Are deeply-insolvent, licensed, deposit-taking financial institutions the norm in a well-regulated financial system?

Early regulatory intervention and prompt corrective action are profound if the Central Bank is to restore its credibility as a financial regulator, and continue to preside over the stability of the financial system with dignity and to prevent allegations of further regulatory failure

Resolving Financial Institution (FI) failure: Responsibility and accountability – the two key determinants

My attention was drawn in the above regard to the very recent Press Notice of the Central Bank of Sri Lanka (CB) on one of the large pioneer finance companies in the country, The Finance Co. (TFC). What was most profound in this Notice was that TFC was, seemingly, under resolution since 2008 when “TFC was severely impacted by the failure of a number of financial institutions in the Group (obviously the Ceylinco Group)… Although several efforts were made to identify prospective investors and to restructure the company such efforts have not materialised yet.”

The defining statements in this Notice as quoted above are:

1.that the entity has been unsound and obviously insolvent since 2008, almost 11 years ago or a decade ago

2.as a result of the failure of a number of financial institutions in the Group (obviously the Ceylinco Group)…

3.although several efforts were made to identify prospective investors and to restructure the company such efforts have not materialised yet

Re (1) above – Recognising the CB’s statutory responsibility for licensed, regulated financial institutions, It is pertinent to ask if the CB has finally awakened from a very deep slumber in which it was for over a decade, obviously intoxicated by the many investor propositions it was handling over the years!? Was the depositing public informed of the insolvent status of TFC during this period? What is the legal or even moral right for any resolution authority, which was the CB in this case, to give itself almost 11 years to resolve a failed FI? Why was the safety net mechanism of the Deposit Insurance Scheme (DIS) (established in 2010 with compensation claims to be payable from 2012), not used to pay off the majority of depositors (93%) who were covered to the full extent of their capital and interest? 

The safety net mechanism – It has two components – the first, the Lender Of Last Resort facility (LOLR) granted by the CB to solvent FIs, to deal with temporary illiquidity problems and to prevent systemic risk; the second, the mandatory Deposit Insurance Scheme (DIS) to safeguard the depositors of insolvent, failed, FIs.

The raison d’etre for a DIS and its modus operandi – The global financial crisis of 2008 provoked the establishment of a DIS in most countries, to restore depositor confidence in their financial systems which had been shattered by the effects of the crisis. Many countries which did not have such a mechanism, were forced to issue government guarantees to depositors till they were able to establish a mandatory depositor protection scheme. 

Even here in Sri Lanka, the Pramuka Bank failure and the aftermath of the GFC, prompted the conversion of a voluntary DIS which had long been established and in which there was little or no participation, except for the CRBs, into a mandatory DIS in 2010, with compensation claims eligible to be paid from 2012, giving a period of time for the Fund to grow. Up to 2014 covered deposits were 200,000; in 2014 right up to 2018 it was 300,000 and in 2018 it was increased to 600,000. The objective of any DIS is to fully insure the largest number of small depositors. 

Hence as stated in the CB’s press notice currently, 93% of depositors of TFC will be fully covered which means that all deposits including accrued interest, which are, in total, not more than 600,000 will be fully paid. The DIS publishes its annual statements in the press and as at 2018, it had a fund of just under SL Rs. 50 billion – more than adequate to meet the claims of the covered depositors of TFC.

Modus operandi – To trigger claims on the DIS, first the FI has to be insolvent and where recapitalisation is not possible, obviously within a reasonable time, liquidation of the FI which is, perforce, the only option available thereafter, makes it mandatory for all covered deposits to be paid within a period of 6 months from liquidation.

The cost of undue regulatory forbearance and procrastination

Taking the case of TFC, if the CB had not procrastinated for so long, it could have liquidated the company at least in 2012 – four years after the DIS was established – giving itself sufficient time to study investment proposals, recapitalise it or restructure it – and as soon as the DIS was mandated to pay compensation, even if it meant that the CB or the GOSL had to fund the DIS to a certain extent. Its liability would have been only limited to Rs. 200,000 or, right up to 2017 even to a slightly higher amount of Rs.300,000. The accrued interest payments alone have enhanced the liability of the DIS significantly. This then is the cost of undue regulatory forbearance. Even the operational expenses of the TFC, progressively increased in the absence of a positive interest income, giving it a negative interest income of as much as 14%!

