‘Yahapalanaya’ for financial institutions

‘Yahapalanaya’ is a slogan heard all too often in the current political arena; however rest assured this article is nothing to do with politics, rather the financial institutions and the financial system stability of the country. 

In the preceding months we witnessed yet another financial institution/group nosedive, namely the Swarnamahal Financial Services Group, and add to the Central Bank’s list of financial institutions pending resolution. 

apital is no panacea

The primary response strategy of the Central Bank consequent to these distressed financial institutions has been to bolster the threshold capital requirements of financial institutions across the board. The amount of capital a financial institution must hold or ‘capital adequacy’, is a foremost means of regulating financial institutions. 

However, capital adequacy is no panacea for all the ills facing financial institutions. There are other important elements in a financial institution that require regulatory scrutiny to ensure the safety and soundness of the financial institution. Therefore, contemporary regulatory regimes have enhanced focus on these elements, which can be categorised as quantitative elements such as requirements on assets, liabilities, earnings, or liquidity of financial institutions, and qualitative elements such as requirements on corporate governance.

However, the focus of this article is on the qualitative elements and in particular corporate governance for financial institutions. 

Good governance (‘Yahapalanaya’)

It is important to distinguish the meaning of good governance in the context of financial institutions from the political slogan; the latter has come to mean a myriad of things to the politicos as witnessed in the media and could not be further from the intentions of its proponents! 

The primary objective of good governance at financial institutions is to safeguard the stakeholders’ interest on a sustainable basis and in this regard the depositors’ interest should take precedence over shareholders’ interest. Governance weaknesses can affect the safety and soundness of a financial institution and depending on the importance of the institution; it can result in the transmission of problems across the financial system (‘contagion’).

Some may see the irony of a discussion on good governance at financial institutions; given that the watchdog entrusted to enforce these standards itself is in the firing line for its governance practices or the lack thereof in the bond fiasco. Nevertheless, establishment of good governance at financial institutions is a means of prevention rather than a cure to the ills facing financial institutions; and prevention is better than cure! The regulator can promulgate any amount of regulations; however they shall not be a substitute for good governance, as the unscrupulous will always find a way to weasel out of any regulation. 

Licensing and authorisation

This is the process by which the regulator grants approval for the operation of a financial institution. The approval is usually granted upon the prospective financial institution satisfying the entry requirements stipulated by law and regulations. The most common requirements of entry concern ownership, capital and management. 

This is the first step in establishing good governance at financial institutions and its importance cannot be over emphasised. The licensing and authorisation requirements act as a filter by eliminating any unsuitable applicants and letting only the acceptable ones to pass through. In management terminology, these requirements help to prevent the problem of ‘adverse selection’. However, given the proliferation of financial institutions in the country and the institutions that are falling afoul, one wonders whether the regulator has made optimum use of the licensing and authorisation filter. 

Nevertheless, it should not be construed that what is called for is a blanket ban on any new entrants. In fact, a suitable new entrant should be allowed in at the expense of existing mismanaged financial institutions. The Central Bank can improve financial system stability by allowing in suitable new entrants and taking regulatory action on some of the mismanaged financial institutions, such as consolidation or a solvent winding down of these institutions. However, the likes of internationally infamous Lycamoblie referred to in the media as a potential investor for the troubled Swarnamahal Financial Services Group certainly does not fit the bill of a suitable new entrant.

Specialised leasing companies

These are a type of financial institution that engages in the finance leasing business; however these are not permitted to accept deposits from the public. Specialised leasing companies only account for 0.6% of the total assets in the financial system. However, due to the finance leasing business being regulated, the Central Bank must stick out its neck for these institutions, even though they do not mobilise savings like the rest of the financial institutions regulated by the Central Bank (these are not financial intermediaries).

At time when we speak of proliferation of financial institutions and the associated regulatory burden, one cannot help but wonder why the Central Bank needs to regulate these institutions. A simple fix to this issue is to amend the Finance Leasing Act, and exclude specialised leasing companies from carrying on finance leasing business. These companies can continue to operate as consumer credit institutions without the intervention of the Central Bank.

