Whistle-blowing on Perpetual Treasuries: Embarrassing but vindication of CB’s supervisory staff

A whistle-blower in the Central Bank

The market last week was livid with a leaked on-site examination report, claimed to have been prepared by Central Bank’s primary dealer supervision staff, on the controversial primary dealer, Perpetual Treasuries. 

It appeared that a good-intentioned whistle-blower from within the Bank had released it to the market. A website linked to a political party had picked it up and reproduced it in full in its website (available at: http://www.lankatruth.com/site/index.php/2014-08-09-14-28-31/item/2806 ). 

Making miraculously high super profits

A week before the leak, Perpetual Treasuries was in the news after it had released its financial position as at end-March 2016 as per Central Bank regulations. The position showed the extraordinarily high amounts of profits it had made in both the 2014/15 and 2015/16 periods, amounting to Rs. 960 million and Rs. 5,124 million, respectively. 

The market’s surprise at first and anger then were directed at the primary dealer when it was learned that it had had a super-performance in profit-making surpassing even a midsize commercial bank. When the financial statements revealed that it had not paid any income tax on profits, civil society activists sprang to action demanding that the Government rectify the apparent anomaly where primary dealers did not have to pay taxes on profits whereas other financial institutions have to do so. 

They even requested the President to appoint a presidential commission to investigate the super profits it had made when other primary dealers had made just meagre profits or even losses. Hence, the leaked on-site examination report added fuel to the furore which had already been ignited in the market against the primary dealer in question.

Central Bank battered by scandalous bond deals

The Central Bank had been at the receiving end since February 2015 after the story of a scandalous 30-year bond issue favouring Perpetual Treasuries hit the market. The Central Bank vehemently denied the allegation that there was impropriety in the bond issue, a position which was subsequently confirmed by Prime Minister Ranil Wickremasinghe in a statement made in Parliament (available at: http://www.ft.lk/2015/03/18/special-statement-delivered-by-prime-minister-ranil-wickremesinghe-in-parliament-ranil-says-his-silence-measured-not-meek). 

Since the primary dealer company in question, Perpetual Treasuries, was owned by the son-in-law of the then Governor, Arjuna Mahendran, there was suspicion that it had benefited from access to inside information which was not available to other primary dealers. Instead of going for a full-scale inquiry, the Monetary Board, which is responsible for upholding the Bank’s reputation, stood firmly by the Governor and maintained denial of the scam throughout. 

A bond disaster worse than the bomb disaster

This writer, in a previous article in this series published in March 2015 argued that the damage done to the Bank’s reputation was far worse than the damage caused by the LTTE bomb explosion in 1996 (available at: http://www.ft.lk/article/398709/From-bomb-disaster-to-bond-disaster--How-to-restore-the-lost-reputation-of-the-Central-Bank). 

However, with the backing of the Government and the connivance of the Monetary Board, Governor Mahendran continued to hold office and the primary dealer Perpetual Treasuries went back to its strange dealing business. But all this time, good governance activists, the media, the Opposition and coalition partners of the Government were critical of the way the matter was handled by the Government as well as the Monetary Board. 

It surfaced again with greater vigour and ferocity when the country was hit by a second bond scam in March 2016 with the same primary dealer as the main actor. This writer in two articles published in April and June 2016 drew the attention of the Board to the serious dent which the scandal caused to the Bank’s reputation by its inaction throughout (available at: http://www.ft.lk/article/398709/From-bomb-disaster-to-bond-disaster--How-to-restore-the-lost-reputation-of-the-Central-Bank and http://www.ft.lk/article/546108/Monetary-Board-s-latest-statement-on--bond-fiascos---A-step-backward-and-waking-up-from-a-demonic-dream). 

Monetary Board was defiant but it cost a Governor his job

The civil society activists, media and the Opposition were angry at the continued denial of bond scams of gigantic proportions taking place under the yielding hand of the Monetary Board and pressurised the President not to reappoint Governor Mahendran when his term expired in June 2016. At that time, there was an inquiry by the Parliamentary watchdog, the Committee on Public Enterprises or COPE, into the alleged bond scams in the Central Bank involving a single primary dealer, namely, Perpetual Treasuries. 

The Monetary Board took a defiant stand and declined to furnish the Auditor General, despite his constitutional rights, with the needed information. It took cover behind an archaic provision in the Monetary Law Act or MLA that Central Bank officials could not divulge the information which they have received from others to a third party. It had ignored the fact that that restriction did not apply to the Monetary Board. 

This writer, drawing on the good governance practices emerging in the rest of the world, especially in India, warned the Monetary Board that its intransigence would damage its reputation in a good governance society which has a high price of transparency and full disclosure (available at: http://www.ft.lk/article/547766/Bond-fiasco-and-confronting-the-Auditor-General--Monetary-Board-should-be-more-mindful-of-its-obligations). 