Uneven playing fields

To permit insolvent institutions to operate alongside the strong, well-managed, solvent institutions in the system, for over a decade, contributed to an uneven playing field and makes it evident that the management of the CB may have been trying to avoid a liquidation at any cost, in view of the heavy burden of work it would entail, including considerable legal processes that would have inevitably ensued, particularly from the considerable vested interests in the TFC that have, hitherto, thwarted all attempts to progressively liquidate the company, in the fear of exposing the obviously fraudulent practices that led to its insolvency which would have, perforce, come to light. It would have opened up a ‘can of worms’ as a result of forensic audits that would have had to be commissioned and the case for liquidation having to be presented to Court. 

Very senior management personnel at the CB very vividly remembered the prolonged, numerous, legal suits that ensued from all quarters in the aftermath of the Pramuka Bank failure and therefore may have wished to avoid a repetition at any cost. Many of them were on the brink of retirement and wished to exit the CB’s service with the least trouble. Some of them also had the time to write books whilst at the level of Deputy Governor! Thus it’s of little or no surprise that not only did the CB shirk their statutory regulatory responsibility to the public at large, scandals like the alleged bond scam which took place under their very nose and for which they had direct responsibility, brought shame to the hitherto hallowed and revered image of the CB, which in its untarnished history of over half a century had never been exposed to such disgrace and shame.

Accountability of the CB for transparency and public disclosure

In terms of the Law (the FBA), where it was evident that TFC was in deep financial trouble since 2008, the CB had a host of options at its disposal to deal with its unsoundness, with a view to protecting the interests of the depositors. Accordingly 25(1)€), inter alia, provides for the publication of the name of the finance company as a finance company regarding which the Board has serious supervisory concerns. Such disclosure puts the public on notice and can always be supplemented with what resolution action the CB is taking to restore its soundness. However, the CB has, consistently, desisted from doing so in the fear that such disclosure will cause a run on the FC, which will further aggravate its condition and can even lead to systemic risk. This fear can be traced back to the Pramuka Bank failure as well where, weeks before its failure, its name appeared amongst all the other stable licensed FIs in the annual publication made by the CB of such institutions. That was almost two decades ago. It is sad that the CB is still in this mindset in breach of its statutory responsibility to the depositing public!

Can the CB rightfully escape its regulatory responsibility to the depositing public on the grounds of market implications? This is where it’s best regulatory skills are called for to allay public fears, with convincing, supervisory actions that a strong and committed regulator must, perforce, take in a well formulated, transparent, communication policy. Therefore it is incumbent upon the CB, from the Monetary Board downwards, to receive periodic reports at frequent intervals of the progress of the resolution process and how viable any recapitalisation options are, whatever these resolution processes were. 

A press conference, under the auspices of a very senior official of the CB, if not the Governor himself, to inform the public of whatever action the CB proposes to take in their best interests and most importantly, the assurance that, in view of the availability of the safety net mechanism of the DIS to cover the majority of the depositors, they should place their confidence in the CB to act in their best interests at all times, thereby averting systemic panic.

It is evident that over the years, all the options available to it were used to restore the company (TFC) to stability, none of which were successful. Section 34(5) of the FBA very clearly says that the Board may, at any time after the taking over of the administration and management of a finance company under subsection (1), …direct the Director to apply to wind up the company, if, on a report made by the Director or any person authorised by the Board, it appears to the Board that the company cannot be made viable and solvent within a reasonable period of time. 

Sec.35 gives the CB legal immunity for such decisions taken which are, to all intents and purposes, deemed to be in good faith and in the larger interests of the depositors of the company. 

