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                                                                                          Mr. Nihal Fonseka, Chief Executive of DFCC Bank

This commentary relates to the interim non-audited financial statements for nine months ended 31 December 2012.

Group Performance

The DFCC Group recorded a consolidated profit after tax of LKR 2,374m for nine months ended 31 December 2012 compared with LKR 2,204m in the corresponding period of the previous year (comparable period).

The financial year of subsidiaries DFCC Vardhana Bank PLC (DVB) and Synapsys (Pvt) Ltd, joint venture Acuity Partners (Pvt) Ltd and associate company National Asset Management Limited ends on 31 December and therefore the results of these entities are consolidated with the bank with a time lag of three months.

The Banking Business of the DFCC Group is undertaken by DFCC Bank (DFCC), a licensed specialized bank and 99 % owned subsidiary DFCC Vardhana Bank (DVB), a licensed commercial bank. Both banks function as one economic entity and as such to the consolidated performance of the two banks referred to as DFCC Banking Business (DBB) is analyzed later in this review. A consolidated Income statement for DBB derived from the interim financial statements has been released to the Colombo Stock Exchange as supplementary financial information.

Apart from the DBB which contributed LKR 2,215m to profit after tax (based on partial consolidation in the supplementary income statement of DBB) and is analyzed below in greater detail, the investment banking joint venture, Acuity Partners (Pvt) Ltd (APL) contributed LKR 105m in the current period, 16pc lower than LKR 125m in the comparable period. The current period however includes a deemed disposal gain of LKR 83m(50% of the total recorded by APL) arising from a transaction by its subsidiary Lanka Ventures PLC accounted in the income statement as per the previous Sri Lanka Accounting Standards. However, at the end of the current financial year, consequent to re-presentation of the full year financial statements under the new accounting standards, this deemed disposal gain would be accounted as other comprehensive income in the equity and not in the income statement as currently presented.

The investment banking business was adversely impacted by the economic environment that prevailed although there were signs of uplift toward the end of the current period. The contribution from APL’s core activities was significantly lower than in the previous period. The contribution from all other subsidiaries and associate company collectively was LKR 103m in the current period (LKR 79m in the comparable period).

Banking Business

Net Interest Income as well as loans and advances recorded growth although DVB due to its lower base was constrained by the credit ceiling imposed on the banking sector by the Central Bank. DBB funded the credit expansion largely through customer deposit mobilization with deposits growing to LKR 60.4 billion in the current period. However, the high interest rate regime that prevailed had an adverse impact on the Net Interest Margin (NIM). On a composite basis, NIM of DBB was 4.6% in the current period compared with 4.9% in the comparable period. The last quarter of the current period saw a reversal of the declining trend with NIM of DBB increasing to 4.6% for the 9 month period compared with 4.4%at the half year stage on an annualized basis.

Other income of DBB was LKR 1,014m in the current period, 14% lower when compared to the comparable period. This reduction was mainly due to the fact that a second interim dividend from Commercial Bank Of Ceylon PLC paid in the comparable period in Dec 2011, being declared after 31 December 2012.As a result LKR 104.6m was not accounted in the income statement in the current period. Also, gains from sale of non affiliated shares was only LKR 76m in the current period compared to LKR 254m in the comparable period since market conditions were not conducive for disposing mature investments.

DBB continued with a funding strategy of selling foreign currencies, mainly USD and generating LKR for lending activities with a better net interest income compared to the margin on foreign currency denominated loans. The market risk relating to these transactions was partially hedged through swaps. The swap cost was charged to foreign exchange income and it exceeded the foreign exchange profit from trading and translation gains thus recording an overall loss.

The gross non-performing loan ratio of DBB increased to 4.8% as at 31 December 2012 compared with 4.3%, on 31 March 2012. The gross non performing loans of DBB increased by LKR 1,064m during nine months ended 31 December 2012. However, there was a reduction of LKR 141m non-performing loans during the quarter ended December 2012. Recognizing that in a relatively high interest rate regime temporary problems of debt servicing do arise, DBB through pro-active measures and active monitoring strived to contain the incidence of default events.

