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The Central Bank yesterday said in a statement that it will place its findings in connection with the Pramuka Savings and Development Bank (PSDB) in full before court, at which stage the public will be made aware of such findings.

It said that the public would be aware that the decision of the Monetary Board is now being challenged in court. This places a further constraint on public discussion of the issues. "It is, necessary in the meantime that the public should be informed of the role of a Central Bank as a regulator and supervisor, as there appears to be some misconceptions on this issue," the CB said in a statement which issued to clarify these misconceptions.

On December 18, 2002 the Central Bank of Sri Lanka announced that the Monetary Board examined a report by its Director of Bank Supervision that unsound, improper and imprudent practices and mismanagement by those responsible for the affairs of the Pramuka Savings and Development Bank (PSDB) has resulted in the bank being insolvent; gave an opportunity to the Chairman and the board of directors of PSDB to respond to these findings; concluded that the directors and shareholders did not show a meaningful and practical commitment to revive the PSDB; and therefore, had no option but to cause the Director of Bank Supervision to take action to wind up the PSDB under the Monetary Law Act and to cancel the licence issued to it under the Banking Act.

The above decision followed the suspension of PSDB on October 25, 2002 after its financial condition indicated insolvency and the proposals made by the management to rehabilitate the bank were found to be unrealistic and impracticable.

Consequent to the said decision various statements have been made in the media regarding this matter. In view of its obligations under the law the Central Bank has not responded in detail to these statements despite serious inaccuracies and misrepresentations contained in them.

In all countries, there is a variety of financial institutions and persons that seek financial deposits and investments from the public, and who perform a variety of lending and financial services. Unlike in other institutions where the turnover of activity is closely related to the capital, these financial institutions are highly leveraged ie., their turnover is several times the capital because the turnover depends on large volume of deposits that the public makes with them on trust. Hence, if the depositors' monies are misused and lost, the depositors have recourse only to a small capital base to seek relief. That is why these financial institutions are supervised and regulated to at least safeguard depositors' money.

Nowhere are all these transactions guaranteed by the State or any institutions, except in a few instances where small deposits are guaranteed, for which an additional premium is payable for insurance. It is not practicable to secure all these transactions because it could lead to reckless deposit taking and lending, generally referred to as "moral hazard". The universal feature of these activities is therefore a higher element of risk, for which a rate of interest (or reward) is paid or charged.

In such a context, the public should be vigilant in assessing risks that are inherent in financial markets. In Sri Lanka, as in other countries, the major participants in the market are supervised and regulated by supervisory institutions, the Central Bank, in the case of commercial banks, specialised banks and finance and leasing companies. This leaves out a large number of other institutions dealing with finance, sometimes even without legal authority, which are almost impossible to regulate or supervise because of their size, nature, diversity and wide dispersal.

The Central Bank of Sri Lanka has been explaining this situation in cautionary public notices from the beginning of last year, where it was clearly explained that the mere fact of Central Bank regulation does not assure absolute safety of one's funds - that such regulation only attempts to ensure that institutions which solicit funds from the public act in a prudential manner, which will reasonably assure the safety at least of the depositor's funds.

This is done by regular off-site and on-site supervision. Under the former, the institutions are required to send monthly information on critical performance indicators such as non-performing loans, capital adequacy and liquidity. Where this information reveals a cause for concern, an immediate on-site examination is conducted and findings evaluated. Regular and more comprehensive on-site examinations are also conducted to assess the prudential conduct of the institution.

After these supervisory examinations, directors and officials of these banks are informed of the findings and any corrective measures are agreed upon. Penalties are imposed on violations of legal requirements.

Where banks persistently fail to take corrective action, they are issued with orders to "cease and desist" from imprudent and unsound practices. Where that too fails, the bank is called upon to submit detailed proposals for rehabilitation as a viable institution such as by injecting new capital and effecting cost savings. Where such proposals are deemed inadequate, the regulator is required to wind up the bank.