Integral to the discharge of its statutory responsibility for licensed regulated FIs, is that the CB must recognise that it is accountable to the depositing public to keep them informed at all times of any supervisory concerns it may have, which may adversely affect the financial soundness of any licensed, regulated entity which has, hitherto, not been disclosed and which may, therefore, mislead the public into believing that it continues to be sound. 

In the case of ETI and TFC, the audit qualifications of their annual audited accounts, are a stark revelation of the seriously unsound condition of the companies, where doubts have been cast on their “going concern” ability. All of the key prudential regulations were breached to a significant extent. Unfortunately all this information is contained in the glossy annual reports made available to the shareholders. The public however have to contend with what is required to be published in the print media to satisfy the mandatory disclosure requirements of the CB, where a full page publication of the audited balance sheet and the P & L accounts of TFC are made every year. (I am not sure if ETIF even complied with this requirement.) 

The last such was for 2017/2018 and despite every key performance indicator and all the key prudential ratios relating to capital, liquidity, and impairment provisions etc. being seriously deficient and where the accumulated losses and the negative net-worth posted were phenomenal, the disclosures in the audited accounts dealing with the eight audit qualifications and the company’s inability to continue as a going concern, were omitted. However, neither the company nor the CB, had made any qualifying, explanatory note in the accounts, which gave the impression to the reading public that a highly negative balance sheet and profit and loss account was the accepted norm in the financial system of Sri Lanka! More so because the company had the audacity to acclaim that notwithstanding its blatantly insolvent financial condition, it was the pioneer of financial service excellence in the country!

Did the regulators at the CB ever pause to consider if the whole objective of mandatory publication of annual audited accounts was serving any useful purpose, particularly to the depositing public who are not financially savvy to understand financial statements. It is obviously this ignorance of the depositing public that was exploited to the hilt by both the CB and the TFC.

As disclosed in Note 44 to the Financial Statements, the company’s total liabilities exceeded its total assets by Rs. 14, 476,503,678 (2017: Rs. 14,405,020,161). Further, as explained in detail in Note 45 to the Financial Statements, the Company has not complied with certain directions issued by CBSL relating to the minimum core capital requirement and capital adequacy ratio. Hence, there is a significant doubt on the ability of the company to continue as a going concern.

This then was what the depositing public had to contend with on disclosures of the true financial condition of TFC, with the CB totally ignoring the grossly misleading information made available to the public, the TFC’s name being published alongside all the other stable, sound licensed FCs and this charade in financial disclosure of a licensed, regulated, but seriously insolvent financial institution, going unnoticed even by the financial press in the country. 

Re (2) above, on its own admission the TFC’s failure is attributed by the CB to the result of “the failure of a number of financial institutions in the Group (obviously the Ceylinco Group)”… However, to-date there has been no information on these financial institutions in the Group which comprised licensed finance companies, leasing companies, a savings bank, a commercial bank, primary dealers, their total undischarged liabilities, how these FI failures were resolved, if at all, and what legal action has been taken against the directors and the senior management personnel. 

Neither the CB’s annual report nor its financial stability report, both published annually, contain any disclosures or information either, in this regard, or even on the current FIs under liquidation and resolution and the progress of any recapitalisation by investors, if any. It is indeed commendable that the incumbent Governor who inherited this ‘can of worms’ has at least dealt with three long-insolvent FIs to liquidate two and to remove them from the system and to hand over the third to an investor. 

Thankfully, thus, the covered depositors of the liquidated FIs are being paid after almost a decade, up to a maximum of Rs. 600,000 and that is almost 85% of all depositors who languished for so long and were denied their rightful claims from the DIS, due to so-called investor interest which never materialised. It is pertinent to ask what the fate of the depositors of the FI which was handed over to an investor has been. Have they been paid and if not, how long will they have to wait to be paid in full. Would they not have been better off if that FI too had been liquidated and their claims paid under the DIS?

