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Mandating credit allocation without fanfare
The Central Bank of Sri Lanka has, without fanfare or publicised press conferences, issued a one and a half page long circular to commercial banks urging them to maintain a minimum percentage of their total loans for six sectors identified as priorities in the said circular (available at: http://www.cbsl.gov.lk/pics_n_docs/09_lr/_docs/directions/bsd/BSD_2017/BSDCircularNo1of2017.pdf).
The title of the circular says that it is issued in accordance with the implementation of the proposals relating to financial services announced in the Budget 2017. Hence, the bank’s Monetary Board appears to have yielded itself to the wishes of the Finance Minister Ravi Karunanayake who had of late taken interest in controlling banks which do not come within his purview in terms of the work allocation of the new Government.
An unsavoury intervention in the market
What the Central Bank has introduced by way of implementation of the Budget proposals is collectively known as ‘mandatory credit allocations’. When the proposal in question appeared in the Budget along with many other interventions proposed by the Minister, this writer wrote in an article in this series that it was an unsavoury attempt by the Minister at grabbing for himself the legitimate powers of the Monetary Board (available at: http://www.ft.lk/article/580074/Budget-2017--Significant-improvement-if-not-marred-by-policy-inconsistencies-and-interference-with-the-Monetary-Board). 
This is what this writer said about the proposal relating to mandatory credit allocations by banks: “The Minister of Finance is planning to introduce mandatory credit allocations to commercial banks in accordance with priorities which he has identified......It is also proposed to issue a directive to commercial banks that they should lend at least 15% of the deposits they mobilise in a particular area to within that area itself. (These two) proposals will lead to corruption because bank managers would devise ingenious methods to allocate funds to fathers in law and sons in law. This is the experience which India had with such mandatory credit allocations.”
This writer then suggested: “These are serious issues and it is hoped that the government would take appropriate action to correct these howlers, inconsistencies and undue interferences with the Monetary Board before it is passed in Parliament.”
Going ahead with mandatory credit allocation
Despite this warning, there has not been any attempt by the Minister of Finance or the Central Bank at revisiting the proposal in the Budget to ascertain its validity, consistency and suitability. Instead, the Central Bank has issued a circular to commercial banks under the hand of its Director of Bank Supervision expressing its wish that all banks ‘may’ take appropriate measures to implement the following:
nDistribution of credit to identified sectors: Credit granted by banks may not be less than the following percentages of total loans - 10% for medium and small enterprises or SMEs, 10% for exports, 10% for tourism, 10% for agriculture which is already being followed by banks, 5% for youth and 5% for women. Thus, 50% of the total loan book of banks should have been allocated to borrowers in these six identified constituents or sectors.
nEnhancing banking services: Under this category, three directives have been issued by the Central Bank to commercial banks. First, credit granted by bank branches in the business development in the respective area may not be less than 15% of the deposits mobilised by each branch within the same area. Second, banks may streamline the procedures for granting credit so that loans of less than Rs. 5 million should be finalised within one month. Third, at least one branch in each district should be kept open for all seven days of the week except on religions holidays.
An ever changing definition of SMEs
The Central Bank, following the national policy framework for SME development, has defined SMEs as those with an annual turnover not exceeding Rs. 750 million. Banks will find it difficult to remain within this definition since all enterprises which may cross the threshold limit will not be considered as SMEs and when it occurs, they will have to go looking for new borrowers who could be treated as SMEs.
That involves an additional cost of loan processing. Thus, it is in the interest of banks to concentrate on enterprises which are well below the threshold limit to avoid additional costs of borrower appraisal.
Central Bank’s continued reluctance to impose mandatory credit allocations
The original Monetary Law Act or MLA had not empowered the Central Bank to direct commercial banks or any other financial institution to maintain a minimum percentage of loans which they shall grant to any identified sector of the economy.
The architect of MLA, John Exter, did not think that it was necessary. The Monetary Board too did not feel that the Central Bank should go for such mandatory credit allocations to identified sectors despite its counterpart in neighbouring India, namely, Reserve Bank of India or RBI, had done so from around 1967. The frustrating experience which India had with such priority sector lending made the Monetary Board consistently go by that decision.
However, this was changed in 2006 when the Rata Perata Government of 2004 thought that banks should lend a minimum of 10% of their loans and advances to agriculture. Accordingly, the Central Bank has now been empowered under Section 101(1)(c) of MLA to “fix the minimum percentage of loans to be extended, to any identified sector of the economy, by the commercial banks or licensed specialised banks.”
The Central Bank invoked the provisions of this section in the case of agricultural loans under which commercial banks were required to maintain a minimum quantum of loans to borrowers in this sector at 10% of their loan book.
However, the current circular has not made use of the powers which it enjoys under this section but simply has informed commercial banks that they ‘may’ provide the minimum percentages of loans to those six identified sectors or borrowers. But banks are required to report back and if they do not meet with the minimum requirement, the Central Bank has the choice of issuing formal directions to them by invoking the provisions in MLA.
Economic rationale of using mandatory credit allocations
The economic rationale for introducing mandatory credit allocations rests with what is known in economics as the ‘divergence between private interests and social interests’. Under the free market economy system, private interests should naturally lead to the allocation of resources for meeting the requirements of society as demonstrated by collective demand for banking services.