Owners/controlling shareholders

The governance at any financial institution shall only be as good as the owners/controlling shareholders. It is the owners that appoint the directors responsible for the management of the financial institution and if the owners are of questionable background, their appointee directors can be no better.

The ownership is the most important criteria that must be vetted by the regulator at the licensing and authorisation stage. However, as change of ownership can take place at any time throughout the existence of the financial institution, it becomes a continuing requirement and at each time the vetting must be carried out with the same intensity.

The regulator should take an active approach to identify the ultimate beneficial owner/s (natural person/s) of the financial institution, lifting any veil of incorporation in the case of holding companies or group structures. Once the ultimate owners are identified, as redundant as it may sound, it is absolutely essential that the regulator collaborate with authorities like the IRD, Police, law enforcement agencies and other financial sector regulators or in the case of foreign nationals the counterparts of these authorities in the respective countries, to ascertain whether any impediments exists with regard to the owners. Any and all cost incurred for such vetting exercise is fully justified, given that it is the public that has to ultimately bear the huge bailout cost of any failed financial institution run by unscrupulous individuals.

Directors

A similar vetting process to that of the owners should be carried out in respect of the directors of a financial institution and in the case of a holding companies or group structures, the directors of the parent and ultimate parent should be held to the same standards, as they wield direct influence over the directors of the subsidiary financial institution. 

The vetting process for directors must ensure the integrity and competence of the directors. However, looking at some of the current boards of financial institutions, one wonders whether the regulator even considers this criterion. Frankly speaking, the integrity and level of competence of some directors is befitting for three wheeler companies; definitely not financial institutions, where the directors act as the curators of public funds. 

The reality is that in Sri Lanka directors, including the ones in financial institutions, are appointed on their connections rather than on what they can contribute to the management of the company or financial institution (does this draw startling resemblance to how the country’s Yahapalana administration operates!?). Hence, a majority of the non-executive directors are there to merely collect the director’s fee cheque or to foster a mutually benefiting business relationship with the company. 

The regulator should consider incorporating a field in the application for appointment of directors, which requires the prospective director to state the responsibilities or the scope of work expected of the director. In the case of listed financial intuitions the same should be incorporated in the announcement to the CSE. This statement shall form the basis for the director’s annual performance review, which shall be available for inspection by the regulator. This should persuade financial institutions and their owners to appoint directors with competencies to contribute to the management of the financial institution, instead of making appointments solely based on connections. 

‘The nine-year rule’

There is a corporate governance requirement that precludes non-executive directors from sitting on a board of a financial institution beyond a period of nine years. The rationale for this rule is that longstanding relationships among the directors themselves and, between the directors and management could impair the integrity, objectivity and independence of the directors. Therefore, the enforcement of this rule provides an assurance that these relationships are at a level that does not suggest excessive familiarity, undue influence or coercion. 

But, why nine years? It is likely that the rule is a copy paste from a governance code of a developed jurisdiction and therefore has not considered the local context. One would think based on the local experience this period should be shorter.

The rule does not apply to executive directors on the likely premise that if an executive director is required to step down, it would disrupt the operations of the financial institution and attract undue negative press. However, given that executive directors are not immune to the excessive familiarity, undue influence or coercion resulting from long standing relationships and corporate governance requirements dictate that financial institutions have in place proper succession planning, it may be appropriate to reconsider the non-application of this rule to executive directors.

Nevertheless, if an executive director subsequently becomes a non-executive director, the above rule shall apply and the nine year period should be counted inclusive of the time such director functioned as an executive director, as otherwise it would defeat the purpose of this rule. 

Final remarks

The requirements for good governance at financial institutions cannot be addressed in a single article. The foregoing is a discussion on the most important precursors to establish good governance. Any attempt at good governance without first satisfying these precursors is futile. 

Good governance at financial institutions is essential to safeguard the financial institutions and the stability of the financial system. Therefore, for the sake of the public let us hope that good governance is restored in financial institutions and the same fate as ‘Yahapalanaya’ in politics does not befall on the financial system of the country. 

(The writer is a Regulatory Compliance Specialist and can be contacted via e mail: [email protected].)