Suspension of parate execution won’t do; establish Bad Bank to resolve issue permanently: Dr. Anil Baddevithana

Dr. Anil Baddevithana

There is a sustainable solution in setting up a licenced specialised national bank which I call a ‘Bad Bank’ by the Government as a public-private partnership or PPP. Its task should be to buy and restructure bad debts from the lending banks and support the MSME sector with advisory services and continuous business supervision for recovery and development. The private sector shareholders will be the licenced commercial and specialised banks. It can get funding as well as technical assistance from the Asian Development Bank, and the World Bank’s private sector lending arm called the International Finance Corporation. Even the US Government’s international development agency known as the USAID can be invited to help.  It should be aptly named to signify its mission as a ‘National Recovery and Renewal Bank’ or NRRB

Suspension of the use of the parate execution power

The Parate Execution power, exercised by lending banks to recover non-repaid debt by borrowers by selling assets without going through the judicial processes in a recession hit economy, has become a hot topic today. While the Central Bank maintains that that power should not be removed, the legislators who represent the people think otherwise. They have jumped on the campaign wagon of the micro, small, medium, and small entrepreneurs, popularly known as MSMEs, and pressured the Government that these entrepreneurs should be given relief through an administrative direction to lending banks not to exercise this power at least till the end of the year. Since this is an election year, the Government too cannot ignore this call. Hence, it was announced that the Cabinet has decided to suspend, against the announced stand by the Central Bank on the issue, the exercise of the Parate execution power by banks in the case of the MSMEs till the end of the year. But it has led to a legal hurdle since the provisions of a law enacted by Parliament cannot be suspended by a directive from the Central Bank or a decision of the Cabinet. At most, it should be done by persuading banks not to exercise this power through moral suasion. That is a technique used by central banks throughout the world to get banks to do things which are not permitted by law by waving a stick in a threatening manner. 

An economy hit by negative or low performance

In this background, I had a discussion with an ex-banker, Dr Anil Priyanka Baddevithana, who has experience in addressing the issue of non-performing small loans, while maintaining the safety of the funds provided by depositors. Baddevithana had been a leading figure in the formation of the HDFC Bank in Sri Lanka in early 2000s and the establishment of the HDFC Bank in the Maldives later. He was the Senior Deputy General Manager of the former and the Managing Director of the latter. Both were housing banks and therefore very much prone to the vicissitudes of the fluctuation of the economic performance of the countries concerned. When the going is good, loans, including housing loans too, do well. But when it is bad, the first casualty is the loan repayment records maintained by borrowers. In that context, the very first casualty is the MSME loans since these borrowers are the very first victims of a negative or a slow economic growth. Sri Lanka which had a negative economic growth for six consecutive quarters beginning from Q1 of 2022 and a marginal improvement in growth in Q3 and Q4 of 2023, offers the best example of delivering the death knell to the MSME sector. Since the growth expected in the next three years is also very low, compared with the country’s historical growth average of about 4% in the post-independence period, the light is very gloomy at the end of the tunnel for this sector. Hence, the sector which contributes more than a half to the national output and provides livelihood to about 65% of the work force, including self-employment opportunities, merits special treatment by the authorities. 

Permanent solution: the Bad Bank

I asked Baddevithana about his views on the Cabinet decision to suspend the execution of the Parate rights by banks to provide relief to the MSME sector. “It won’t help the sector to come out of the present economic crisis” he said. “Rather it will set a bad precedent too. In future, whenever such a crisis occurs, the Governments in power will seek to resolve it, getting the banks to bear the full brunt and eye washing the borrowers. Rather, the permanent solution comes from a joint effort by banks, the Government, and the Central Bank by taking over these bad assets and rehabilitating them. This is the case for a ‘bad bank’ which I will explain fully later.”