If a particular sector needs credit, such a need is communicated to banks by prospective borrowers by queuing at banks and making their needs known to them. Hence, if there is a demand, the market should allocate resources to meet the demand. In this case, private interests become identical with social interests.
Structural issues leading to divergence between private interests and social interests
However, there can be a divergence between the two if there are structural deficiencies in the system. One such structural deficiency is the lack of information to prospective borrowers which sectors are profitable.
Another is the lack of technical knowhow and skills to undertake businesses in the proposed areas. A third is the inability of borrowers to present their case in a way acceptable to bankers. A fourth is the lack of the needed security and collateral with borrowers as demanded by banks. A fifth is the perception of banks that the identified sector is not a profitable sector or the borrower is not credit worthy.
Then, the credit flows fall short of the socially desirable levels. Instead of taking measures to address the structural issues, politicians think that they can sort the problem by directing banks to mandatorily lend to these sectors.
Undesirable consequences of mandatory credit allocations
But such directions lead to many undesirable consequences. Hence, before they are issued, it is necessary to examine all the consequences they might bring about and how such directions would in fact defeat the very purpose of introducing them. Such examinations should be done by specially appointed technical groups as has been done in neighbouring India.
India’s frustrating experience in priority sector lending
India had introduced mandatory priority sector lending from 1967 emphasising that commercial banks should increase their involvement in the financing of priority sectors as identified at that time as agriculture, exports and small scale industry. However, by 2005, it was felt that the whole program should be revisited with a view to making amendments if necessary or completely do away with the system.
To address these issues, an internal working group consisting of senior officers was appointed by RBI in 2005 and its report is available on the RBI website (available at: https://www.rbi.org.in/upload/content/pdfs/66391.pdf ).
The report has emphasised that “the experience of most countries around the world showed that directed credit programmes suffered from abuse and misuse of preferential funds for non-priority purposes, increased the cost of funds to non-preferential borrowers, involved a decline in financial discipline that resulted in low repayment rates, and contributed to the government being burdened by unpaid loans and huge arrears. Moreover, once introduced, directed credit programmes proved to be difficult to discontinue.”
The report has tabulated the international experience with regard to mandatorily directed lending and found that it has failed in Brazil, China, Indonesia, Nepal and the Philippines, the countries which had experimented with the system. In India, the demand has shifted from mandatorily directed lending to microfinance as an effective method of addressing issues involved at the grassroots level.
Since then, RBI has simply modified the system from time to time while retaining the system as a credit allocating method for what has been identified as priority sectors, because once introduced, it cannot be taken away without causing political turmoil.
In this background, Sri Lanka’s entry into directional credit is fraught with many practical as well as systemic issues.
Shocking commercial banks with a suggestion for a mandatory credit allocation
The circular has shocked commercial banks which had not been prepared to undertake such a feat without advance notice. The staffs of banks have not been trained to identify creditworthy, viable loan proposals which prospective borrowers might present to them. Hence, the introduction of a mandatory credit allocation system without consulting banks or appreciating their practical problems has been a real shock to them.
The result of such a shock treatment is that neither the Central Bank nor the government would be able to realise the targets or objectives of introducing mandatory credit allocational system.
Treating all banks alike
Another deficiency is the disregard of the specialities which banks may have attained over the time in lending to particular sectors when uniform mandatory credit disbursements are imposed on different banks. For instance, one bank may have developed speciality in extending credit for the export sector, while another bank may have developed skills in granting credit to youth. A third bank may have specialised itself in lending to agriculture. Now, when all these banks are treated uniformly for minimum credit disbursement targets, it would be an advantage for some banks, while it is a stressful experience for some other banks. It, therefore, leads to develop distress in failing banks, while remunerating handsomely those banks which enjoy an advantage in lending. India, having well recognised this disparity in the lending behaviour of banks, has allowed the banks which have done well in a particular area to sell their excesses to banks which have remained below the minimum lending goals (available at: http://indianexpress.com/article/business/banking-and-finance/priority-sector-lending-certificate-guidelines-banking-on-reforms/ ).
Stress on the loan book
A third deficiency is the stress which the proposed mandatory credit allocations might build on the loan books of banks. The priority lending to the six indentified sectors will just occupy a half of the loan book of commercial banks. It would completely disrupt the risk management practices which these banks have already introduced since a half of their loan book representing lending to priority sectors is now outside their control. The corollary of such a lending system is the distress it would create in banks leading to the accumulation of a large number of defaulted loans by them. The resultant financial instability will impose an additional burden of the government to bail out the problem banks.
Giving rise to fraudulent practices
Mandatory credit allocations also lead to fraudulent practices in banks. As also noted by the working group appointed by RBI to study the priority sector lending system, bank managers might use the new facility to direct credit to undeserving customers or their own kith and kin. It is difficult for a central bank to monitor such corrupt practices.
Betrayal of Social Market Economy Policy?
The present Government is following a social market economy policy under which the role of the Government is limited to facilitating the market to function as the leader of economic development.
The Prime Minister has been very emphatic about following this economic policy to deliver prosperity to people. Hence, the action taken by the Ministry of Finance and the Central Bank to impose mandatory credit minimums, an unworkable intervention in the market, has not only shocked the banks but also betrayed the Prime Minister’s social market economy policy.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected])
