By Dinesh Perera
The Central Bank has been taking out all its regulatory energy[i] on the Non-Bank Financial Institutions. The current 25 percent cap on ownership targets only the NBFI sector. The earlier guise to this regulatory movement was the need to be compliant with BASEL 3. However, the not so subtle true purpose of the regulation is best given in the words of the IMF[ii] ‘The CBSL’s six-fold increase in the end-2020 minimum equity capital requirement for NBFIs is expected to strengthen capital positions while promoting consolidation of small institutions.’ A truism, increasing capital six-fold would invariably strengthen capital positions, followed by the actual objective of the policy.
The identified problems with the NBFI sector are always more true for the Banking sector. For instance issues of concentration of control are more salient at HNB where they just changed their articles[iii] to allow for longer tenures of directors. The problem with the proposed regulation and the framing of the discourse is that through abstraction the Central Bank is avoiding the actual issue. Instead of asking whether institutions are making good loans they are trying to debate something more within the remit of our companies act.
This debate on finance companies is peculiar to our nation. The notion of limiting finance companies is odd as they are associated with the smooth functioning of specialist credit. Our finance companies are an anomaly, they are really savings and loans institutions, in the sense that they can accept public deposits. This pseudo banking nature of the industry is problematic in that it calls for more stringent regulation of the industry. This is more than semantic as the Central Bank’s classifications have legal ramifications and there is no room for the existence of Finance companies separate from the current definition. Here, the regulator is not being flexible in allowing finance companies to become leasing institutions.
Context
Our capital markets, payments system, lending infrastructure, public debt, and monetary policy are all weak. Our reluctance to change has left us for instance with systems where digital documents are manually signed and then scanned and then uploaded[iv]. All the benefits of being digital are lost. At the very least the original digital document sans the signature could be uploaded. This is not just symptomatic of a lack of common sense widespread amongst institutions but also the lack of a feedback mechanism with those in power.
Finance companies are a fix to this weak system. They look to minimize unnecessary processes and provide credit. They act as a shield against regulatory harassment that would indirectly impact small enterprises. In the governor’s world of provisioning, only the wealthy would have access to credit further perpetuating the current lack of investment outside Colombo.
Contrary to bank-led lobbying of public opinion[v] IFRS 9 does not change the value of a bank. Being able to record a lower profit and thus pay a lower level of tax is something people with money tend to strive for. A firm’s accounts combined with regulatory directives on provisioning do not actually represent value held. People do not trade banking stocks solely on the audited accounts. Receivables are hard to measure especially when relying on the company to disclose values publicly. Paying out dividends can be done when receivables are received. The people who currently control the banks are not that patient.
Regulatory Priorities
A CBSL failure recently in the limelight is the inability to control market rates[vi]. This is due to the weak transmission of monetary policy within the banking networks. Low access to the government securities market combined with a high concentration of deposits amongst a few banks means that there is very little competition amongst rates. This is made worse by a tax structure making the effective rate of return on fixed deposits relatively high.
Within the current market environment, people are not able to make money by trading on large disparities between the risk-free and other market rates. Trading in government securities due to unnecessarily high minimum purchases and the lack of an accessible market means that trading in government securities is limited to primary dealers or banks. Oddly people needing to hold government debt are actually taking a considerable risk[vii]. This risk is through poor oversight and considerable counterparty risks.
Normal members of the public, contrary to plans made as far back as 2013[viii], are still restricted from accessing the debt markets. Those wishing to access the debt markets tend to do so through an intermediary many of whom have large related party transactions[ix]. Worse are the banking institutions who sell repurchase agreements on the treasury bills they hold as if they were actual treasury bills. Notions of counterparty risk[x] are foreign to our capital markets discourse in spite of already having considerable failings.
Who Finance Companies Deal with?
A more complex network of specialist lenders who are financed through risk-bearing capital would be the actual solution to the current ‘risk aversion’ of the banks[xi]. If the Governor wants, there to be increased investment in the economy he should let finance companies deal with a small enterprise. Currently, we have an LKR 2 trillion fund[xii], the EPF, made up mostly of government debt and growing sizably every month.
As so many savings are plowed into government securities the onus falls on the government to invest wisely. The banks in a world of fewer finance companies and much smaller equity positions than the fund will just be making fewer of the same loans to the more anglicized clientele at higher margins. They would not be forced into making the project loans that the Central Bank imagines.
Finance companies are good in that they deal with a lot of people. People the banks would readily shun. Consider limits on online-based fixed deposits. At Commercial Bank the minimum for a 5-year deposit is LKR 100,000. That is about twice the median monthly income. Finance companies on the other hand readily make deposits. On smaller sums of money, deposit insurance makes higher rates of return less risky.
Actual Fixes: Short Term
Finance companies need better regulation. However, limiting ownership can drive incentives to make riskier loans or siphoning money. The central bank can always do more thorough examinations[xiii] and wind up companies who are committing fraud. There are actually a lot of things the Central Bank can do in the interim period as opposed to fire sales to limit risk to the financial system.
The Central Bank should let the auditor be selected by the minority shareholders. The current system of selecting an auditor is problematic[xiv]. The auditor’s interests are aligned to being selected again by the board who are appointed by majority shareholders. Allowing audit firms to bid their services directly to minority shareholders at the AGM is quite feasible. This should be done for all companies.
The Central Bank should also limit the voting on directors by large shareholders. Minority shareholders should have at least one board seat. Mandate that the CSE allows for digitized systems via a central portal for voting. Disclose publicly the direction of voting to prevent considerable collusion between state held funds and extreme wealth.
