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EPF should quit the banking and financial sector as fast as possible and the Central Bank should leave private banks in the hands of the private sector. That is in line with good governance in central banking
Monetary Board acquiring private banks through EPF
The latest reports filed by private banks and a few financial sector non-bank institutions with the Colombo Stock Exchange reveal that the Employees Provident Fund or EPF owns shares up to the maximum limit of 10% of the issued share capital of banks and a significant portion of the shares issued by other non-bank institutions.
The banks involved are the Commercial Bank, Hatton National Bank, Sampath Bank, Seylan Bank, National Development Bank and DFCC. The non-bank institutions are the People’s Leasing, Vallibel, The Finance and LOLC. These shares have been acquired for EPF by the Monetary Board of the Central Bank as the custodian of the EPF funds.
Indirect nationalisation of private banks by using EPF money
This practice started by the Monetary Board since around 2010 has been quite opposite to its earlier policy decisions on the subject. One is that it should not invest EPF monies in shares of banks and financial institutions regulated and supervised by it. The other is that it should not acquire more than 5% of the issued share capital of any listed company. 
Along with these share ownerships in banks, the shares owned by other Government institutions, namely, Insurance Corporation, Employees’ Trust Fund or ETF, National Savings Bank and in some cases, the Bank of Ceylon and DFCC, have enabled the Treasury and the Central Bank to effectively control the private banks in the country.
Accordingly, in the case of the two largest private banks – Commercial Bank and HNB – chairpersons and majority directors have been nominated by the duo – Treasury plus Central Bank. In the case of other private banks, there is effective control over the businesses of those banks by the same duo.
This has resulted in the private banks being indirectly nationalised by the Government. Thus, in Sri Lanka, there are no pure private banks today. They are indirectly State-owned and not different from the other wholly owned state banks like the Bank of Ceylon or the People’s Bank.
Central Bank is prohibited from acquiring banks
The founding architect of the Central Bank – John Exter – never expected the Central Bank to own banking institutions, directly or indirectly. For that matter, he did not want the Central Bank to get engaged in any profit making businesses. Thus, in Chapter VII of the Monetary Law Act, he prohibited the Central Bank to purchase the shares of “any other banking institution or of any company”, among others (Section 117(b)).
Exter’s wisdom behind this prohibition was discussed by this writer in a previous article in this series titled ‘Why engaging in commercial businesses is taboo for central banks’ (available at: http://www.ft.lk/2013/10/07/why-engaging-in-commercial-businesses-is-taboo-for-central-banks/). The need for following Exter in running the Central Bank has arisen today more than in the past. That was why Governor Arjuna Mahendran made it a point to remind the staff, in his initial address to them, that they should be conversant with the Exter Report on which the Central Bank has been founded. That was because, according to Mahendran, Exter’s wisdom, though expounded in 1950s, was still relevant to the main functions of the Central Bank (available at: https://www.youtube.com/watch?v=hf6uKcfhpuI).
The purchase of shares of banks and banking institutions for EPF by the Monetary Board in the recent past is therefore a circumvention of the wisdom of John Exter as enshrined in the Monetary Law Act.
Trust reposed on Monetary Board
In terms of the EPF Law, the Monetary Board of the Central Bank functions as the custodian of the funds belonging to the members, while the Labour Commissioner acts as its administrator. This type of dual responsibility in the management of a social security fund is found only in Sri Lanka.
The reason behind this aberration in the management of EPF was the trust which the Government had reposed in the Monetary Board of the Central Bank for the safety of the monies belonging to the working population of the country. Thus, as the custodian of the EPF monies, the Monetary Board is required to handle the investment of funds with the same caution, care and diligence as when it manages its own monies.
The financial integrity which the Monetary Board has to show in managing EPF funds is all the more important since EPF members, individually or collectively, have no say in the investment of their funds.
Central Bank is not the proper home for EPF
However, the assignment of the management of the EPF funds to the Monetary Board of the central bank has come under severe criticism on account of the obvious conflicts of interest it has generated in three areas.
