Buried mines, time bombs under stock/financial markets?

The Executive and the Ministry of Finance have received bouquets recently from the IMF and the World Bank for effective fiscal and monetary management of a nation stepping towards becoming the ‘Miracle of Asia’.

The Central Bank boasts of how effectively it managed the banking and financial services sector during the global financial crisis. The Securities Exchange Commission crows about being the best performing market of Asia last year and plans to repeat its performance this year, and become one of the best performing markets in the world and a financial trading hub with a top global ranking.

The SEC, Directors Institute and the Institute of Chartered Accountants have begun focusing on effective risk management and have organised many useful awareness building workshops. Fox News gives a Sri Lanka a 10-minute plug, stating that this awesome nation is the best performing stock exchange in the world and describes it as the oldest democracy with economic resilience enjoying high growth and market stability, whilst the world struggles with an economic downturn.

Post the successful war against terrorism, the Sri Lankan security forces and intelligence wings are continuously on the alert to effectively manage all external and internal risks. Mine clearance is a key to effective resettlement and development of the north.

Security staff diligently follows up on any available evidence and information to uncover remnant pockets of potential risk, including cadres that escaped the military onslaught, risks coming from dissident elements across the Palk Strait, re-established dissident Diaspora groups canvassing separatism and unearth hidden weapon caches buried by the terrorists.

The Military Chief highlights even the need for their alertness to extend further to cover potential cyber attacks as well.

A valid question in the minds of analysts is whether the Sri Lankan stock market and the financial services sector are effectively risk managed by the responsible stakeholders, taking a pointer from the level of alert risk management practiced by the stakeholders of internal security?

Risk 1

A new breed of players has entered the stock market. Unfortunately they do not understand the market risks and rewards nor how their monies are invested. They are driven by greedy intermediaries playing with and profiting from the hard earned savings of these poor people.

The money passes through many hands of intermediaries. These intermediaries as well as the original investors have no record of who the final fund managers are. Lower middle class monthly salary earners, housewives and elderly retired persons in the suburbs of the cities, finding it difficult to manage the adverse effects of the increased costs of living, are targeted by these intermediaries.

Their modus operandi is to provide a large return on capital within a few months, purportedly made by investing in the stock market. These interim returns are some times as high as 30-50% and are paid back in three to six months.

This draws in further investments from the same target group and their network attracted by the experience of the original investors. These investors see no documents of title and part with money and receive cash as their returns.

How long can this investment framework last without a mine blowing up and severely impacting on many lives? The next question is whether the regulators are unaware of this market and its associated risks? Is this blindness by regulators to market risks a part of a useful mechanism in making Sri Lanka the best performing market again? And realise the dream to double the market capitalisation?

Analysts see this risk ending with a market disaster and possibly even with a repetition of Bangladesh street riots!

Risk 2

All stakeholders have forgotten recent history of the Sri Lankan investment scenario with pyramid scams, primary dealers selling guaranteed returns invested in government securities but in fact transferring funds to unregulated fund management companies within the group and finance company failures (both regulated and unregulated).

Regulators have not exercised credible and professional efforts at punishing the wrong doers in a manner that no one will dare try similar pranks in the future, tracing assets siphoned out nor learning lessons and taking effective market awareness and control initiatives.

The lower interest yields in official channels for investment with low risks are directing the market to seek higher return options. New breeds of intermediaries have entered the market to capitalise on such a scenario. They target the market with novel schemes of sale of products (e.g. miracle cures embedded combs) and club memberships (fitness, medical care, lifestyle support networks) which in effect are nothing but pyramid schemes.

The intermediaries are trained to dress these offers as genuine and the reward structure makes it very attractive to gullible investors. In fact even old ladies engaged in Poya day sil programmes are targeted by the intermediaries. Promotional events for intermediaries are lavish functions with musicals, great food and entertainment and addresses by foreign key executives.

The market has forgotten the period when investment certificates tagged to future rewards in timber and fuel wood trees were marketed promising high returns via attractive billboards and even sales points erected at bus stands. Now telemarketing involving sweet and sexy voices use credit card, privilege card and other data bases to effectively target and offer investment options.

These offers are hard to match in the traditional markets. Well dressed young men and women do house to house calls and mail boxes are filled with attractive brochures, most of which fail to meet required standards of disclosure of effective yields and associated risks. These offers are even made via the print, voice and electronic media and none of these advertisements meet minimum standards specified by the professional financial analyst associations.

Despite all this open evidence, the regulators appear to await much-desired legislative changes before effective action. Will in the meantime the time bomb get activated with very many casualties?

Risk 3

Are market manipulators having a field day? Why are regulator led investigations taking so long? Why are obvious manipulative transactions not being acted upon with timely and firm response action? Why are some of the well known manipulators allowed to hold high positions?

What is the truth behind the market talk that you can sell any quantity of stock at a profitable price in the market if one is willing to put Rs. 1 million behind the sale strategy-related expenses and with a few millions put behind such an offer that you can sell any quantity of stocks at the price dictated by the seller?

Are small sales and small purchases of stocks, say 100 shares at a time, not observed when they are obvious transactions of manipulation? Are some transactions of State institutions and State operated funds not reviewed for market manipulations?

Are stocks with high PE ratios beyond market’s most optimistic expectations, operations with non transparent funding and investment sources, obvious operations with disclosed and undisclosed related parties and related but non transparent sources of future cash flow expectations, ignored recognising the positive role in realising benchmark performances and targeted market capitalisations? Why are some operations which are obvious lookalike of the scams of yester years allowed to continue?