Actual Fixes: Long Term
As previously hinted, the Central Bank can use the EPF to easily make the banking system BASEL compliant. A BASEL compliant system would reduce risk. They can use that power then to do away with the Colombo socialites currently on the boards of the leading banks. This, in the long run, will drive mergers.
The Central Bank can force banks to wind up or prevent deposit-taking from subsidiary finance companies. They can further close any state-owned finance company or bank, of which there are many, which do not serve any national purpose.
Why They Won’t
It is difficult due to the complexity of the regulatory movements of the Central Bank to convince people publicly that this is against their interests. It is made even more difficult by the very visceral image of failed finance companies in the media. Why is it not imperative (by 2020) to consolidate the NBFI sector? Put simply it is because the finance companies have an insignificant asset base and play a vital role in credit dispersion to underbanked segments of the population.
It is Simpler to See in the Payments System
Take JustPay a brilliant initiative of LankaPay. There lies a system that allows for retail digital payments at a fraction of the cost of the current credit card system. The system is functional and very well implemented except for a lack of merchants and public adoption.
JustPay’s tariff is a fraction of current merchant transaction rates[xv]. It allows for the instant realization of funds as it is based on the CEFTS system. This and the allowance for digital wallets could allow Sri Lanka to follow in the footsteps of China[xvi]. Here the Central Bank will prevent the telecommunications providers from allowing the instant opening of digital wallets assigned to mobile numbers (Telco’s anyway collect data sufficient to open a bank account) or allowing the JustPay system to be used between individual bank accounts.
To further make sure the system is not used the Central Bank has set legislation preventing any price benefit to be passed on to the consumer. This is the same that VISA and Mastercard used to gain dominance globally which they were later sued for[xvii]. The rule from a broader document[xviii] is given below;
2.3 Merchant Acquirers are strictly advised to make sure that the merchants do not recover full/part cost of Merchant Discount Rate from the end consumer.
This is to prevent the price benefit from a better-processed payment reflecting in the consumer’s choices. Why should the merchant not pass on the costs incurred in processing the payment to the consumer? This is the same regulation applied domestically on credit card terminals. It is now illegal in the EU. It is like preventing companies from charging a rate different to Sri Lanka railways for the movement of freight. Price differentials i.e.: - lower prices, are what drive consumer choice. Anyone put through the extent of reading economics required to work at the Central Bank already knows this.
It is too ambitious
The fiscal responsibility management act initially placed the bar too high. This made it unfeasible to implement. Why such learning can’t be implemented with the NBFI roadmap? There have been very few consolidations with subsidiary companies being sold off to monetize the ‘never to be issued again’ value of a finance company license. Why doesn’t the Central Bank reprioritize reform on the NBFI sector? Things can be done and have already been outlined to improve the sector. We have already seen it in the regulation of microfinance, the high real interest rates, the political role of banking investigations, and in payments regulation.
(– Dinesh studied at the London School of Economics obtaining a degree in management. You may contact him at dinesh@wronglk.com. The opinions expressed in this article are the author’s own and they do not necessarily reflect the position of any other institution or individual. –)
[i]https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/laws/consultation_papers_20190516_Introduction_of_Ownership_Limits_of_the_Licensed_Finance_Companies_e.pdf
[ii] 2018 ARTICLE IV CONSULTATION AND FOURTH REVIEW UNDER THE EXTENDED ARRANGEMENT UNDER THE EXTENDED FUND FACILITY—PRESS RELEASE; STAFF REPORT; AND STATEMENT BY THE EXECUTIVE DIRECTOR FOR SRI LANKA
[iii] https://cdn.cse.lk/cmt/uploadAnnounceFiles/5661553858915_373.pdf
[iv]https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/laws/cdg/Finance_Business_Act_Direction_No_2_of_2019_e.pdf
[v] http://www.dailymirror.lk/147889/CB-may-go-easy-on-capital-if-banks-hit-severely-by-IFRS-
[vi] https://www.lankabusinessonline.com/central-bank-will-impose-lending-cap-if-sri-lanka-banks-do-not-cooperate-cbsl-chief/
[vii] http://www.ft.lk/article/516369/CB-takes-over-Entrust-Securities
[viii] http://www.sec.gov.lk/wp-content/uploads/consultation-paper-v3..pdf
[ix] https://cdn.cse.lk/cmt/announcement_portal_prod/CTB%20-%20Grade%20Fund_7825033690575333.pdf
[x] https://www.investopedia.com/terms/c/counterpartyrisk.asp
[xi] https://economynext.com/Sri_Lankan_banks_too_risk_averse,_regulator_says-3-14867-17.html
[xii] http://www.epf.lk/
[xiii] http://fiusrilanka.gov.lk/docs/Circulars/2017/Circular-01-2017.pdf
[xiv] https://www.reuters.com/article/us-india-il-fs-auditor/india-seeks-bans-for-deloitte-kpmg-arm-for-alleged-auditing-lapses-idUSKCN1TC1E4
[xv] https://www.lankaclear.com/products-and-services/justpay/
[xvi] https://www.visualcapitalist.com/china-digital-wallets-payments/
[xvii] http://fortune.com/2018/09/18/visa-mastercard-6-billion-price-fixing-lawsuit/
[xviii]https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/laws/cdg/Payment_and_settlement_systems_circular_no_06_of_2018_e_0.pdf