First, a central bank has to decide on the appropriate interest rates under its main mandate of maintaining economic and price stability. Thus, it cannot offer the best rate of return to EPF members when it follows a low interest rate policy to stimulate the economy. Second, the Central Bank being the regulator of financial institutions acts as the ‘referee’ of the financial system. But when it manages the EPF’s investment portfolio, it has to act as a ‘player’, an awkward position for a regulator.
Third, the central bank being the manager of the public debt (another conflict with its monetary policy objectives) has to find money for the Government at the cheapest rates. But the very same central bank has to earn the highest rate of return for EPF members as the manager of its investment portfolio.
The safety first principle
Thus, what the Monetary Board does as the custodian of the EPF money is not a very pleasant job. Yet, it has been added to numerous functions of the Central Bank because the government could not find any other suitable institution in 1958 to entrust that responsible job with confidence.
Over the years, trade unions and members of EPF too have come to appreciate what the Monetary Board has been doing and do not appear to be desirous of a change in view of the perceived safety of money with the Central Bank. Hence, the Monetary Board has to be extra-cautious when it makes investment of EPF monies, because the ultimate barometer of its success, in the eyes of the members, is the safety of the funds.
‘The safety first’ principle is also an important guidance for the Central Bank, because EPF does not have a capital base and therefore, any losses it would make have to be charged to members thereby eroding their hard-earned savings.
Need for paying a good return on EPF money
EPF Act was enacted in an era when Sri Lanka had a low inflation regime. During 1953 – 57, the country’s average inflation was just 0.5% per annum. Hence, the drafters of EPF Act, presuming the same low inflation regime will prevail forever, stipulated in the Act that a minimum rate of return of 2.5% per annum should be paid on the member balances by EPF. If the rate payable falls below this minimum for any reason in a given year, the Treasury will meet the shortfall by way of a loan which EPF has to repay later.
Given the low inflation that prevailed, this minimum rate generated a real rate of about 2% per annum which was considered an adequate real return at a time when the average rate on twelve month fixed deposits stood at 1.75% per annum. Since, during this period, the Government Securities paid an average rate of about 3.5% per annum, paying this minimum rate of 2.5% was not considered a challenge.
Near zero real return on EPF money
But later events proved to be different. Sri Lanka became a high inflation country especially after 1978. The average annual inflation rate during 1978-1996 stood at 12.6% per annum and since the interest rates lagged behind the inflation rate, the real rate of return of the EPF members during this period was virtually close to zero.
There was public agitation and demand for higher rates of return on EPF balances. Since all the monies had been invested by the Monetary Board on the ‘safety first principle’ in government securities or public sector debentures guaranteed by the government, there was no way for enhancing the rate of return unless the portfolio was diversified to the private sector, especially the equities in the newly emerging share market of the country.
At this stage, the Monetary Board headed by Governor A S Jayawardena decided to diversify the portfolio. But it faced two types of problems: first, a legal problem and second, a capacity problem.
The investment in private securities: The legal problem
The legal problem was that it was not clear whether the Board could invest EPF monies in private bonds and equities, because the Act had not defined what was meant by ‘securities’. The prevailing wisdom at that time was that the eligible securities included only the government securities, because that was the only securities which EPF had chosen for investment since its formation in 1958.
This interpretation is understandable because in 1958 when the EPF Act was enacted, there was no private debt securities market in Sri Lanka, though company shares had been traded as private transactions on a limited scale by the Share Brokers’ Association. But after 1980s, a private debt securities market was developed in the country and an investor could earn a competitive rate of return by tapping that market after putting appropriate safety measures in place.
A guiding light in this connection was shed by the ETF Act enacted in early 1980s. By going by the general commercial interpretation, this Act had defined securities to include private securities as well. Hence, the Monetary Board sought the opinion of the Attorney General in late 1990s on the definition of securities stipulated in the EPF Act.
AG’s opinion: Securities includes private securities as well
The Attorney General having considered the general commercial definition of securities and the developments that had taken place in the country’s economy since 1958 ruled that ‘securities’ in the EPF Act includes private debentures and company shares as well.
However, the learned Attorney General drew the attention of the Monetary Board to the requirement of introducing safety measures for the protection the members’ money when the Board decides to invest in private debentures and the need for refraining from making speculative types of investments.
