do relevant changes according to them. They consider their competitor’s pricing strategies as well. Due to competitive pricing, we can see differences in share market prices in publicly listed commercial banks. A common example in Sri Lankan banking industry is that Bank of Ceylon has the largest market share of foreign exchange market in the country. There is a major tendency among other instructions banks to for central foreign exchange rates determined by Bank of Ceylon. There can be slight differences but if they do major changes, they will lose their customer base. Non pricing strategies mainly use in banking industries as they cannot change the prices of the product largely as they are experiencing an oligopoly market structure. Advertising and promotions can be used to compete with others. 13 Mainly the interest rates are being controlled by the Central Bank of Sri Lanka. Commercial banks have to follow the instructions given by the Central Bank of Sri Lanka when determining their interest rates. The Monetary Board of the Central Bank of Sri Lanka, at its meeting held on 05 October 2022, decided to maintain the Standing Deposit Facility Rate (SDFR), Standing Lending Facility Rate (SLFR) of the Central Bank at their current levels of 14.50 pent and 15.50 per cent, respectively. Recently the commercial banks in Sri Lanka have introduced special fixed deposits with special rates to attract customers. We can see the differences in minimum payment to be deposited in order to open the fixed deposit and also the slight differences in interest rates and maturity period changes. Figure 3: Rates for fixed deposits of Commercial Bank Figure 4: Rates for fixed deposits of Seylan Bank Source: https://www.seylan.lk/mybrochures?category=Promotions Source: https://anybanq.lk/bank/index/4/Commercial-Bank 14 Table 5: Exchange rates of Bank of Ceylon Source: https://www.boc.web.lk/ExRates Table 6: Exchange rates of Sampath Bank Source: https://www.sampath.lk/en/exchange-rates 15 Table 7: Exchange rates of People’s Bank Source: https://www.peoplesbank.lk/exchange-rates/ The Future of Bank Pricing Strategies Most banks use a cost-plus and market-based pricing strategy. These strategies have played a great role in the banking industry. Usually, the traditional approach in banking consists of riskbased spread and assessment of the competitor product portfolio. But there are some underestimated or fully uncounted factors such as the correct cost of servicing and customers’ value perspective regarding such products. Figure 5: Pricing approaches Source: (pwc "Pricing innovation in banking: The next frontier", 2019) Value-based pricing Banks have to move away from traditional strategies in to future based strategies. The future banking is value driven and if they do not pay attention to these new strategy shifts, they will 16 lose their market. It shows a gradual shift from product-centric mind set to a customer-centric approach. It should understand the factors that drive value to customers. Value-based pricing help to increase profit margin and to increase customer loyalty. The given below factors will help the banks to identify the value aspects of customers. • Customers have easy access to market information – With the development of technology customer can access wide range of information in a short time. Data shows banking products with complicated features are rejecting by customers even given at discounted prices. • Poor marketing can lead to a dissatisfied customer – Even when the products supplied by the bank are in good level if they didn’t market them properly the customers will not pay attention to them. There are so many commercial banks in Sri Lanka. If we didn’t market our products properly, they will easily shift to other competitors. Figure 6:Value based pricing steps Source: (Google images) 17 Chapter 4 Cost, Revenue, Profit Behaviors in Banking Industry Since there are different banks in the banking industry, the behavior of cost, revenue and profit vary between each bank. Because of this, one bank is taken as a sample and conclusions are drawn about the behavior of the entire banking industry based on the information obtained from it. People’s Bank is taken into this study. COST Cost means the amount of money which a company expend on the creation or production of goods or services. In aspect of the banking side, the cost can be defined as the mean ratio of overhead costs to total assets. It included all taxes and insurance premiums of every kind and nature of the Borrowers paid by the Bank. There are two major costs can be seen in a bank. 1. Interest Cost - This is the cost incurred from deposits, short-term and long- term loans and trading account liabilities. 