ETIF and the lack of transparency

In this regard even the President’s attention has been drawn to the lack of transparency in the CB’s dealings with the sale of assets of the other large failed FI – ETI Finance. At a very recent meeting of the National Economic Council the President highlighted that the ETI depositors should be compensated as soon as possible. 

Several observations made by the National Economic Council on the sale of assets belonging to ETI Finance were presented at this meeting. The Council in their observations show that it is unclear as to whether the two local companies of the three companies that came forward to purchase ETI Finance, “were dealt with transparency during the dealings. It was also highlighted that the highest payment for the depositors was not bargained during the transactions. The council also stated that it is unclear if all three companies were given similar opportunities when placing their bids”. 

In response the CB states that “investors who expressed their interest in this regard were requested to deal directly with ETIF as ETIF was the owner of the assets”. It is pertinent to ask – who represents the interests of ETIF, the CB or still the directors of this highly-insolvent deposit taking company who have the blessings of the CB to preside over the fate of the depositors they defrauded!?

Since mid-January 2018 the CB has taken over the management of the operations of the ETIF as stated in a newspaper report quoted here: “The Central Bank yesterday moved to stabilise the speculative environment recently created by various media reports and to support depositors of both ETI Finance (ETIF) and Swarnamahal Financial Services Plc (SFS) and allow negotiations with potential investors to be carried out in a professional manner (sic!). Depositors will continue to be serviced vis-à-vis their interest payments as normal, but premature withdrawals have been halted temporarily. Deposit maturity dates also have been extended by six months as a purely stabilising measure in the interim period of final negotiations with investors. Under the proposed investment proposals, ETIF will benefit with a cash infusion in excess of Rs. 11 billion with all its subsidiaries receiving a further cash infusion of around Rs. 4 billion. Under this directive the CBSL non-banking division will manage the operations of both finance companies of the group, with the assistance of the existing management teams, whilst the directors will concentrate on finalising the new investment proposal. Analysts expect this directive to be removed in a few months once the cash infusion is completed.”

Bona fide vs. mala fide! – This stance taken by the CB is clearly untenable and thus unacceptable and not in the best interests of the depositors of ETIF, as these are the assets of the ETIF which rightfully belong to the depositors. ETIF’s directors just cannot be trusted to act in the best interests of the depositors after their track record of the breach of fiduciary responsibility at the highest level, with a negative net worth of as much as 19 billion and deposit liabilities of 36 billion. It is incomprehensible indeed that the Board of Directors was not asked to resign many years ago when the company became insolvent. 

The Companies Act also contains mandatory responsibilities for directors of insolvent companies which may not have been complied with. Instead they continue to be entrusted, by the CB, with the sale of the valuable assets of the ETIF in the best interests of the depositors; and the CB has undertaken to do the dirty work on the operational side to facilitate these sales by the directors and their consultants “in a professional manner”! 

The CB just cannot be serious – Is this the same professionalism these directors and their consultants displayed in the way they handled the business of ETIF and defrauded the depositors of their legitimate funds? In the discharge of its statutory responsibility to the depositors of the ETIF, the Central Bank has to assert itself with integrity and vigour and ensure that all sales are carried out under the close supervision of the CB’s management team and that none of the directors or its consultants are involved in these negotiations. 

The sale proceeds of these assets should be channelled through the CB to prevent the directors from helping themselves and to ensure that there are no under-the-counter deals, which most certainly will be resorted to in view of their proven track record of misfeasance. It is only after ETIF’s depositors have been paid out in full, that any surplus can go to its subsidiaries where the ETIF is also the majority owner. This is the responsibility of the CB. It is pertinent to ask – why should any sale proceeds go to the subsidiaries before the ETIF’s depositors have been paid in full?

An independent panel from the industry, whose integrity and independence must be beyond reproach, should be appointed by the CB to deal with prospective buyers, who it must be ensured are not the cronies of the Directors of ETIF or of its consultants. The sale of the assets of the ETIF require very close scrutiny of the CB and must move out of the control of the directors of ETIF with immediate effect. 