In the previous article in June, this writer also warned the Board that its continued denial of information to the public would lead to the breeding of ‘whistle-blowers’ which would be more embarrassing and damaging to the Board. This warning has been prophetic as demonstrated by the leaked on-site examination report.

The leaked report is professionally done

The authenticity of the leaked report has not been established. Yet, even after three days of its appearance in the World Wide Web, the Monetary Board has neither denied nor accepted the existence of such a report. Hence, it is reasonable to presume that it is a draft report that would have originated from the Central Bank. 

Further, the language, coverage, content and the depth of analysis all point to the fact that it is a report prepared in the Central Bank. This writer has to admit that it is one of the finest examination reports which he had seen during his long career in the Bank. Certainly, the leak is an embarrassment to the Monetary Board. Yet, the professional standards maintained in the report vindicate the Central Bank staff that prepared the report in an environment where the Bank has been accused of having staff that are partial, politically-driven and deficient in professional standards. Hence, the staff that undertook the on-site examination deserves the highest commendation from everyone.

Whistle-blower jumping the gun

It appears that, in his haste, the whistle-blower has jumped the gun by releasing the draft report before it was fully-baked for final consumption in the different procedural steps in the Central Bank. 

Such procedural steps are as follows. The on-site examination is done by the Bank’s supervision examiners by visiting the entity being examined. They examine the books of account, compare the numbers with those sent to the Bank under its off-site examination of financial institutions, go into the depths of record to elicit information even at the basic micro level, question staff, go through files and records and finalise the report. Then, it has to be vetted at least at two levels in the department, in this case, the Department for the Supervision of Non-Bank Financial Institutions or DSNBFI. 

The first level is the Deputy Director level and the final level is the Director level. Then, the supervisory concerns identified are communicated to the Perpetual Treasuries to enable it to provide its side of the story. Once the responses are received, a one-on-one meeting is held by the Bank with the directors and the senior officers of Perpetual Treasuries. The discussion notes, together with Central Bank’s further observations and comments, are also added to the final report. Then, it is formatted to a Board paper and submitted to the Assistant Governor and through him to the Deputy Governor in charge of the operation.

Once it is approved, the Board paper is submitted to Governor for sanctioning for submission to the Board. The evidence available on the leaked Board paper points to the fact that it has not been vetted even at the Deputy Director’s level in the department. Hence, the leaked paper has had no opportunity, it can be surmised, for being fine-tuned within the hierarchical structure of the Central Bank. Yet, the raw information that has been provided in the report is revealing and guiding. 

Did the staff get strength after the change of Governor?

According to the background information in the paper as well as what is available in public domain, the on-site examination has commenced in November 2015 when the responsibility for supervising and regulating primary dealers  had been vested with the Bank’s Public Debt Department. 

However, with the failure to detect the Entrust fiasco in which the primary dealer Entrust Securities had defrauded the investors, including some of the funds maintained by the Central Bank as well, in government bonds and bills to the extent of Rs. 12 billion, there was wide dissatisfaction about the way in which the Public Debt had conducted its supervisory work. 

Accordingly, the job of supervising the primary dealers was assigned to the Bank’s Department for the Supervision of the Non-Bank Financial Institutions or DSNBFI in early June 2016. 

In early July, Governor Mahendran was succeeded by Governor Indrajit Coomarswamy since the President declined to reappoint the former for another term. After the change in the Bank’s top position, DSNBFI had begun a comprehensive examination of Perpetual Treasuries during late July and early August 2016. 

When writing the report in question, the DSNBFI supervisory team had made use of the findings of the earlier examination done by Public Debt, its own findings during the examination and the latest reported data since the date of the examination. Hence, the report contains the latest internal information relating to Perpetual Treasuries which is not available to any outside body. 

A start-up company making super profits should arouse suspicion

Perpetual Treasuries is a single entity company that has been licensed by the Central Bank to function as a primary dealer in September 2013 but it has started its business only in February 2014. These single entity companies are not connected to any big financial institution and therefore they are called ‘standalone primary dealers’. 

As against them, there are institutional or bank primary dealers who are connected to big financial institutions like Bank of Ceylon, People’s Bank, Commercial Bank, Sampath Bank and so on. The Central Bank has been a little stricter on these standalone companies when conducting its supervisory work since they carry a greater risk than bank primary dealers on account of the absence of funding lines in case of an emergency. As a result, they are not big players in the government securities market and are not expected to emerge as large profit-makers. If they make big profits, rather than being happy, the Bank should be extra alert because they cannot continue to make profits and would become a financial liability to the system. 

Thus, when Perpetual Treasuries – a start-up company with a small capital base, inadequate experience and limited staff – made a profit of close to Rs. 1 billion in the first year itself, a trigger would have been activated within the regulatory mechanism of the Central Bank. 