2. Non-interest Cost - This is the cost other than interest payment on deposits and bonds. In 2020 and 2021 period, the cost behavior of People’s Bank can be taken as follows. Interest Expenses Table 8: Interest expenses Source: (People’s Bank Annual Report 2021, 2022) 18 Total interest expenses contracted by 3.3% in 2021 relative to 2020. During these two years, the most interest expense is incurred due to other customers. But it higher in 2021 than 2020. Also, least interest expense is coming from interest on lease liabilities during these years. In addition to that, deposit related expenses made up close to 84.0% of which more than 74.0% was on account of term deposits in 2021 relative to 2020. Further there are some operating costs such as personnel costs, other costs, fee and commission expenses, tax expenses. Personnel Costs Table 9: Personnel Costs Source: (People’s Bank Annual Report 2021, 2022) Personnel costs accounted for approximately 55.0% of total operating costs, with an increase of 15.5% in personal costs during 2021 when compared with 2020. Each two years, highest expense was salaries, bonus and related expenses. Further least expense was gratuity. However, in 2021 the amount of highest expense is higher than 2020. Other Costs The highest expense was office administration and establishment expense in these two years. But there is small gap between this expense and depreciation and amortization cost. However, these costs higher in 2021 than 2020. 19 Table 10: Other expenses Source: People’s Bank Annual Report 2021 Fee and Commission Expenses Source: (People’s Bank Annual Report 2021, 2022) Fees And Commission Expenses Fees and commission expenses also higher by 22.8% in 2020 relative 2021. The highest expense is represented by cards according to these costs. Table 11: Fees and Commission Expenses Source: (People’s Bank Annual Report 2021, 2022) 20 Tax Expenses Total tax expense is decreased in 2021 than 2020. Therefore, it showed positive cost behavior. Also, effective tax rate was reduced to 21.9% in this time period. Table 12: Tax Expenses Source: (People’s Bank Annual Report 2021, 2022) REVENUE Simply, revenue refers to the total earnings a company generates through its core operations. The main source of revenue for banks are client’s loan and deposit operations. They deposit money at the bank but they receive a relatively small amount of interest. Then the bank lends funds out at a much higher rate, profiting from the difference in interest rates. This is the normal way of generate their income. Mainly, banks are making their revenue in two ways. 1. Net Interest Income - It is the difference between the revenue generated from a bank's interest-bearing assets and expenses obtained while paying its interest-bearing liabilities. 2. Non-interest income - It is the revenue made through fees other than interest income on loans. As an example, monthly maintenance fees, deposit and transaction fees, insufficient funds fees, annual fees, monthly account service charges, etc... can be taken as non-interest income In 2020 and 2021 period, the revenue behavior of People’s Bank can be taken as follows. 21 Figure 7: Total operating income, net interest income, non- interest income According to this graph, the year 2021 saw a year-on-year increase of 5.8% in the Group’s gross income, reaching LKR 236.8 Bn. Also, interest income, fee and commission income as well other non-funded income continuing to remain its main sources of revenue. Source: (People’s Bank Annual Report 2021, 2022) Table 13: Gross Income Source: (People’s Bank Annual Report 2021, 2022) The highest percentage of income was from interest income. Also, it higher in 2021 relation to 2020. Further, these four main revenues are contributed different way for gross income. Unfortunately, net gain from trading is become a loss in 2021 than 2020. Table 14: Total Operating Income Source: (People’s Bank Annual Report 2021, 2022) 22 Net interest income It is representing core operations of the Group accounted for 87.5% of total operating income, increasing by 30.2% year-on-year to LKR 96.9 Bn. in 2021 from LKR 74.4 Bn. in 2020. Given above is an analysis of the constituents of net interest income. Total interest income higher in 2021 relation to 2020. However, that difference was a smaller amount. The highest interest income generated through the Loans and receivable to other customers. But the least interest income generated from Cash and cash equivalents. Table 15: Interest Income Source: (People’s Bank Annual Report 2021, 2022) Non-interest income Non-interest income consisted of fee and commission income, trading income and other operating income. According to the above analysis, net non-interest income decreased by 15.7% to LKR 13.8 Bn. from LKR 16.4 Bn. Table 16: Non-interest income Source: (People’s Bank Annual Report 2021,2022) 23 Fee and commission income gave a highest contribution to the non-interest income and it amount also increased in 2021 than 2020. Although, the net trading amount changed as a loss in 2021. It was a negative affect for the non-interest income. PROFIT Actually, bank profitability is the measurement that can be used for measure bank's performance. They can make profit by earning a lot of money than what they are paying in expenses. Mainly, banks collect profit from the service fees (charged for their services) and earned interests from their assets. There are three major types of profits in the banking industry. These profits can be found from each banks’ income statement. 