There is already an allegation that these assets have been transferred to a company in which the daughter of one of the directors is a director! What then, it is pertinent to ask is the CB’s management committee doing while these transactions are happening under their very nose? Housekeeping for the directors and consultants so that they can concentrate solely on continuing to help themselves to the assets of the company which is the only salvation for the depositors?

For the information of the incumbent Governor and the members of the Monetary Board who are suffering the backlash of all the media attention on these transactions, it is important to look back at the 1980’s finance companies crisis where the CB took over the management of many of these companies and handled the sale of their assets themselves. The CB’s officers and the CB’s Legal Department who handled these failed companies worked diligently to save whatever there was for the benefit of the depositors of these failed FCs. It is therefore pertinent to ask, what is so special about the assets of ETIF and its subsidiaries, that the directors and consultants who should quite rightly be languishing in jail, are thought fit to be entrusted with the sale of these assets, instead of the CB, on behalf of the depositors? 

This is a question that requires the immediate attention of the CB. Does the CB believe that without the co-operation of these unscrupulous directors and consultants, these sales cannot be successful? This is obviously what is made out and for which the CB unfortunately and very conveniently, has fallen hook, line and sinker. 

Since restructuring TFC is still being contemplated, even after a decade of failed investor proposals, the same attention should be paid to such negotiations. The CB just cannot wash its hands off these critical issues since they must recognise that these assets rightfully belong to the depositors of these two institutions and their interests should be safeguarded on a priority basis. Once again it is evident that the CB’s officials do not wish to step out of their comfort zones with the excuse that they will be blamed if anything should go wrong. 

The question arises here – who can be expected to best act in the interests of the depositors – the CB or the fraudulent directors of these FIs? Whatever decisions the CB takes will be taken in good faith, but that certainly cannot be said of the directors of these FIs, who have proved beyond doubt that they have never acted in the interests of their depositors and have deprived them of their legitimate hard earned savings, with the reckless and fraudulent misuse of these deposits for their own purposes. I am confident that there are many statutory examination reports to prove this contention, the 19 billion negative net worth notwithstanding.

The Right to Information – Transparency is the need of the hour and the details of all these investment proposals and the sale of the assets of these FIs, should be published for the benefit of the depositors who are the owners of these assets. The CB can prove their good faith and that they have acted in the best interests of the depositors by furnishing the information on these proposals to the President and to the Economic Council. After all, the CB should also be made accountable for its decisions to someone – to Parliament, to the President, to the Minister in charge or to COPE. 

In this same regard, it is also noteworthy that many loss-making FCs using the recently-introduced IFRS, were able to skilfully convert their losses into significant profit within one year (a miracle) and in publishing their audited statements in the press, very craftily changed their names as well without any reference being made to their previous corporate persona which was associated with their weak financial condition. This charade by these crafty FCs went unnoticed to the detriment of the depositing public who were misled by such accounting engineering resorted to with the blessings of the auditors of these FCs too. The need for up-to-date information on the regulated FIs is therefore paramount in safeguarding depositor interest and maintaining public confidence in the regulated financial system.

Depositors’ legitimate rights – Finally it is my contention that when 93% of depositors of TFC stand to benefit from the liquidation of the company, when the totality of their deposits plus interest, will be paid under the DIS, what is the legitimate right of the CB to deny them this benefit even after so long and to call for fresh investment proposals to restructure the TFC for the sake of the 7%? The 93% are not going to gain a cent more than their 600,000 so how will the restructuring benefit them? 

Is the lobby of the 7% so strong that the CB wishes to succumb to this pressure – even the threat of legal action against the CB can be met in any Court of Law when it can be represented that the majority of depositors will not gain from such restructuring but will only suffer further, after having been denied their rightful claims for their legitimate funds for almost 11 years. 

Surely one can have faith in the country’s system of justice to uphold the action of the CB to liquidate the company for the sake of the majority of depositors and where any restructuring proposal can be accommodated after the liquidation, to recover the highly encumbered assets of the TFC for the 7%, through concerted legal action against all those who have plundered the deposits of this company over the years for their enrichment and are still enjoying the spoils, without any legal action being taken to pursue them. 

