The Central Bank of Sri Lanka (CBSL) has petitioned the Commercial High Court of Colombo to wind up Central Investments & Finance Ltd (CIFL). It was the latest in a string of failures involving regulated finance companies. And the company’s balance sheet had long indicated to the regulator that a collapse was looming. A Ponzi [...]


CIFL crisis exposes weakness in Central Bank’s regulatory systems

Questions over why large number of finance companies are crashing

The Central Bank of Sri Lanka (CBSL) has petitioned the Commercial High Court of Colombo to wind up Central Investments & Finance Ltd (CIFL).

It was the latest in a string of failures involving regulated finance companies. And the company’s balance sheet had long indicated to the regulator that a collapse was looming.

Depositors are left in the lurch: It is alleged that the system favours the finance companies, not the depositors

A Ponzi scheme

In April 2011, the CBSL circulated internally the results of an on-site examination into CIFL. It deemed the company’s for future losses “very high”. It did not have sufficient resources. It had no earnings from a whopping 61.4 percent of its assets. It depended entirely on new deposits to meet expenses and repayments, “thus operating as a Ponzi scheme”—or an investment fraud that pays existing investors with funds collected from new ones.

CIFL continued unethical, fraudulent business practices specifically with respect to real estate transactions, the report also held. The modus operandi was similar to other companies in the Aspic Group to which it belonged. Among them was Industrial Finance Ltd (IFL), also distressed at the time.

Three years later, the crisis broke. CBSL finally acknowledged publicly that CIFL had liquidity and management issues and placed it under People’s Leasing and Finance PLC. In 2018, the regulator announced that all efforts to revive it through different strategies had failed and cancelled its licence.

There is a pattern here. This is the path many “regulated” Sri Lankan finance companies ending up in distress have taken. Suspended Swarnamahal Financial Services (SFS) Private Limited admitted to CBSL in February 2011 that it was taking deposits from the public without authority through, among others, EAP Networks (Pvt) Ltd, Swarnamahal Property Developers (Pvt) Ltd and Universal Consultancy Services (Pvt) Ltd.

Cooking the books

By November 2012, Swarnamahal Jewellers had taken Rs 7.2bn worth of deposits from the public when it was not licensed to do so, documents obtained by the Sunday Times through a Right to Information application showed. Meanwhile, Edirisinghe Trust Investments Ltd (ETI) already had off-balance sheet assets, liabilities and undisclosed deposits liabilities of Rs 6.48bn. These are assets or liabilities that do not appear on a company’s balance sheet.

But the CBSL cancelled the licences of SFS and ETI only in July this year. Both companies, the regulator admitted, were insolvent due to “various irregularities” that had taken place since 2011. Their directors had failed to find suitable investors as part of a revival plan. There were no viable proposals.

Today, we know more. ETI had maintained separate books, one for legitimate activity and the other for shady ones. Investor were offered two options. They could put their money into the first, pay withholding tax and have their deposit reflected in the books of the regulated company. Or they could put it in the second, unregulated company and avoid tax. They received a deposit certificate of a particular colour based on what they chose.

The deposits in the unregulated entity, which had no authority to accept public monies, were kept off the books and used to buy land and make other investments. “It was from this company that money was siphoned out,” said a source who knew what had transpired.

This source recalled a land purchase of hundreds of acres on the East coast. The plot was revalued at a much higher value and the money siphoned out, leaving a “gaping hole” in the balance sheet that had to then be funded by deposits. It was evident even then that “there was no way they could have continued this operation”.

“They had neither minimum capital nor capital buffers to run a finance company,” he said.

Copy cats

Lalith Kotelawala played a similar trick. “Some of them say what a good man he was, and that his empire collapsed because they took revenge on him,” another source said. “Sorry, no. We are not questioning his empire, which was licensed finance companies, banks, whatever.”

“He ran one organisation, a credit card company, which was not supposed to take deposits. It was only purely for the purpose of settling liabilities and charging of penalties for not making repayments. But he used this as a loophole and a conduit. The Golden Key Credit Card Company’s liabilities were Rs 26bn and, at the point it collapsed, it had assets amounting to about Rs 13bn. By the time courts went through all of it, the value of those assets was Rs 6bn.”