The ratio of operating expenses to operating income of the DBB was 41% in the current period approximately the same as in the comparable period. The 15% increase in operating expenses in the current period was compensated by additional income.

In common with banking industry, the personnel cost is a significant proportion of the operating expenses. The personnel cost in the current period inclusive of retirement benefits was LKR 1,036m being a 26% increase over LKR 825m in the comparable period. DBB increased its head count from 1228 employees at the beginning of the current period to 1268 on 31 December 2012, a modest increase of 3%. Salary and benefits in DBB were revised following a survey to bring these in line with market. Some high level skills needed for business expansion and succession planning in personal financial services, marketing, risk management, treasury and senior management were acquired through external recruitment. The DBB has embarked on a comprehensive review of its organization structure to optimize the deployment of its human resources through further synergies to be reaped through centralization, shared services between DFCC and DVB and expected attrition. The DBB recorded a 10% increase in operating profit before taxes which to LKR 3,146 m. Profit after tax (both VAT on financial services and income tax) was LKR 2,215m, an increase of 9% over the Rs 2,031m recorded in the comparable period. The current period included an adjustment for a one off, non recurrent financial services value added tax over provision for the prior year amounting to LKR 184m. Without this, DBB’s profit after tax for the current period was LKR 2,031m, approximately the same as in the comparable period.

Investments

The quoted equity investment securities of DFCC are carried at a cost of LKR 4,992m as at 31 December 2012. The aggregate market value of the investments on 31 December 2012 amounted to LKR 14,702m with an unrealized gain of LKR 9,710m. The unrealized gain reported on 30 September 2012 was LKR 11,396m. As commented in my previous commentary on half year results given vagaries of the domestic and global stock markets the unrealized gain can fluctuate significantly. For instance as at 30 January 2013, the date interim financial statements for nine months ended 31 December 2012 was authorized for issue, the unrealized gain was LKR 10,009m.

The interim non-audited financial statements are not based on the new accounting standards and therefore the unrealized gain is currently not recognized in the financial statements. However, under the new accounting standards all listed shares currently classified as investment securities would be reclassified as available for sale and marked to market and the unrealized gains recognized in the equity of DBB.

Transition to new Accounting Standards

This is the last occasion on which financial statements are presented under previous accounting standards. The final quarter interim financial statements and the Annual Financial Statements for the year ending 31 March 2013 will be prepared under the IFRS based new accounting standards. As indicated in the notes to the interim financial statements, based on current unaudited estimates, the impact on the equity of DFCC of transition to the new accounting standards will not be adverse.

Prudential Indicators

The capital adequacy and liquidity ratios continued to be well above the stipulated regulatory minimum. Specific provision cover for the DBB was 72% and un-provided NPLs as a proportion of equity was under 8%.

Future Developments

Access to diversified sources of long term funds at a reasonable cost is important for DFCC to prudently leverage its franchise in the project lending space in post war Sri Lanka. For DVB, increasing the current and savings account (CASA) component of its customer deposits and the higher yielding personal financial assets are priorities. The environment in 2012 was not conducive to achieving either of these but looking forward the DBB is better placed to realise these objectives.

The Road Map 2013 announced by the Central Bank indicated that inflation, interest rates and exchange rate will be managed in a manner that will encourage investment and economic growth. The credit ceiling that applied in 2012 is not applicable in 2013 which will permit DVB to target the growth of personal financial assets more aggressively. The announcement made in the budget proposals for 2013 that the Government will facilitate DFCC Bank to raise up to USD 250m in long term funds from international capital markets is also a favourable development. The foreign exchange risk cover and tax free interest income from deployment of funds raised that were proposed in the budget will stand the Bank in good stead to enhance its development financing mandate. The bank is actively pursuing this opportunity.