27th January 2002

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Point of View

Radical reforms to Banking Act necessary

(The writer is a banking expert who has worked abroad and seen many bank failures. His name has been withheld at his request).

These days newspapers are filled with reports about attempts to take control of publicly quoted companies and banking institutions, taking advantage of falling stockmarkets at a time when the economy is facing temporary setbacks due to problems local and foreign. This category of investors eagerly await opportunities like this to grab control of asset-rich institutions at bargain prices circumventing laws and guidelines which prohibit these practices.

Unfortunately, this is one of the weaknesses of the capitalist economic system because it enables investors to take control by forming various 'front' companies, thereby skillfully concealing the true identity of the actual buyer. 

These 'front' companies usually have no tangible assets or a business record. They have only backers with deep pockets full of illegally earned money lying in various numbered accounts in Switzerland, Bahamas, Cayman Islands, St. Helena and other laundering centres. Even though these centres operate very much against international laws and norms little is being done by the IMF and the World Bank, without whose implicit approval these centres cannot thrive.

When several 'front' companies owned by one individual get together to take control of a publicly quoted company, very little can be done to safeguard the minority shareholders who are affected. 

One safeguard available in this country is the Takeover and Mergers Code of the Securities and Exchange Commission which requires any party acquiring over 30% of shares in the company to make a compulsory offer to all the remaining shareholders at the highest price paid by the investors to acquire the 30%. If properly and intelligently implemented, this could be accepted as a sufficient safeguard. 

Sadly, proper implementation does not happen. Those who are really committed towards acquiring control, form front companies leaving little evidence of the link to the true owner. What is lacking here is a mechanism to identify these 'front' companies and their true owners, thereby unravelling the web of tangled shareholdings which invariably lead to one party.

Dangers of total control
The dangers of one party gaining control of large public quoted companies are many. It can become highly damaging to the society and the public at large when an individual takes control of a company that is holding a near monopolistic position in a country. Banks in Sri Lanka are essentially in this category. The minimum capital required to set up a bank is over Rs. 250 million. Approval of the Central Bank is needed and it is not readily given. The reputation and the integrity of the original investors are looked into carefully. All this is done to make sure banks are stable and the interests of depositors are not jeopardised.

In the banking sector there are certain additional safeguards limiting the percentage of shares that could be owned by an individual to 10%. The Monetary Board of Sri Lanka (MBSL) has authority to permit this limit to be exceeded but not beyond 15%. Thus, no individual or a corporate body acting alone or in concert cannot exceed this 15% limit. These well-intentioned enactments were included in the Banking Act which was a major piece of legislation introduced by the last UNP government after much consultation with all parties. These limitations of 10% and 15% were included specifically to ensure that no individual could take undue advantage of one's own shareholding in a bank by influencing the decision making of the bank. It also prevented the directors from abusing their positions to borrow from the bank at concessional rates by making it mandatory for their borrowing to be disclosed in the annual reports. A further safeguard was to impose a limit on the amount that could be lent to any "one party" known as the "Single Borrower Limit".

These provisions were included to safeguard the interests of the four stakeholders of a bank namely, shareholders, staff, depositors and borrowers. A delicate balance of all these four countervailing forces is essential for the successful functioning of a bank. Any attempt by one stakeholder to take undue advantage will impact on the whole model leading to its collapse sooner or later, mostly sooner. The framers of the Banking Act went deep into many cases where depositors had been defrauded by owners of banks in the US and several South Asian countries before including the protective clauses referred to earlier.

Capitalising on loopholes
Despite such legislative and regulatory safeguards, attempts are being made at gaining control of banks by capitalising on the tiniest legal and regulatory loophole. The frequent excuse given by the offenders for trying to break the law, particularly the 15% limitation imposed by the Banking Act, is the precedence set by the Central Bank in permitting ownership beyond the 15% limit in the case of certain banks. For instance permission was given to the Browns and Stassens Groups to hold nearly 40% each of the shares of the Hatton National Bank, the Ceylinco Group and the Readywear Groups' holding in Seylan Bank, approval given to the DFCC Bank and the Sri Lanka Insurance Corporation to hold nearly 30% each of Commercial Bank shares.

Governments owning 100% of state banks are also now treated as transgressors of the Banking Act by international regulators. The principle enunciated is the same. No individual or a group of persons, whether private or state should be permitted to hold any equity stakes in a bank in excess of the 15% limit.

Empirical evidence very clearly shows that, higher the percentage shareholding in a bank by a single party, higher will be the cases of conflicting interests, murky dealings and unethical practices ultimately leading to a weaker bank. The burden of operating loss-incurring state banks has now fallen on the government as the 100% owner, the serious management conflicts that weakened Seylan Bank and the efforts of DFCC to manipulate the Commercial Bank share structure are some strong cases in point.

Aberrations set a bad precedence and this encourages untested entrepreneurs to seek cover behind these precedents and try to gain control of other banks. The attempt made by Hatton National Bank and the Stassens Group to gain control of Sampath Bank is one such case. Competition between Vanik, Pramuka and Samurdhi to control Pan Asia Bank is another. 

Nevertheless, the recent refusal by the Central Bank to permit the holding company proposal of DFCC and Commercial Bank has finally sent the correct signals that it will not tolerate more such breaches of the Banking Act.

Weaknesses of the Act
The fundamental weakness of the Banking Act is its many ambiguities. It is not clear whether the upper limit on shareholding of a bank is 10% or 15%. The discretion given to the Monetary Board and the Director of Bank Supervision to interpret the law on a case-by-case basis is specious and frequently challenged.

Many legal luminaries now agree that the wording of the Banking Act does not empower the Monetary Board to permit any individual or group to hold shares in a bank in excess of 15%. It must also be remembered that the 15% limit was originally contemplated because it was felt that anything higher would unnecessarily complicate the running of a bank, impair its decision-making and finally endanger depositors' interests. 

In order to ensure the long-term stability of banks in Sri Lanka it is high time the Central Bank directs all banks having shareholdings in excess of 15%, whether in the name of an individual, company or state corporation, to divest these shares and bring down holdings to be within the maximum of 15%. Even if implementing, such a directive would take at least two to three years it would ensure the long-term stability and competitiveness of the banking sector in Sri Lanka.

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