Each time a finance company comes under stress, the tremors are felt across the industry. In the post-mortems, they are found to have had weak portfolios, questionable investments, lame management and inflated asset values that made a mockery of their balance sheets.

String of failures

The failed companies so far include Mercantile Credit Limited in the late 80s. In the 90s, there was Union Trust and Investment Ltd; House and Property Traders Ltd or HPT; Translanka Investments Ltd; and Home Finance Limited. Pramuka Savings and Development Bank buckled in 2002, becoming the first bank in Sri Lanka to cave in.

Golden Key Credit Card Company collapsed later in 2008 along with Industrial Finance Ltd (IFL). In 2016, Central Investments and Finance Ltd (CIFL), City Finance Corporation Ltd, The Standard Credit Finance Ltd and Entrust Securities PLC were declared insolvent.

In May this year, CBSL cancelled the operating licence of The Finance Company Plc, a non-bank lender of the troubled Ceylinco group. And in July, it halted the business of ETI and SFS.

This week Fitch Ratings (Lanka) gave Mercantile Investments and Finance PLC a BBB- and deemed its outlook “negative”. The agency expects the company’s capital buffers to deteriorate from pressure on its already-weak asset quality owing to “the challenging operating environment and below-average earning generation”.

Of course, finance companies have failed the world over. But why are so many crashing here? And why within such a short span of time?

This week, Industries Minister Wimal Weerawansa blamed CBSL for formulating its monetary policies for the benefit of banks and finance companies, rather than depositors. It role should be to protect customers and not to swoop in assume control of institutions and they fall, he was reported as saying at an event.

The Minister also reportedly accused finance companies of running away with depositor funds, causing the Central Bank to step in and shoulder the burden, leaving customers in the cold. “The Central Bank’s role is to identify financial institutions that are about to fall and protect their customers before they fall,” he is quoted as saying.

Shooting himself in the foot

But Mr Weerawansa forgot to factor political interference into the equation. In 2005, there were only 28 finance companies in Sri Lanka. By 2014, the number shot up to 44. During the same period, seven new leasing companies also received licences. The number of registered companies today is 41, still an unwieldy number for a single regulator.

“Every mother’s son was given a licence during President Mahinda Rajapaksa’s administration,” said an industry source, requesting anonymity. “They went ballistic. It was not considered whether they were fit and proper. The licences were granted as political pay-offs. And some of these companies went belly-up.”

Minister Weerawansa was in that Government. And it is privately acknowledged–in other words, “everyone knows”–that CBSL’s hands were often tied owing to the political patronage the managements of some of these companies generously received.

ETI and Swarnamahal were two of them. “There was political interference where the bigger companies were concerned,” an official source from the finance sector said. “The Edirisinghes could use their political clout to stop action. The Central Bank could not even suspend the activities of the company.”

The regulator has another challenge. “The received wisdom is that, if you go public about the weaknesses in a financial institution, it can cause systemic instability,” the source said. “That is one of the reasons why they were concerned. Although these companies account for just seven percent of total assets in the financial sector, if people think there is a weakness in the system, it will cause a run that in turn can spill over into the banking sector.”

The previous Monetary Board inherited as many as six insolvent companies. The regulator received letters every day from helpless depositors, including six people. So it increased the insurance payout, managing to settle around 90 percent of unpaid depositors of The Finance and more than 60 percent of ETI customers.

The Monetary Board also finally decided to remove the ETI and SFS licences and take legal action. The Edirisinghe directors have had their accounts frozen and are banned from travel abroad. There are ongoing court cases to seize their assets.

Traffic light system

The CBSL started employing the “traffic light system” whereby companies were categorised as green, amber or red in order of health. There are twenty in the green channel, 15 in amber and six in red.

“The regulator is now being very much more proactive and aggressive in dealing with the vulnerable companies,” the source said. “It is tough on those who don’t meet capital requirements, ordering them to merge or have their licences revoked.”

Prosecution, however, is difficult–that is, finding enough evidence to stand up in court. Companies also have a tendency to “run to court and get things delayed”. Forensic audits are necessary and, even then, it is difficult to pin the blame.

CBSL has said it will once again promote the consolidation of non-bank financial institutions sector through a restructuring master plan. It intends to cut down the number of companies to between 20 and 25.

It remains to be seen whether the politics that Minister Weerawansa seems unaware of will put a stop to progress.

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