At the launch of the Central Bank of Sri Lanka’s Monetary Policy Roadmap for 2020 yesterday, the new Governor has said in his speech that Sri Lankan banks should finance startups more and be less risk-averse. According news coverage by Economynext, the Governor has said:

“I urge Sri Lanka’s banking sector to rethink its credit disbursement policies, as the traditional ‘risk averse’ mindset has deprived emerging entrepreneurs and new ventures of much needed initial capital. […] Credit schemes that take into consideration the specific challenges faced by startups have failed to develop.”

I fundamentally disagree with this proposition. Here’s why,

Globally, banks are risk averse to this segment startups, and is not unique to Sri Lankan banks. Before calling for banks to fund startups, regulators must understand the financing needs in a startup’s lifecycle. It’s a bad idea to take on debt as an early stage startup. Its usually “friends family and fools” that provide capital first and then angel or seed funding rounds, followed by venture capital in the growth stage. In all these, the investor would typically take an equity stake. Banks cannot do that.

Moreover, banks fundamentally don’t understand startup biz models (esp digital startups) and its hard to expect them to do so. Banks typically have less than 20% capital, part of which is also debt capital, and the rest is public depositors funds. These depositors are extremely sensitive to ratings where bad debt ratios play a key role. Banks cannot afford to lend to high risk startups using depositors money. Also in Sri Lanka, you’d be hard pressed to find a retail depositor who has an appetite for more than one year tenor, whereas startups typically require longer term funding preferably at fixed rates. So the timing mismatch of assets and liabilities don’t lend themselves to startup lending. If banks are to lend long term, they need to get sources of funding to match that. There’s certainly a role for development banking to play a stronger role in Sri Lanka, as currently there is no strict development bank (DFCC and NDB are no longer development banks). In addition, banks are a highly regulated business globally (by Central Banks!) with close controls on integrated risk, provisioning, NPL management, capital adequacy, etc. This regulatory environment naturally does not lend itself to high-risk high-reward startup financing.

Even in the past when Sri Lanka began its venture capital journey, in the early 1990s, several banks started their own VC funds to invest in startups (Lanka Ventures with DFCC, NDB Ventures with NDB Bank, and People’s Venture Company with People’s Bank). But they didn’t do too well. They were run by bankers, and with a banker’s mindset of ‘moderate risk moderate return’. The only notable exit was Millenium IT, which had investments from NDB Ventures and People’s Venture Company. Whereas, the new incarnation of VCs in Sri Lanka – of the likes of BOV capital, Lankan Angel Network, etc. – are doing a better job since they’re not run by, and thinking like, bankers and can take disproportionate risk. The capital for these come from a closed group of investors, not public depositors and public shareholders like in the case of banks. As a general rule, only one in nine startups succeed and VCs make adequate returns with the successful 10% upside covering the rest of the downside. This kind of equation doesn’t work for banks, as its a totally different business model. So, it’s easy for regulators to say “banks should be less risk-averse and lend more to startups” – but in practice, its not so easy!

Furthermore, I would encourage that the regulator looks inwards to see what of it’s own policies and procedures are hindering startup growth beyond the financing question. I have heard numerous startups complain about the cumbersome rules and procedures  around eKYC adoption, seamless digital customer on-boarding and mobile and digital banking innovation. Ease up those and digital startups will flourish without any need for pushing banks to finance them. On the banks’ side, I think what they can do better is to open up to working with startups – especially fintechs. Open APIs, opening up for collaborations on digital banking and wallets, easing up their paperwork for startups to begin a banking relationship, developing startup-friendly banking tools etc.

Having said all this about banks, what’s clear is that Sri Lanka needs more financing sources for startups, beyond bank finance. We have a few angel, seed and VC funds and some exciting exits recently. Startups have a high failure rate. We need capital sources that have an appetite for, and an understanding of, this and provide different kinds of financing rather than bank loans.