Long delay in delivering justice

“Parate execution has a history,” he told me. “For millennia, the disputes between the borrowers and lenders were settled by resorting to judicial processes. A good example is William Shakespeare’s drama on the Merchant of Venice. It was the judges who were expected to go into the details and provide relief to either the borrower or the lender or to both. As a result, the acquisition of assets pledged by a borrower to a lender could not be done ex parte. Once the judgment was delivered, it was the duty of the fiscal officers and auctioneers to sell the asset and pay the lender. This was the principle enunciated in the Roman-Dutch Law which Sri Lanka also follows. But it took a long time, sometimes five to six years for a court to deliver a judgment on a case. In that case, the lender became a victim and therefore, he did not have incentives to lend money to borrowers at all.”

State banks had enjoyed this power throughout

I reminded him that even the banking commission appointed by the colonial Government in 1934, popularly known as the Pochkhanawala Commission headed by its chairman, had observed that Roman-Dutch Law was an obsolete legal instrument to tackle disputes between borrowers and lenders. “Yes,” said Baddevithana. “Even at that time, lending institutions in the UK had been permitted to recover debt without going through courts. Since by this time the incidence of purposeful loan defaulting too has been on the increase, Ceylonese authorities also had felt the necessity for allowing banks to recover loans by following a simple procedure. Accordingly, the Agricultural and Industrial Credit Corporation set up in 1943 was permitted to recover debt by resorting to Parate execution. This corporation and the State Mortgage Bank were amalgamated to form the State Mortgage and Investment Bank in 1971 and the new bank was also granted the Parate execution power by the Parliament. Before this, in 1961, the People’s Bank and the Bank of Ceylon had been given the Parate execution power by the relevant statutes, again approved by Parliament. In 1985, this power was extended to the newly formed Regional Rural Development Banks (RRDBs) through a statute approved by Parliament. Hence, Parate execution power had been used selectively by several lending institutions in Sri Lanka as approved by legislators from time to time. Ironically, it is these legislators who now ask for its temporary suspension.” 

Creating a level playing field for all

I asked him how it became a general law in Sri Lanka. Explained Baddevithana: “By late 1980s, it was felt that there was no level playing field for lending institutions in Sri Lanka. The banks owned by the Government had the Parate execution power to recover loans easily, but the private banks still had to go through the cumbersome courts procedure to recover loans. To remove the inequity, President Ranasinghe Premadasa, on the advice of the then Central Bank Governor, Dr Neville Karunatilake, enacted the Recovery of Loans by Banks (Special Provisions) Act in 1990 permitting all licensed commercial banks and specialized banks to use the Parate execution power to recover debt. As a result, they all could sell an asset pledged by a borrower for a loan just by passing a resolution to that effect by its Board of Directors if the loan has become a non-performing one. They didn’t have to seek court’s approval for that. This was how it became a universal principle in Sri Lanka.” 

Not the first resort but the last resort

But that seems to be a draconian power being enjoyed by a section of the population, namely lending banks, to seize assets without following the judicial process, a right which people enjoy under the Roman Dutch Law. I asked him about it. Says Baddevithana: “That isn’t the case as argued by many. Parate execution isn’t the first resort to loan recovery by a lending bank. According to the best banking practices followed and instructions issued by the regulators, that is the last resort which they can turn to if all other ways of loan recovery have failed. According to these practices, banks should follow a certain set-procedure when a loan has turned sour. They should first contact the borrower who is not repaying the loan regularly and come to a settlement for it. If it does not work, then, the bank should seek to rehabilitate the borrower by helping him to come out of his problems. If this also does not work and the borrower is absconding, then, there isn’t a way for the bank to protect its depositors. It is at that stage that they should resort to Parate execution rights. Normally, it takes a one-to-two-year time-period for banks to reach that stage. Hence, it should be applied only for chronically defaulting borrowers who cannot be contacted or rehabilitated at all. Hence, it isn’t the first resort but the last resort. If banks use it as the first resort without following the due process, then, it is bad.” 