The Legal Department of the CB should be strengthened for this purpose to assist the AG’s Dept. where any legal action is unduly delayed if at all. These miscreants are named in the company’s Annual Report and are still at large, not to mention the directors whose personal assets have yet to be pursued. 

It is a reflection on the management of the company that it had even invested the TFC’s pension funds in the infamous Entrust and posted a loss of Rs. 144 million as a result? Who is accountable for this decision?

A lesson from the US – I wish to strongly reiterate again and again the lessons we can learn from the pursuit, by the US authorities, of the personal assets of Bernie Madoff who was once the head of NASDAQ and who defrauded the US public of billions of dollars and where the relentless pursuit of his assets and of those of his immediate family, raked in billions which were used to pay off most depositors. 

In conclusion I wish to make two important points for the consideration of the authorities:

1.The failure of these two institutions, in particular the ETIF and the TFC, is so scandalous, it would be in the best interests of the incumbent Governor and the Monetary Board to commission an internal investigation into the antecedents of these insolvent institutions which would pre-empt any other external commissions being appointed, since the amounts involved are so large, much larger than the alleged bond scam. This is an imperative to ensure that the perpetrators are brought to justice and that there is no repetition of these financial crimes in the future, to the detriment of innocent depositors, who chose to have faith, not in Ponzi schemes, but in the licensed, regulated financial system of this country.

2.More importantly, a definite timeframe must be specified in the law for the resolution of failed, insolvent FIs and the conclusion of investor interest – a maximum of one year – after which their liquidation must be undertaken and the covered depositors under the DIS paid off. The sale of whatever assets are available can then take place by the liquidator to pay off the uncovered deposits. With the operation of a very strong regulatory and legal framework, the CB can very well be held accountable for the failure of ETIF and the TFC, where their negative net-worth was as much as Rs. 19 billion and Rs. 14 billion respectively, and which did not take place overnight. “ETI Finance Limited is bankrupt today due to the lack of proper supervision by the Central Bank and because depositors money was poorly managed and used to finance other businesses. As a result, a large group of depositors have lost their investments….” (15 July 2018 – News First). Regulatory failure can be attributed to failure to make timely interventions on the early warning signals that were evident over a considerable period of time, through its efficient, dynamic, offsite surveillance mechanism and to take the prompt corrective action necessary to prevent further deterioration of the company. It is only fair, therefore, that the depositors must be compensated through the safety net mechanism of the DIS without any further delay. More importantly, the Governor may do well to ensure that all those responsible at the very senior level too, those who have since left the service and those who have retired, that did not heed these early warning signals and permitted the insolvency of such a magnitude in both of them, should be held accountable, just so that he is not faced with further instability of a similar nature, which may already be creeping up upon him in a similar fashion. It is high time the incumbent Governor and the Monetary Board made accountability a priority for the breach of statutory regulatory responsibilities in the interests of restoring the greatly eroded confidence in the CB as the regulator of deposit-taking FIs. This is more profound in the background of the Bond Commission Report which was an indictment on the sheer lack of accountability and professionalism at the CB, where many officers were seen to very conveniently turn tables on the previous Governor to save themselves.

Early regulatory intervention and prompt corrective action are therefore profound, if the CB is to restore its credibility as a financial regulator, and continue to preside over the stability of the financial system with dignity and to prevent allegations of further regulatory failure. It must be recognised that we have an excellent regulatory and supervisory framework, which is home-grown by our own officers, without any external expertise. It just needs to be used effectively and enforced strictly in terms of the law without fear or favour.

The Governor and the Monetary Board must understand that a well regulated, credible financial system has no place for highly insolvent, or even marginally insolvent, deposit-taking financial institutions which should have exited the system a decade ago!!

(The writer is a former Director of Bank Supervision and Advisor to the Governor, Central Bank of Sri Lanka, an independent consultant and freelance writer to the financial press.)