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By Channa Kasturisinghe

The Central Bank of Sri Lanka in its Annual Report 2002 highlighted a timely issue in an article under the heading 'Should banks that fail be bailed out with public funds?.' In this article it has been clearly said that the failure of one bank may lead to a loss of public confidence in other banks too, threatening the survival of even financially sound banks.

Therefore, in the context of the future well-being of the country's banking sector, it would be vital to find out whether failed banks should be bailed out with public funds or not. It was not so long Sri Lanka experienced a sudden collapse of a bank, which the public felt (or were made to believe) was doing well until tragedy struck.

No matter how the Central Bank would justify its stand with regard to the recently collapsed Pramuka Savings and Development Bank, this unfortunate incident has led to a loss of public confidence in the country's banking sector at least to a certain degree. However insignificant the effect of this particular incident to the banking sector may be the impact of the repetition of such an event would be far too serious.

It is no secret that there are a few other banks, which are not doing well at present. The President of the Ceylon Bank Employees' Union M.R. Shah told the Daily News that there are several members of his union who are employed in these banks.

"But they do not like to reveal the names of these banks because the mere mention of these names would cause the depositors to withdraw their money threatening the job security of the employees," Shah said.

Asked whether it is possible on the part of the authorities to take action to inform the public on financially unsound banks, Shah said that such practice is not encouraged by the Central Bank as it would cause a premature collapse of these banks before any remedial measure is taken.

"What the Central Bank should do is to strengthen its Bank Supervision Division and make it a more responsible and an effective unit," Shah said.

However, the unfortunate depositors of the Pramuka Bank feel that they should have been informed before the Central Bank took the decision to suspend the operations of Pramuka.

The Pramuka Depositors Association, President, Palitha Gamage said that some members of his association had deposited money just a few weeks before the suspension of the bank and they would not have done so if they had the slightest idea of the risk they were taking.

"The only tangible assurance the depositors had about the stability of the bank was that it was registered under the Central Bank," Gamage said.

In this context it is needless to say that the authorities should take precautionary measures to safeguard the interests of the depositors in case of a bank failure considering the role of the `depositors' towards the success of a bank.

The Central Bank in its article said that deposit insurance could help in safeguarding the depositors by minimising the losses and also contributing to reduce the systematic effect of a failure on one bank.

"Further, the need for public funds for bail outs does not usually arise if there is a deposit insurance scheme. However, one concern in setting up a deposit insurance scheme is the problem of moral hazard as the deposit insurance schemes could tempt banks to take on more risks and depositors too may not be vigilant about banks," the Central Bank said.

Although we cannot ignore the fact that there is a certain element of risk involved in the banking business it would prudent on the part of the authorities to take effective measures to minimise this risk. The consequences of lack of such measures have been elaborated by the Central Bank in the Annual Report 2002.

"Unlike other business failures, any large disruption of banking operations affects the public as a whole and hence, bank failures are treated differently from failures of other enterprises.

A bank failure is a situation where a bank cannot meet its obligations to depositors and creditors and ceases to carry on the business of banking. If a bank becomes insolvent, i.e., when its equity capita is exhausted and its net worth becomes negative, and the authority decides to revoke the banking licence, that bank has failed. A related problem faced by an individual bank is illiquidity, i.e, the inability to meet liabilities on demand in a timely manner. Although illiquidity may be one of the first signs of insolvency, illiquidity does not always cause insolvency. Illiquidity could result from a banking system failure or from a run on banks.

It is important to differentiate between an individual bank failure and a banking system failure. The failure of one bank may lead to a loss of public confidence in the other banks, leading to premature withdrawals of deposits at one time due to fear that the banks may not be able to repay; this is the case of a bank run. The failure of one bank could lead to the fall of other banks, which could even be financially sound banks; this is the case of bank panics.

Further, a problem at one bank could lead to the failure of other banks if they operate on similar fundamental characteristics.

That is, a group of banks could be affected by the same shock, leading to a systemic failure of banks," the Central Bank said.

The question of bailing out a failed bank would only arise after the failure of a bank. What matters are the measures to be taken to avoid such instances. The Central Bank in its article has recommended various alternative methods to address bank failures including the promotion of bank mergers.

"In order to strengthen the soundness of financially distressed banks, they may seek mergers with other banks in the system. There are many instances when banks have voluntarily opted to merge with other banks, though in some countries the authorities have attempted forced mergers as well," the Central Bank said.

However, it is not quite clear why the authorities could resort to one of such methods to prevent the Pramuka debacle. At least to rectify the situation depositors and stake holders have suggested to facilitate a merger of the Pramuka Bank with some other financial institution.

Whatever action the authorities may take regarding the Pramuka debacle the most important measure to be taken would be to further strengthen regulatory and enhancing the screening process in entry to the banking sector.

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