Protecting enterprises to protect banks 

Then, why is there such an objection to its use today? I asked Baddevithana. “It’s a special situation,” he replied. “The economic hardship that prevailed over the last three years has affected all the businesses – large, medium, and small-scale businesses – in the country, and severe cash flow pressures have made it difficult to service debts that were taken during better times. The forecasts of growth at the time of due diligence to underwrite credit simply disappeared as the national economy collapsed under a mountain of Government debt that needed to be surmounted before any optimism or sustainability could return to the markets. Therefore, for successful utilisation of the limited breathing space given to the MSMEs with a suspension of Parate execution, there has to be planned action to protect the enterprises as well as the banks because the last moratorium given on loan recovery during the pandemic led to a compounding of the problem. Different financial institutions have used different formulas to recover the accumulated debt, making it unrealistic for businesses to grow sufficient revenue inflows in a climate of economic uncertainty, public maladministration, corruption and the brain drain. Protests, demonstrations and disruptions continue to be the way of life, making business recovery and sustainability a distant dream for many enterprises.” 

Rising NPLs

Baddevithana further elaborated on his point: “In terms of severely stressed sectors like tourism, NPLs are 33%, with transport and logistics at 30%. The restructuring of debt without resorting to Parate execution is a prudent practice to resolve non-performing loans in sectors like tourism where the recovery from the Easter bombing and the pandemic debacle will have to be over a very long term and unless a more proactive solution for recovery than a moratorium on the acquisition of properties of loan defaulters by banks is formulated, the industry is only delaying the inevitable, and could also take down the banks with them.”

Setting up a Bad Bank 

Then, what is the way out? I asked him. He said: “There is a sustainable solution in setting up a licenced specialised national bank which I call a ‘Bad Bank’ by the Government as a public-private partnership or PPP. Its task should be to buy and restructure bad debts from the lending banks and support the MSME sector with advisory services and continuous business supervision for recovery and development. The private sector shareholders will be the licenced commercial and specialised banks. It can get funding as well as technical assistance from the Asian Development Bank, and the World Bank’s private sector lending arm called the International Finance Corporation. Even the US Government’s international development agency known as the USAID can be invited to help.  It should be aptly named to signify its mission as a ‹National Recovery and Renewal Bank’ or NRRB. The capital structure and the management can be designed to be private-led, giving all participating banks, private institutions and the Government a shared responsibility for decision-making. It should be staffed with specialised market professionals and turnaround experts possessing capabilities for recovery and development funding.”

Funding of the Bad Bank

Baddevithana further elaborated on this proposed NRRB: “As for the funding structure, the participating banks would become shareholders, contributing to the capital of the bad bank, and their shareholding could be prorated according to the value of the NPLs to be sold under the supervision and approval of the Central Bank. The multilateral agencies such as the ADB or IFC may become shareholders and appoint Board Directors with an undertaking for debt funding on a business model that meets with their approval. The Central Bank’s sanctioning process for financial institutions to sell NPLs will be based on the determination of a threshold for them to manage, say, about 2.5%, which the industry achieved in 2017 while selling the rest to the NRRB on a discounted present value on a book transfer for the purchase of voting and non-voting shares according to the terms of a shareholders’ agreement. This would clean up the balance sheet of the banks where the debt provisioning will decline in proportion to the investment in the capital of NRRB.”

Boosting the resources of the Bad Bank

“There is another way to boost the funding of the proposed NRRB,” says Baddevithana. “That is the use of the money recovered from stolen assets by those so-called economic assassins or miscreants about whom there is growing concern by the public today. In this way, its mission could be widened to engineer economic revival based on investment and lending to startups in special segments like artificial intelligence, food sciences, agriculture, and innovative technologies and so on. It can not only provide direct funding to them, but also guarantee for them to raise funds elsewhere.”

Hoping for making the Bad Bank a Golden Bank

Why do you call it a ‘Bad Bank’ if it’s so vital to the economy of Sri Lanka? I asked Baddevithana. He laughed: “That’s because it has only bad loans in its portfolio. But like the garbage which can be converted to gold through its further use in a circular economy, this bank can turn the bad loans into golden loans through its close supervision and technical support. Hence, it’s a matter of time that the so called ‘Bad Bank’ will be known as the ‘Golden Bank’. Let’s hope for this.”

So, let’s hope for it, along with this seasoned banker. 

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected])