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| Saturday, 19 June 2004 |
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Bank failures: Causes and actions by Susith Randeniya After the spate of finance company failures of the 1980s Sri Lankan depositors were fortunate not to experience the failure of a financial institution until the Central Bank moved in and closed operations of Pramuka Savings and Development Bank in 2002. The closure of Pramuka does not ensure that all other remaining financial institutions are in good financial health. Looking closely at the Banks and Financial Institutions, which are in operation today, it would not be too difficult to identify some potentially dangerous institutions. Let us now give some thought to the core problems, which had been the main reasons for the failure of banking and financial institutions in Sri Lanka. However, it must be admitted that these problems are not confined to our country and even banks in developed countries have been affected by similar problems. The most common problem being the parties having controlling stakes misusing power and position to obtain large advances on very favourable terms. The Banking Act of Sri Lanka is quite extensive and includes many important provisions aimed at minimizing such occurrences. These safeguards and also a plethora of other similar regulations (explained below) are in place to ensure the stability of Banks: 1. Limitations placed on ownership of Banks 2. Spelling out a single borrower limit. 3. Capital adequacy rules. 4. Maintenance of the statutory reserve ratio. 5. Classification of non-performing advances. 6. Borrowing and other activities of Directors. But having rules and laws is not enough. What is important is to ensure proper implementation of these by Banks and that's where we in Sri Lanka always fail. The Banking Act gives wide powers to the Central Bank, particularly to the Director of Bank Supervision who is statutorily required to ensure all banks comply with the Banking Act provisions, both, in letter and in spirit. At the same time, Central Bank and Monetary Authorities should not toy with these regulations when there is pressure from powerful segments and individuals. Let us examine the importance of some of the safeguards mentioned above. 1. Limitations of ownership of banks The limitation placed on ownership of Banks is 10% in Sri Lanka with an allowance to go up to 15 per cent with the approval of Central Bank. This is one of the main strays of a stable banking system and Authorities should not meddle with this. One may inquire why this condition is so important. This condition, if properly followed, would ensure that no one party or group can meddle with the management to the detriment of other minority shareholders and depositors. It is the natural tendency of a large shareholder or a group of shareholders to look after their own interest first, often to the detriment of others. Past experience of Central Banks world over proves that this 10% limitation on ownership has a very useful balancing and controlling effect on the powers of the bank board members and is regarded as essential for prudent management and good corporate governance. In fact, many second and third world countries are now taking steps to include this safeguard into their banking legislation. In the recent past there were two classic examples how 2 shareholder groups holding more than the stipulated 10% shares made attempts to bend this rule to their advantage. If not for the Central Bank ruling in one, and the Appeal Court ruling in the other, two of the most stable banks, the Commercial Bank and the Sampath Bank would no longer be there today. In the first case, a development bank was trying to get into commercial banking and in the other, a group of companies was trying to consolidate their power through majority ownership of 2 key private banks in one go. Though both these attempts were stalled it took an unusually long time for the Central Bank and the Monetary Board to deliver their rulings despite the clear transgressions of the Banking Act which only goes to show the power wielded by interested parties attracted by short-term gains. 2. Single Borrower Limit The single borrower limit is the maximum amount, which could be lent out by a Bank to one party or a connected group of companies without the express approval of the Central Bank. This limit is arrived at by working out a percentage (currently 20%) of the capital funds of the Bank. The idea here is to avoid banks being unduly exposed to one party in its lending activities and ensure they have a good spread of different borrowers and sectors. 3. Capital Adequacy Another important set of regulations covering banks is the capital adequacy rules imposed by the Bank for International Settlements of Basel, Switzerland. Known as the "Basel Rules" it specifies that all bank lending has to be partly backed by capital funds of the bank and not simply by customer deposits. These rules effectively protect depositor funds by providing a capital buffer against unforeseen losses. It also makes banks more conscious of the need to properly price, get security for advances and ensure timely recovery. 4. Statutory Reserve Ratio (SRR) The SRR requires banks to keep in Central Bank a specified percentage (currently 10 per cent) of their deposits. This ensures that Banks do not lend the entirety of their deposits and that adequate funds are available as a liquidity buffer to meet requests for withdrawal by the depositors. 5. Classification of Non-performing Advances It is important for a lending institution to have a reasonably sound loan book. To this end it is necessary to identify on an ongoing basis, advances which are turning bad so as to take timely action to either reschedule or recover such advances. If this is not done the Bank runs the risk of having to provide for the possible loss out of its profits leading to erosion of capital funds. Sudden and unexpected need for high levels of loan loss provisions will even endanger the depositor funds. 6. Borrowing by Directors and connected parties Borrowing and other activities of Directors are also controlled to an extent by the Banking Act. But there is a serious doubt whether this is properly monitored by the Central Bank because many annual reports of banks (both quoted and unquoted) contains enough disclosures to indict many a director even though no deterrent action has yet been taken. Conclusion In the aforesaid manner banks and banking come under a plethora of rules and regulations more stringent than any other trade or industry. It is mainly because banks deal with large volumes of assets, most of it (at least 90%) backed by depositors monies with minimal exposure of the owners i.e. shareholders. Therefore it is not surprising that banks are tightly regulated. Left to the directors and senior management to run a bank without legislative and administrative controls, they would always do so only for the benefit of the majority shareholders ignoring the depositors who have provided 90% of the resources and minority shareholders. Though Sri Lanka hasn't thankfully seen one, the failure of a big bank can cause havoc to the entire economy. Depositors lose money, borrowers lose their source of credit, the bank may have obligations to other banks, which may fail in return creating a countrywide impact. The problem of thousands of employees losing their livelihoods will be the least of these problems. Recent attempts had been made by interested parties, especially the two Development Banks, and some businessmen with political connections to get the limitations placed on the ownership of Banks removed from the proposed amendments to the Banking Act. The Monetary Authorities should be sharp enough to identify the hidden agendas of such lobbyists and their wheeler dealer principals. Therefore, instead of liberalizing shareholder limits in banks, the Authorities should look at further tightening the limits, so that room for corruption and decisions with self-interest would be reduced. A broad-based shareholding would not only minimize irregularities but would encourage good corporate governance practices that will do more to protect depositors, than all the laws, rules and regulations. (The writer served the Central Bank of Sri Lanka for over six years and joined the E. C. B. Task Force in Eastern Europe where he noted many bank failures in the aftermath of the Russian pullout from the region). |
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