Mandatory Corporate Governance Code and the Central Bank

Recently, the Central Bank of Sri Lanka announced the new directions for the maintenance of Capital Adequacy by Banks, under the Basel II, and at the same time its Supervision Department published a Mandatory Code of Corporate Governance for Licensed Banks in Sri Lanka. While the Central Bank wants licensed banks in Sri Lanka to observe the Code of Corporate Governance, the regulator itself is unable to observe the rules under this Code.

The IMF has serious doubts about the independence of Sri Lanka’s Central Bank and its ability to regulate banks fairly, due to the presence of a Treasury representative on the Monetary Board. This creates a conflict of interest between the obligations and responsibilities of the Central Bank and the requirements of the Treasury to meet their payments. The Monetary Board’s independence is also constrained by the presence of the Secretary to the Treasury on its Board. The Secretary to the Treasury is also the largest shareholder of the two state banks, the Bank of Ceylon and the People’s Bank.

The Treasury Secretary has been given the responsibility for appointing members to the boards of the two state banks. This action is inconsistent with the standards of Corporate Governance expected by the Central Bank from the banks whom they are expected to supervise.

In the UK, the Bank of England does not control the banking system as it may be in conflict, with the primary goal of achieving price stability. In India, the Reserve Bank of India, does not appoint members to the boards of state-owned banks. Several independent Central Banks all over the world no longer regulate commercial banks. Even in the US, the smaller banks are supervised by agencies separate from the Federal Reserve Bank.

The IMF has commented that the Central Bank’s regulatory independence has been compromised. The IMF called on the government to limit the conflict of interest, arising from the Treasury Representative’s role as a shareholder of state commercial banks. The Central Bank in response to the IMF’s comment, maintains that the Treasury Secretary’s representation on the Monetary Board facilitates greater cooperation between the government and the Central Bank. It fails to recognize the fact that the Central Bank is merely an institution, an instrument through which the Monetary Board and especially, the Governor of the Central Bank who is the Head of the Monetary Board has a very heavy responsibility to act independently, fairly, correctly, professionally and competently to advise the government on how it should conduct its policies and its activities so as not to conflict with the mandatory role imposed on the Governor of the Central Bank by the Monetary Law Act 1949.

To get back to understand the proper role of the Central Bank, or more specifically that of the Monetary Board, let us have a look at the provisions of the Monetary Law Act which were passed in Parliament in the year 1949. Sri Lanka gained independence in the year 1948 and shortly after that, it recognized the need to set up through the Monetary Law Act, an institution to administer and regulate the monetary system.

The services of John Exter of the Federal Reserve Bank of Wisconsin, a member of the Federal Reserve System was obtained by the Government of Sri Lanka to do the spade-work for the drafting of the Monetary Law Act. Accordingly, Section 9 of Part 2 of the Act, states very clearly that the Monetary Board of the Central Bank shall in that name be a Body Corporate, with perpetual succession and a Common Seal and may sue or be sued in its Corporate name.

The fact that it is the Monetary Board that has Corporate status, and not the institution called the Central Bank, was purposely done so that the Governor of the Central Bank who is the Chairman of the Board, and the other 4 members, are charged with the duty of regulating the Supply, Availability, Cost, and International Exchange of Money, so as to secure, as so far as possible by action authorized by the Act, the following objectives.

(a)The stabilization of domestic monetary values.

(b)The preservation of the par value of the Ceylon Rupee and the free use of the Rupee for current international transactions.

(c)The promotion and maintenance of a high level of Production, Employment, and Real Income in Sri Lanka.

(d)The encouragement and promotion of the full development of the Productive Resources of Sri Lanka.

If we peruse the Monetary Law Act, starting with Chapter (1), which provides for the establishment of the Monetary Unit, we find that Clause 3 says, that the par value of the Ceylon rupee shall be two grains and eighty eighth hundredths (2.88) of a grain of fine gold. It is obvious that this is not the par value now. There is however, provision for the par value to be amended under certain circumstances and the amendment has to follow a laid down procedure.