It should also be mentioned that the regulatory authority imposes minimum prudential requirements on licensed banks and supervises them to ensure, as far as possible and practicable, that such requirements are complied with. For instance, the banks are required to maintain a minimum ratio of capital to advances, a minimum ratio of liquid funds, and limit the volume of lending to a single customer and the directors.

However, the soundness, the strength and the viability of the particular bank ultimately rests on the internal governance of that bank in a prudent manner, by its chairman and board of directors, operating through the senior management. In fact, detailed guidelines for good corporate governance have been issued by the Central Bank, to banks last year. Monthly meetings are held with banks where problems and policies are discussed. Other than that, the regulator cannot and does not step into the shoes of the directors or the management of the bank to run the daily operations of the bank.

Intervention by the regulator is only effective in a context that the bank submits itself to a regulatory regime whose aim is to safeguard the safety of the financial system. Where a bank seeks to defy or evade the regulations, and also engages in fraud, the regulatory process loses its effectiveness. In such rare instances, a more comprehensive and intrusive investigation beyond the action that could be taken by a regulator has to be carried out. Such an examination would be time-consuming and expensive and a bank under examination has to be required to suspend operations.

Until that time, a regulator and supervisor can only make spot examinations and require the bank to take corrective action. It expects the bank to comply. No amount of external supervision or regulation can correct an institution that is unresponsive to regulation and engages in fraudulent activity while misleading the public with false information.

In order to discourage such misrepresentation by public companies, the company laws require banks to disclose their "true and fair" position by publishing their financial statements certified by qualified auditors. In the case of banks, these financial statements and auditors' observations are required to be published with an annual report of its performance within five months of the end of the financial year.

These reports should be made available at all offices of the bank for public examination. Also, the banks are required to publish a statement of accounts of their financial performance, every six months in the newspapers. The Central Bank has an approved list of auditors for engagement by domestic banks. Foreign banks are required to publish the financial statements of their global and local operations. The public is expected to inform itself of the true and fair condition of their bank from these reports. The financial media often analyses these reports and its comments are an important source of information to the public.

It has been argued that it is the duty of the regulator to inform the public early; as soon as any bank is faced with problems, so that the depositors could be safeguarded. But there is no easy way by which the timing of such a caution can be ideally determined. By the very nature of banking business, banks frequently face liquidity problems and central banks provide regular financial accommodation.

Where the problem is deep seated and not deemed to be a need for purely temporary accommodation, central banks are justified in declining such requests and seek proposals from the bank for rehabilitation, such as an injection of new capital. If the proposals are inadequate, the Central Bank will have no alternative but to close down the bank and settle the depositors, creditors etc.

The time to go public is at that time and not earlier. If the Central Bank goes public earlier, there will be an immediate run on the bank and it would collapse immediately, perhaps prematurely and unnecessarily. Hence, a Central Bank does not have the option to warn the public of an impending collapse, except to take steps to prevent such a collapse and attempt to rehabilitate the bank.

A careful perusal of audited financial statements and annual reports of banks should yield a satisfactory picture to the public of the strengths and weaknesses of a bank. In this regard, the auditors of the bank primarily have a duty to ensure that timely and accurate financial statements are maintained and published.

The Central Bank works closely with the auditors to ensure that audits are done and information published as legally required.

It has also been argued that the publication by a Central Bank of the names of authorised or licensed banks signifies a recommendation to the public that they could deposit their monies in the licensed institutions with assured facility of withdrawal. That could happen only if deposits are guaranteed, for which an insurance fee will have to be paid. Otherwise, financial savings will have to be made at some risk and the rate of interest payable on the deposit will naturally reflect the degree of risk.

Generally, only lending to a government is considered risk free and hence such lending attracts the lowest rates of interest, which then becomes the price for losing personal control over the money for the duration of the lending. Incidentally, this position was clearly explained in the public information notices that appeared in January and August last year.

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Copyright 2001 The Associated Newspapers of Ceylon Ltd.
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