Are the above-market risks warranted in order to gain star performances and targets of growth or is it better to act cautiously and grow on a risk managed sustainable basis by immediately getting down to the task of de-mining of buried weapons of potential great destruction?

Risk 4

Are the stock market entrants seeking new listings being scrutinised adequately and professionally risk rated by the regulator? Are the new listing seekers with sudden profit growth and expansion in the most recent one or two years treated by the regulator in the same way as those with a steady growth over five years? Are these listings to be allowed without a risk signal to the market?

For example a company that increased its profits in the last year by tenfold announced its intent to seek a listing – will it come to the market with no highlight of this unusual gain? Should stocks with PERs over market’s most optimistic acceptable multiples be listed in a separate board, along with those new entrants with unusual growth just prior to listing?

Risk 5

What risks will flow in to the financial markets in the future with the decision taken by the Auditor General to replace professional firms of auditors of key State financial institutions and the audits of these institutions being carried out by the staff of the Auditor General’s Department?

Who approved this decision? Were the potential risks flowing from that decision evaluated and if so by whom? Does the Auditor General have the necessary capability (knowledge, skills and attitudes) to support the needs for effective audit of these institutions?

Does the Auditor General’s Department have necessary systems and processes for an effective risk based audit? Do they understand the complex business transactions which take place within these institutions and their national and international dimensions, the complex instruments, documentation and contractual commitments? Do they have skills and computer aides to audit the ICT bases records and data bases?

Can the department staff extend the scope of the audits to cover key management, operational and efficiency issues and regulatory compliance issues? Do they have the capability to understand and validate the asset and liability valuations and complex provisioning requirements and international standards?

The Auditor General’s own administrative report setting out capability weaknesses and how ill-equipped and understaffed the department is to meet its accountability and a responsibility with effectiveness, answers most of the above questions.  If so, why is this risky change management process being implemented? Does it support the planned commitment to good governance enhancement, State management reforms process and State enterprise development initiative headed by key ministers of cabinet and announced plans to list a part of the stocks of these institutions in the local stock market?

Some of these State financial institutions have been subjected to costly restructures and will the new move be the burring of a new time bomb, with audits concentrating on compliance with AR and FR only?

Risk 6

All State institutions are required to compulsorily insure with the State insurer. These State institutions are not allowed to use a professional insurance broker in managing and placing their insurance portfolios?

The State insurer gives a direct discount to the insured but does not offer portfolio review, risk assessments and effective risk mitigation measures; nor do they validate the comprehensiveness and cost effectiveness of the risk transfer programmes and backing re-insurance programmes.

The directors of these State institutions have a fiduciary responsibility over the assets under management and are required to have in place all necessary risk management processes that are effective and safeguard the interests of all stakeholders. How can these directors perform that role in the face of their hands being tied behind their back in regard to professional risk management and risk transfer arrangements?

Risk 7

State financial institutions and State managed funds being used as a vehicle for funding State investments not channelled through national budget allocations. This practice is yet another critical area and a mine field waiting to become a catastrophe!

Who is responsible for the professional evaluation of all key investment decisions made by State financial institutions in investing in State and State sponsored institutions? Or are they mere exercise of directives by powerful ministers and secretaries?

Who is responsible for their approval? Who exercises effective supervision and decision making over such investments despite most of these being funds financed by non State actors and made up deposits, contractual commitments and old age support wealth management options?

It is worrying when the chairpersons and managing directors of these State institutions make political pronouncements of how they have invested billions of rupees of assets contributed by non State actors as long term investments in State ventures, State sponsored new business ventures and even most likely to turn to disaster high risk ventures of the State. Who will ultimately be accountable for these investments, most of which are totally non transparent as well?

Risk 8

What are the looming risks that may crystallise on listed entities, State institutions and financial service establishments of the State and private sector arising from the present wave of unrest in Middle East and African countries?

What are the exposure of Sri Lankan businesses to such presently high risk and potentially risky countries? Are there effective risk management measures in place to protect the possible down side? Especially, what are the risk exposures on current trade deals pending settlement, potential trade and investment deals of the short to medium term and especially what are the exposures of banks and export houses?

There appear to be three potentially severe looming risks in the horizon, relating to export proceeds due being delayed or force majeure terms preventing remittances (it is reported that in the targeted Middle Eastern states there are severe difficulties in obtaining forex funds for prioritised remittance in settlement of contractual obligations), worker remittances not growing as anticipated and oil price hikes severely impacting on the economy.

It is the market expectation that the Executive is using the best expertise available to manage and mitigate all these potential risks!

The President in his 63rd Independence Day message said: “We must have the same commitment to building a (economically developed, sustainable and prosperous) united nation as we had in defending our country.”

Are the key stakeholders of the stock exchange and financial markets following the above dictate of the President and effectively managing with due commitment the potential risks of the stock market and financial services sector? Are they, in addition, removing any buried mines and time bombs under stock market and financial services sector?

The above questions are now over to the Minister of Finance, Senior Minister of Good Governance, Ministers of State Assets and Enterprise Development and State Management Reform, Secretary to the Treasury, Governor of the Central Bank, Auditor General, Chairperson of the Securities Exchange Commission, Chairperson Insurance Board, Chairman Stock Exchange, Presidents of Institute of Chartered Accountants and Chartered Financial Analysts, President Sri Lanka Institute of Directors and Chairpersons of Bankers Association/Insurance Association/Insurance Brokers Association.

“There are risks and costs to a programme of action, but they are far less than the long-range risks and costs of comfortable inaction” – John F. Kennedy.

(The writer is a former Chairman of the Ceylon Chamber of Commerce.)