This latter proviso was made by the Attorney General having taken into account the legal responsibility of a trustee or a custodian that such trustee or custodian should ‘exercise the same care and caution when he invests the monies belonging to the beneficiaries as the monies owned by him’.
EPF’s capacity enhancement problem
The capacity problem was that EPF lacked in-house skills to study the market, analyse the risks involved in different types of shares and debentures, keep a track of the market developments and make an appropriate exit if a particular share or a debenture becomes risky for the Fund. This was the job to be performed by trained investment analysts and fund managers.
In addition, it was necessary to organise the EPF’s investment activities on the basis of the international best practices where the functions are separated into front office, mid office and back office and the suitable audit trails are introduced to detect frauds and irregular practices in trading. This challenge was met by the Board by recruiting a team of young officers as fund managers and taking them through a comprehensive training programme.
Financial sector shares:
Potential insider trading
When the Board decided to invest in the share market, a new problem came up in the form of ‘potential insider trading’ in the case of shares of banks and financial institutions supervised by the Bank. This is because, the Monetary Board, being the supervisor of banks and other financial institutions, had access to more detailed and advance information relating to them compared with other investors. Hence, if the EPF invests in the tradable shares of these institutions, the Monetary Board as the investor opens itself for scrutiny by another regulator of the financial market, namely, the Securities and Exchange Commission.
Even though the Board may have created firewalls between the investment decisions and subsequent ratification by the Board, an outsider may not view it in that flavour. Any move by EPF to buy or sell a tradable share of a bank or a financial institution may give the wrong signal to outside investors that the EPF would have done so with superior information. That may create an unhealthy ‘herd behaviour effect’ in the share market and subsequently, the Monetary Board may be criticised by the market for creating that unhealthy development.
Two self-restraints on the Monetary Board
Therefore, the Board decided to impose two self-restraints on itself by approving a special Investment Policy Statement that was disclosed to the public by posting the same in EPF’s website. One was that it would not acquire more than 5% of the issued share capital of any listed company because it had no intention of managing private companies. The other was that it will not acquire shares of banks or financial institutions supervised by the Board.
However, these self-restraints have been overlooked by the Board when it decided to acquire shares of listed companies beyond 5% threshold and shares of banks and other financial institutions. When there was public criticism of these two deviations, the original Investment Policy Statement was surreptitiously replaced by a new statement without disclosing why the self-restraints imposed in the original statement were changed (available at: http://www.epf.lk/assets/library/investment_policy_statement.pdf).
The Board can change its rules, but disclose them to the market
These are not laws, but ethical and moral rules which the Board has imposed on itself. The Board can, therefore, at any time, depart from them with suitable justification which should also be disclosed to the market in advance. In fact, the Board made such a decision once when the National Development Bank was converted to a commercial bank and the Central Bank’s holding of shares of NDB was transferred to EPF as an ‘investment for return only’.
Such a clearly-laid-down procedure is necessary to prevent interested parties from using EPF funds for attaining their personal goals.
Hence, it is absolutely necessary for the Monetary Board to disclose fully to the market what it intends to do regarding the investment in tradable banking shares. As the largest fund in the country, the EPF, and as the good practice setter for other financial institutions, the Monetary Board cannot and should not attempt at investing in banking shares without due consideration of the risks involved.
The Central Bank becoming player and referee
Apart from the potential insider trading charges, EPF’s investments in the banking sector have enabled the Central Bank to run private banks as well. It has put the Bank in the awkward position of functioning both as referee and player. It has given the wrong and damaging signal to the financial sector that the government and the Central Bank are now managing private banks.
Further, when the directors to such banks are nominated by political authorities, the Central Bank is not in a position to check on the fitness and propriety of those directors.
The Central Bank by investing EPF monies in banks has made a mistake in choosing to run private banks. It has made a bigger mistake by placing the deposits of the public in the hands of those who are not fit and proper to manage them by collaborating with political authorities.
Hence, EPF should quit the banking and financial sector as fast as possible and the Central Bank should leave private banks in the hands of the private sector. That is in line with good governance in central banking.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)