1. Gross profit - It is the value of a business has earned minus the direct costs of manufacturing or the cost of goods sold. 2. Operating profit - It is the value of the gross profit minus operational costs. 3. Net profit - It is the total value left over after the business has accounted for all deductions, including interest and taxes. Table 17: Income Statement of People’s Bank Source: (People’s Bank Annual Report 2021, 2022) In 2020 and 2021 period, the profit behavior of People’s Bank can be taken as follows. 24 Figure 8: Profit before tax According to this graph, the bank’s pre-tax profit increased by 51.1% to LKR 37.2 Bn. in 2021 from LKR 24.6 Bn. in 2020. The total operating income of the bank reached LKR 110.7 Bn. and total operating expenses amounting to LKR 50.5 Bn., either of which up 21.9% and 14.9% respectively over 2020. Source: (People’s Bank Annual Report 2021, 2022) In summary, operating cost before including VAT or after including VAT, it was higher in 2021 than 2020. Also, the profit for the year is increased. Therefore, it showed a positive profit behavior for sustain in future. 25 Chapter 5 New Trends in Financial Services Industry The Sri Lankan economy is currently undergoing a distressed situation, in a level never experienced in Sri Lankan history. Currently, Sri Lanka face problems such as Critically low official reserves, Accelerated Inflation, Overshot Exchange rate, Power crises and Social and political unrest. Therefore, the financial services industry is turning its focus toward innovations to ready the future. There are key trends in the financial services such as, • Artificial Intelligence • Automation • FinTech • Blockchain The financial industry focuses on digitization to enhance operational efficiency and speed. Banks are cutting down spends on their branches and invest in self-service digital channels; mobile and online banking. For examples, People’s Wave, Smart Pay, Com bank digital etc. FinTech combines financial services with information technology. The development of FinTech using smartphones has become the global attention as the trend shift from payment cards to mobile- based applications such as e-money, near field communication (NFC), QR code-based payments etc. A growing technology change affecting the financial services industry is blockchains. HSBC bank already use blockchain technology to settle forex trades. PayPal, Mastercard allow users to make payments using blockchain currencies. Figure 9: Rise up of search interest in blockchain in 10 years Source: (Howarth, explodingtopics.com, 2022) 26 Conclusion 27 References − Banton, C. (2021, June 13). Investopedia. Retrieved from www.investopedia.com: https://www.investopedia.com/terms/n/noninterest-expense.asp − Central Bank of Sri Lanka. (2022). Annual Report for the year 2021. Colombo: Central Bank of Sri Lanka. − Central Bank of Sri Lanka. (2022, April 16). FINANCIAL SECTOR PERFORMANCE AND SYSTEM STABILITY. − Dr.P.K.G.Harischandra. (2022). The State of the Sri Lankan Economy,Challenges and Outlook. Central Bank of Sri Lanka . Retrieved May 23, 2022 − EIU. (n.d.). Retrieved from eiu.com: https://www.eiu.com/n/global-themes/financialindustry-hub/ − Howarth, J. (2022, October 05). Exploding Topics . Retrieved from explodingtopics.com: https://explodingtopics.com/blog/financialtrends#:~:text=More%20banks%20are%20transition%20to,their%20networks%20usi ng%20blockchain%20currencies − Law Insider . (n.d.). Retrieved from www.lawinsider.com: https://www.lawinsider.com/dictionary/bank-costs − Ministry of Finance, E. S. (2022). Annual Report. Colombo: Ministry of Finance. − People's Bank . (2022). Annual Report-2021. − Phaneuf, A. (2022, January 06). Insider Intelligence . Retrieved from insiderintelligence.com: https://www.insiderintelligence.com/insights/financialservices-industry/ − pwc. (2019). "Pricing innovation in banking: The next frontier". Pricing innovation in banking: The next frontier. − Team, C. (2020, December 29). CFI. Retrieved from corporatefinanceinstitute.com: https://corporatefinanceinstitute.com/resources/accounting/non-interest-expense/ − Team, C. (2022, December 6). CFI. Retrieved from corporatefinanceinstitute.com: https://corporatefinanceinstitute.com/resources/accounting/financial-statements-forbanks/ − Vishnava. (2022, December 07). cleartax. Retrieved from cleartax.in: https://cleartax.in/g/terms/net-interest-income-nii − Wagner, H. (2021, September 13). Investopedia. Retrieved from www.investopedia.com: https://www.investopedia.com/articles/stocks/07/bankfinancials.asp 28 − Ziad Kubursi, H. S. (2022, March 05). The Hartford. Retrieved from thehartford.com: https://www.thehartford.com/insights/home-workplace-safety/financial-servicestrends Contribution of group members Student Name CPM Contribution H.Salani Keshala CPM 22699 Conclusion of the analysis M.G. Sadeesha Nelumi CPM 22700 Introduction, future trends, overall report merge S. Haeshintikaa CPM 22701 Market structure and justification W.M. Kavindu Induwara Wanninayaka CPM 22702 Cost, revenue and profit behaviour and illustrations S. Hasanditha Dahanayake CPM 22703 29 Pricing model and justification