THE CENTRAL BANK SHOULD TAKE RESPONSIBILITY FOR FINANCE COMPANIES UNDER ITS ADMINISTRATION
Posted on June 8th, 2020

BY EDWARD THEOPHILUS

A recent statement of Mr. Mahinda Rajapaksa, the Prime Minister of Sri Lanka has stated that the responsibility for the failure of the finance company must be taken by the central bank as the company has been under its administration.  I am fully agreed with the statement of the prime minister and would like to analyze why the central bank should take responsibility. Theoretically, the statement of the prime minister is based on the point that the account administration of the finance company and considering the finance regulations introduced in the country. If there were regulations to prevent bankruptcies of finance companies what were the causal factors for the insolvency of the finance may be a question of depositors. There may be other reasons that could not publicly state such as the political influence and other dishonest relationships may be associated with the issue. I have no idea to look into such points.     

As I reiterated many occasions by posted articles in the Lankaweb the Central Bank as the regulatory authority of the financial system of Sri Lanka must take the responsibility for the regulatory role and administrative strategies that have been applied to manage the finance company ltd after the undertaking of the company.

 In the early stage, although the Central Bank treated as the banker to banks it had not performed regulatory responsibilities toward non-bank financial organizations. Later, when the market dynamic came to light the Central Bank was given more power to regulate finance companies. Were the power given by the new laws suffice to rescue might be an additional problem associated with the problem.  

Under the regulatory responsibilities, the Central Bank’s role was to supervise the operational activities of the finance companies. Was the Central Bank given sufficient power by new legislation and required muscles to manage finance companies is another question? The original law of the Central Bank gave the specific role on account of the trading banks and was the same authority given to control the finance companies is not clear to analyze the role of the Central Bank’s power towards the non-bank financial institutions.  The extent of the Central Bank’s power has not clearly defined and the role of the Central Bank appeared confusing. The regulatory framework adapted after the bankruptcy of the finance ltd disclosed that the regulation adopted by the Central bank was not sufficient to prevent the insolvency and after the bankruptcy of the company the Central Bank has a little option and to play the receivership role. The most vital role was to prevent insolvency rather than taking action after bankruptcy.  

In this stage, it needs to understand that the management responsibilities of finance companies are vested with the company directors and general management. Regulatory advises of the Central Bank usually direct the company management to consistent with the advice which would be dependent on the finding after a regulatory audit.  For example, if the central bank identified the finance company was operating without sufficient capital to contain the risk of company financial assets in such a situation the central bank should have advised to maintain adequate capital to cover the total risk assets. Practically, increasing the quantum of capital might be confusing advice, and deposit holders may not know the advice with a view to responding against the regulatory advice of the Central Bank.   

The bank directors should have contributed the additional capital requirement or transfer annual profits to reserves or convert deposits to the capital with the consent of depositors. In that way, the regulatory advice should have directed to the finance company management, which is responsible for compliance and there is no evidence for depositors whether the Central Bank played the right role to protect depositors. 

Did the Central Bank play such a role as the regulatory authority?  The statement of the prime minister implied that the Central Bank had not played the regulatory role. If the Central Bank had been played the regulatory role the failure of the finance company could have prevented or minimized. If the professional role had not been played by the central bank it must take responsibility for the failure.  The management of the Central Bank (the governor, members of the monetary board, and the executives of the central bank are personally responsible for the breach of trust and this type of harsh responsibility has not been insisted over the executives of the Central Bank before.

According to the freedom of information customers of the finance company (Deposit holders and Credit Customers) have a right to obtain information about what kind of regulatory role was played and advice was given by the Central Bank to the finance company. Generally, the advice of the central bank to the finance company treat as confidential and the court can decide to what extent information could be released to customers and government authorities such as company registration, taxation, and others.     

This was an issue in many countries such as Australia, England, and Canada and during the early 1980s in other countries, and such countries have changed banking laws and regulations. In Sri Lanka, finance law and regulation have not been changed by various governments elected to the office. Why it was delayed, might be a question to the public. 

Banking texts published in Sri Lanka and overseas pointed out the management issues of Non -Bank financial institutions and it is difficult to see that educated officers in the Central Bank informed the government to change the existing legislation to adopt the new environment.

The other point raised from the statement of the prime minister is that the Finance Company was undertaken over by the Central Bank and at this stage, the Central Bank has been responsible for the entire administration (company management and consistent with the compliance of the regulatory authority) of the finance company. The nature of the transaction is similar to receivership, which has broader responsibilities like the owner of the finance company. Under the receivership, the central bank has limited options and the best option is to pay depositors a reasonable amount liquidating the company.  The statement of the prime minister implied that the Central Bank has not performed due responsibilities to take out the company from the management mess and the prime minister stated that on that ground the central bank is responsible for the failure of the finance company.   The Executive Officers of the Central Bank have no practical experience in financial institution management though they have higher degrees of finance subjects.

Customers of the finance company must take responsibility for their deposits.  They were not risk-averse customers and they loved to take the risk to make higher returns than the interest yield offered by trading banks of the country. As a strongly Buddhist country, customers should have concentrated the teaching of Lord Buddha on the desires.  

The government of Sri Lanka needs to develop policies for finance company management and operations and I would like to point out some vital areas.

  • The registration of a finance company should be based on five-pillar factors ( (a) Industry Environment of the finance industry, (b) Competitive Position of the proposed finance company based on the industry average and the proposed company (environment and standards of the proposed company), (c) Operational Knowledge, Experience, Skills, and Capability of the management, vision, mission, and objectives of the management. All these called management quality of the proposed company ( d) the Volume of paid-up capital and the quality of existing assets of the company (e) Accounting Quality of the proposed company).
  • Before registration of a finance company, it needs to ensure that the company chairman and directors have contributed more than 50% of paid-up capital from the authorized capital. Debt capital or preference shares should not allow at least 7 years of successful operations. The Central Bank needs to insist to transfer a least 10% of annual profits to reserves of the proposed company.
  • The Central Bank should train the proposed finance company management on setting rates of interest for deposits and debt finance (credit extension, leasing, Jewelry mortgages, Promissory Notes, floating and fixed charges, fixed and others) based on the prime rate of the Central Bank and contain the risk.  The highest risk factor of finance company management in Sri Lanka is the rate of interest (for deposits and charge).  The practical experience indicates that finance companies cannot offer higher rates of interest for deposits over the interest offered by trading and saving banks to attract more deposits misleading customers and charge a higher rate of interest from borrowers, who cannot afford a high rate of interest.
  • The intention of directors and the past behavior of them must be checked for more than ten years.

Sri Lanka has sufficient finance companies and many companies need to merge, sometimes may need to merge with hostile bids.

It is clear that the Central Bank has a massive regulatory role and it should not play an operational role in the market like superannuation management, rural credit, and others.  It is a conflict of interest and legally wrong.

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