Chapter 2 deals with the establishment of the Central Bank to administer and regulate the Monetary System and Section 6, sets out the objects which have been mentioned earlier in this Section, which the Monetary Board is mandated to secure so far as possible.

Part 2 of Chapter 2, spells out the Constitution of the Monetary Board and Section 9, gives the Monetary Board Corporate Status. Section 11, shows how independent the Governor of the Central Bank should be, by disqualifying anyone who is a Senator or a Member of Parliament or a Member of a Local Authority or a Public Officer or a Judicial Officer or a Director, Officer, Employee or Shareholder of any Bank from being eligible to be appointed as Governor.

Part 3 of this same chapter provides the Governor to be assisted by a Dy. Governor. Section 20 states that “The Governor shall in his capacity, but in accordance with the policies or rules approved by the Board, have authority to represent the Board in all its relations with other persons.” Again this Section stresses the independence of the Governor of the Central Bank.

Section 30, provides power for the Monetary Board to suspend or restrict the business of a Banking Institution upon the report of the Director of Bank Supervision, who is of the view after examining the affairs of the Institution to recommend discontinuance of business by the Institution. It is therefore, an obligation which appears to have been overlooked in the case of Pramuka Bank.

Section 44 of Part 8 states that persons with interests in banking institutions are not eligible for employment by the Central Bank. Section 51 states that currency notes and coins issued by the Central Bank shall be the liabilities of the Central Bank and therefore, the quantity of currency notes printed must be determined solely by the Central Bank.

Section 61 of Part 2 defines Money Supply as all currency and demand deposits owned by persons other than commercial banks or the government. Section 62 of chapter 4 Part 1, states that the principles governing the determination of Monetary Policy are those formulated by the Monetary Board and therefore it is their responsibility to preserve domestic monetary stability. In the event that Board finds that the amount of money supplied has increased or decreased by more than 15%, or the Cost of Living Index has increased by more than 10% of its level, at the end of the corresponding month of the preceding year, measures must be taken to rectify Monetary, Fiscal or Administrative Policies and recommend these measures for adoption by the Government.

The Monetary Board is also enjoined to maintain the International Stability of the Ceylon Rupee in terms of Section 65.

Section 68 provides for the alteration of the par value of the Rupee, if the Monetary Board by a unanimous decision recommends to the Minister of Finance that such alteration is necessary.

The legal parities of foreign currency with respect to the Ceylon Rupee have to be determined by the Monetary Board in consultation with the International Monetary Fund in terms of Section 72. Section 80 makes it mandatory for the Monetary Board to take action as is appropriate under Section 63 or 67, if there is danger by an inward or outward movement of Capital to the domestic or international stability of the Ceylon Rupee.

Section 88 provides for the Central Bank to make direct provisional advances to the government to finance expenditure authorized by Parliament provided that such advances shall be repayable within 6 months and the total amount of such advances shall not exceed 10% of the estimated revenue of the government for the financial year in which they are made.

Parts 6 and 7, covering Sections 92 to 104, provide for a regulation of the Reserves of Commercial Banks, and the Credit Operations of Banking Institutions. It will therefore be seen that the 131 Sections of the Monetary Law Act are comprehensive enough, if adhered to by the Monetary Board to control and regulate the Banking System in this country.

As if this were insufficient, 40 years after the Monetary Law Act was passed the Banking Act No. 30 of 1988, sought to provide for the deficiencies of the Monetary Law Act in regulating the day to day operations of the Commercial Banks and Specialized Banks licensed to operate in this country. It would therefore appear that after 20 years of administering the Banking Act, the Central Bank now feels that still further regulations are needed in the form of a Mandatory Code of Corporate Governance.

I shall give below my observations on the Banking Act No. 30 of 1988 in the next few paragraphs of this article. Part 1 of the Banking Act deals with the licensing of persons carrying on Banking Business which is restricted to Limited Liability Companies which have complied with the provisions of Part X111, of the Companies Act No. 17, of 1982 or have been incorporated outside Sri Lanka or have obtained a Royal Charter or have the status of a Body Corporate in that country. At the very inception, the Banking Act in Schedule 1 listed the Banks already conducting banking business in Sri Lanka as having complied with the requirements for licensing. In Section 4, companies incorporated outside Sri Lanka, had to remit currency to Sri Lanka to form part of the assigned capital of such bank and to be kept as a deposit with the Central Bank. Section 6 of Part 1 imposes limits on all licensed commercial banks to carry on only banking business specified in the license and to restrict the forms of business to those specified in Schedule 2 of the Act. Section 7 is again blatant evidence where discrimination has been made in the provision of limits for carrying on business to the People’s Bank, the Bank of Ceylon and Regional Rural Development Banks. This is evidence that the terms are not equal between the banks.

Section 12 of Part 1 provides for obtaining the approval of the Monetary Board prior to carrying on certain transactions in certain areas of the country, or of opening or closing a Branch, Agency or the alteration in the location of such Branch of Agency in any part within Sri Lanka. A license has also to be obtained to open or close a Branch, Agency, or Office outside Sri Lanka. Any person or nominee of such Person, Partnership, Company or Corporation was restricted from acquiring more than 10% of the issued Capital of a licensed Commercial Bank. Part 2 of the Act place a restriction on the words used “Bank, Banker or Banking”. Section 17 of the same Part does not permit commercial banks to have as its subsidiary a company which is not a licensed commercial bank. Part 3 of the Banking Act deals with capital requirements, Reserve Funds and maintenance of liquid assets. Every licensed commercial bank which had formerly had to maintain a minimum unimpaired capital of Rs 25 million is now required to maintain a minimum capital of Rs.2,500 million. It has also to maintain a Reserve Fund which has to be built up annually, by transferring out of the net profits, after the payment of Tax, at least 5% of such profits, until the Reserve Fund, is equal to the paid up or Assigned Capital of the bank. The Liquid Assets of every bank have to be not less than 20% and not more than 40% of its total liabilities less the liabilities to the Central Bank and to the shareholders. Section 22 restricts the payment of Dividend on Banks established within Sri Lanka and the remittance of profits earned in Sri Lanka, for transfer abroad in the case of banks incorporated outside Sri Lanka.

Off shore banking business can only be conducted by licensed commercial banks with a special license which sets out the terms and conditions for permissible off shore business.

Part 5 of the Banking Act covers the requirements in relation to the Accounts, the Audit, the Inspection and the Information to be published by the licensed commercial banks. Section 38 of part 5, requires every licensed commercial bank to transmit to the Director of Bank Supervision and publish within 5 months after the close of the Financial Year its Balance Sheet and Profit & Loss account and exhibit them in a conspicuous place in each of the places of business it carries on in Sri Lanka.

Part 6 of the Banking Act spells out the disqualification for appointment as a Director, a Secretary, a Manager of a licensed Commercial Bank. Part 7 gives the power of control over licensed Commercial banks into the hands of the Director of Bank Supervision who in conjunction with the Monetary Board may give directions as it may deem necessary specifying,

(a)Class or classes of advances which may or may not be made

(b)The margins to be maintained in respect of secured advance

(c)The maximum amount of accommodation to any one Company, Firm, Association of Persons or individuals or in the aggregate, to any individual, his close relation or a company or a Firm in which he has a substantial interest. Banks may not grant accommodation against the security of its own shares or shares of Companies which have a substantial interest in the Bank or Shares of Companies in which the Companies referred to above have substantial interest.

In the light of the foregoing, which spelt out the provisions of the Monetary Law Act and that of the Banking Act, and the role of the Central Bank in the regulation of the Banking System, it is unclear why a further set of rules under the guise of a Draft Mandatory Code for Corporate Governance for licensed banks in Sri Lanka needed to be published, given the history of banking in Sri Lanka since 1950, and that only one (1) bank, collapsed and that too due to the omission of the Central Bank, to exercise its powers of site examination, of site examination, perusal of weekly, monthly, quarterly, half-yearly and annual reports. It appears to me that the Central Bank is preaching to the already converted, and to a very responsible, honest and competent set of persons who are performing the duties of Chairman, Directors, Managers and Auditors of Banks. I feel that the Mandatory Code is a conviction of the guilt of the Central Bank in the discharge of its obligations to the general public.