THE PROPOSED BANKING ACT AND VITAL AREA TO BE CONSIDERED IN THE ROLE OF THE CENTRAAL BAK (PART 2)
Posted on January 14th, 2020

EDWARD THEOPHILUS

Governance – It is not clear governance refers to the management of the Central bank or other trading banks.  I believe that Central Bank has own policy and procedures manuals, which are updated amalgamating internal circulars. However, governance of the Central Bank should consider appointing members to the Monetary Board and heads of departments and other matters.  As the regulatory authority of the financial system of Sri Lanka, which consists of trading banks, Non-bank financial markets, the Development Banking market, the Leasing market, the Stock Market, the Insurance Market, the Superannuation market and other the monetary board of the Central Bank should be consist of representatives from all markets. Central Bank should have the authority to control and regulate all markets.  The Central Bank should not be a market player doing market business such as EPF management, rural credit operations, and development lending, etc.  When the regulator becomes a market player it creates more negative impacts on the regulatory role.

  •  The amalgamation of Off-show Banking Units and Domestic Banking operations into a Single Banking Business – This is also a controversial aspect of bank management. This idea is not clear and since the 1980s this idea has been in the banking circle. The amalgamation of off-shore banking units (FCBU units) might be a good policy action, however, individual banks will object to it.  In this connection, the Central Bank needs to think about risk factors. Many trading banks in Sri Lanka shows profits from exchange earning (For example X bank has the US $ 1000 balance in Off-shore banking unit and the accounting standard of Sri Lanka insists that this deposit needs to record in Sri Lanka rupees and if a US $ 1= Rs 175.00, it will record in the balance sheet Rs 175000 asset and Rs 175000 liabilities to customers.  If the foreign value of Sri Lanka Rupee depreciates and become the US $ 1.00 = Rs 180.00, the end of the month provision records the Rupee value of US $ 1000 increased by Rupees 5000, which treats as exchange earning or profit.  When there are millions of the US dollar balance in a bank, automatically exchange earning goes an upward trend but it is not liquid earning to the bank It is paper profit and the government banks transfer to .the treasury as earning and finally the government uses such book entries for fiscal spending, which supports inflation in the country.  One day a bank chairman asked me although the bank has so much of profits they made by the change in or depreciating value of Sri Lanka rupee, but not real earning from the business. There is nothing wrong with accounting provision, the impact of the increase in exchange profit would be creating more money supporting to inflation. Central Bank should talk with FCBU owned trading banks and should come to regulate the accounting system.

In Western countries, trading banks treat exchange earning as bank profit, however, in those countries, there is a trend of exchange rate going up and down.  In such a situation, treating exchange gains would not be negative to the economy, but in Sri Lanka, it would be negative to the economy when there is a continuous depreciation of the foreign value of Sri Lanka rupee.  Originally, the legislation to establish the Central bank aimed at stablishing the domestic and foreign values of Sri Lanka rupee and the stabilization of the economy, despite these aims the central failed to achieve aims.

Amalgamation of off-shore banking units and domestic business such as export and import business is good policy, however, Sri Lanka has a trend in boosting international business, in such a trend, it is better to allow international business to major banks with standards and small banks and non-banking financial institutions should give only retail international business such as providing services to tourists, and making inward and outward remittances. Exchange contracts (forward) for export and import businesses should do only major banks. This idea needs a broad debate, which should be participated by customers, banks and government policymakers.

  • Improving Resolution, Enforcement and Supervisory Actions – The Central has a major role as the banker to banks and the nation.  This role needs to expand covering non-bank financial markets, which creates many problems in the financial system. The regulatory role is the priority of reserve banks in all countries and supervisory actions also have become vital as an aspect of the role and many banks and non- financial institutions need well supervision and good advice to remain as solvent institutions.  Banks and non-bank financial institutions have no policy and procedures manuals.  These institutions don’t conduct risk asset reviews once in two years and classify credit portfolio and make credit loss provisions.  Bad credit decisions will increase in non-performing credits and finally, institutions should go courts to recover loans and exercise para te execution regarding fix or floating mortgage charges which might not appropriate in a democratic society.  Credit loss may create unexpected loss to banks and when the loss cut off from the capital the balance sheet many reflect negative net worth.  To avoid this situation, the regulation and the supervisory acts of the central bank must effective. banks and non-bank financial institutions must need risk acceptance criteria for customer and industry-wise.  The central bank must guide banks and non-bank financial institutions to do these works.
  • Capital ratios are expected to increase – What is capital of trading banks and non-bank financial institutions is a broader area and financial text writers outlined that capital functions as the provision of funds for the development and expansion of finance organization’s infrastructure, to provide buffer against unexpected credit losses so to protect depositors’ balances and work as contributor to the profitability. Balance sheet items such as ordinary shares that should be called or paid up shares and not uncalled shares or unpaid capital, preference shares, convertible notes that began as debts instrument such as bonds or treasury bills, retained earnings, general or special reserves, minority interests in subsidiaries, provisions, which don’t represent permanent commitment such as credit loss provisions, subordinated debt, and perpetual floating-rate notes are considered as capital. In the prudential supervision process, capital ratios expected is given in BIS regulations.

Capital ratios are considered as capital to some balance sheet measures.  The widely applied capital ratios are the ratio of capital to total assets, which is also called the gearing ratio.  The other important capital ratio is the ratio of capital to risk-adjusted assets.  This ratio is an attempt to relate the risk associated with the bank’s differing assets portfolios to its ability to absorb unexpected losses. Risk weighting to different kinds of assets in Sri Lanka is a quite difficult task.  In the risk weighting process, my experience is temporary overdrafts, Bills Receivable and investments in subsidiaries contain very high risks. Bank of England has published many articles on this matter in its Quarterly Bulletin. The Central Bank of Sri Lanka can use a risk-weighting system advised by Bank for International Settlements.

As I mentioned before Law of Negotiable instruments has been changed by many countries and the central banks as the regulatory authority and the banker to banks need to consider modernizing the law relating to negotiable instruments and laws of banking operations. From time to time the central bank issued instructions and Weerasooriya (1974), Banks and Banking Law in Ceylon have summarised the law and it should be updated by the central bank. Merchant banking is a new area of development and electronic banking has created many problems creating liabilities to banks and customers.  Many countries have taken steps; however, the actions or response of Sri Lanka is slower and there should be regulations to spend at least 5% profits for staff training purposes, which is the direct way to enhance productivity, preventing frauds, improvement of credit quality and many areas. Banks, which spend 5% or above annual profits for staff training should be given tax concession and for double deductions like in some countries.

Banking is a highly dynamic business, which has a trend to change policies and procedures.  Many bank executives in Sri Lanka have poor knowledge and practical experience in this area     

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