To act promptly on that trigger would have been the duty of the Superintendent of Public Debt, Assistant Governor and Deputy Governor in charge of Public Debt and finally the Monetary Board led by the Governor of the Central Bank. This did not happen and the result was the continuation of the ever-expanding super performance of Perpetual Treasuries making bigger and bigger profits in each subsequent year. 

Accordingly, as the leaked examination report reveals, its cumulative after-tax profits rose to Rs. 6.2 billion by March 2016 and further to Rs. 11 billion by May 2016. This extra super performance is a ‘miraculous wonder’ for any start-up small standalone securities dealer in any part of the world. 

Making super profits by using other people’s money

How did Perpetual Treasuries pull out this miracle? It is by doing everything outside the book which all other primary dealers had been faithfully following. 

In the first place, it did business by using other people’s money which in the securities market place is called the job of a ‘jobber’. In the first bond scam of February 2015, within the last 15 minutes of the close of the auction, it bid Rs. 2 billion on its own account and got Bank of Ceylon to bid Rs. 13 billion on its behalf. If the bid had been successful for the entire amount, it is the funds of the Bank of Ceylon which would be used to settle the transaction but the ownership of the bonds was with Perpetual Treasuries. Thus, it could sell the ownership certificate to Bank of Ceylon or any other unsuccessful bidder which had been after these bonds and settle its obligation to the Bank of Ceylon. 

It was a sure game for it to sell those bond ownership certificates since the market price of those 30-year bonds on the day of the auction was around Rs. 121 per Rs. 100 bond when it had made its bids at a ridiculously low price of around Rs. 90 per Rs. 100 bond. This was indeed a fine business. But unfortunately, it could not have all its bids accepted by the Public Debt, despite Governor Mahendran’s insistence, due to the protests by the management of the Public Debt Department at that time. 

Hence, only Rs. 5 billion out of Rs. 13 billion was accepted but it was still a good bargain for Perpetual Treasuries. The outcome is reflected in the profits of Perpetual Treasuries in the year 2014/15 amounting to Rs. 960 million. 

An anomalous interest rate policy

According to the leaked on-site examination report, Perpetual Treasuries had even made use of the interest rate anomaly created by the Monetary Board headed by Governor Mahendran. Despite the pressure for market interest rates to rise, the Monetary Board sought to swim upstream by reducing the Central Bank’s lending rates from 8% to 7.5% in April 2015. This was done by the Board when the interest rates in all government securities had gone up by about 2% or 200 basis points in March 2015 due to the high rates of the scandalous 30-year Treasury bonds issued by the Bank in end-February, referred to above.

Naturally, when the Central Bank cuts interest rates, the market rates should come down, but as the leaked on-site examination report has shown, they have moved in the opposite direction increasing interest rates by about 5% or 500 basis points to about 13% in the case of 10 year bonds for example by March 2016. Yet the Bank maintained its low lending rate of 7.5% throughout. 

Super profit-making has been helped by the Monetary Board

This writer warned the Monetary Board in an article published in April 2016 in this series that its anomalous interest rate policy would breed opportunities for market participants to borrow at low rates from the Central Bank and lend at high rates to the Government, a process known as ‘arbitraging’ (available at: http://www.ft.lk/article/534654/Dilemma-in-monetary-policy--Monetary-Board-being-caught-in--The-Devil-s-Alternative-?). 

The Board paid a blind eye to this warning. But the leaked examination report says that that was exactly what Perpetual Treasuries had been doing in order to make super profits. In April and May 2016, according to the report, Perpetual Treasuries had used the intra-day liquidity facility and Reverse REPO facility of the Central Bank available at 7.5% to borrow cheap money from the Central Bank and lend to the Government at high interest rates prevailing in the market. It had made capital gains of Rs 4.7 billion out of these transactions in just two months. Thus, the Monetary Board, through its naivety, immaturity and irresponsibility, has permitted one primary dealer to make super profits by taking advantage of its lack of supervision and anomalous interest rate policy. 

Finance Minister and EPF have borne the costs?

Who had borne the costs? In the first place, it is Finance Minister Ravi Karunanayake who had been forced to borrow at high interest rates. Then, it is the investors who have bought these Treasury bonds from ‘the chain of market transactions’ created by Perpetual Treasuries at higher prices than those prevailing at the primary market. 

The supervision team has not identified these secondary losers, but it has pointed its fingers at EPF which is also functioning under the management of the Monetary Board. The supervision team has recommended that an inquiry should be conducted into the investment pattern of EPF to ascertain whether it was also a collaborating party to these scandalous bond deals.

Indictment against the Monetary Board and certain senior officers

Thus, the leaked examination report is an indictment against the Monetary Board and certain high officials of the Central Bank in charge of Public Debt. The leak of the report is surely an embarrassment to the Board, but the supervisory staff that prepared the report without fear or favour should be commended and is fully vindicated.

(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected])