The Sunday Times Economic Analysis                   By the Economist  

Should bank crashes be prevented?
Sri Lanka has had a proud record of not experiencing any bank crashes since independence. Prior to independence several efforts to establish local private banks failed. In fact it was these failures that prompted the government to initiate the establishment of the Bank of Ceylon in 1939. There can be no doubt that the record of not having bank crashes is a good one.

Of course several foreign bank branches that were opened in Colombo after 1977 closed down. Even when the Bank of Credit and Commerce (BCCI) was collapsing internationally, the Central Bank took measures to ensure that its depositors of funds in Sri Lanka did not lose their deposits with the Bank. All these are commendable in the country's banking history. Currently there are rumblings that several banks, both private and state, are facing financial difficulties and that if some remedial measures and assistance are not forthcoming their liquidity and financial sustainability would be threatened. Should the Central Bank step in and rescue these banks? The maintenance of the country's record of not having had bank collapses may not be a good enough reason.

There are several considerations that must be applied to determine an answer to this question. First and foremost, what would be the consequences of a crash of a particular bank to the financial system and the economy? If these are serious and of proportions that would affect the economy as a whole, then there are indeed justifications for the Central Bank and the government to intervene. On the other hand, if the banks are too small, of recent origin and the ripple effects on the financial system would be limited, then there may be no justification for public funds to be expended in the interests of a few in the affluent class. The economy that is already in bad shape should not be burdened by the results of mismanagement of directors and management of a bank.

It is a different story when it comes to the big state banks. In the first instance these banks together control over half the banking assets in the country. In fact in 2001 the two banks together accounted for about 58 percent of the country's total banking assets. This is not the only reason though a very important one. The failure of these banks could have ripple effects on many a business establishment and the economy. Besides people have a right to expect that state owned banks are financially secure. The mismanagement of these banks should not result in a threat to the economy and to the financial system as a whole.

The reasons for the possible insolvency of these banks should also be considered. These reasons include the government's pressurising the state banks to finance purchases for which there were no budgeted resources. Such a course is of course in contravention of the principles of accountability of public funds.

A second major reason appears to be that these banks financed several large corporations that are themselves in difficulties for various reasons. A third problem is the bad debts incurred owing to politicians pressurising bank officials to give credit to financially risky ventures and individuals. In such cases bank officials have often by-passed the usual lending criteria, not evaluated the financial risks and not taken adequate collateral. The directors of these banks being appointees of the government may have approved such loans. In each of these cases there is a need to establish the principles of accountability and those who have abused their authority should indeed be brought to book.

Another related issue is whether the regulatory framework for banking is weak and whether there are needed reforms in banking regulations. What may be even more pertinent is whether the Central Bank has the capability to supervise the expanding and fast developing banking institutions. Finance has grown in complexity in recent years and it may be that the Central Bank's skilled personnel are inadequate to the modern tasks. Banks and financial institutions have found innovative means of circumventing the regulations imposed by the authorities. Creative and innovative accounting methods can sometimes fool the supervisor as it has happened in even the most advanced countries.

There is a need to look into the causes of the financial difficulties faced by banks. Where possible those responsible should be made to make amends or be adequately punished. The principles of accountability must be applied. Private banks that have become insolvent owing to their own mismanagement should not be bailed out through public funds. They must be allowed to crash.

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