Timely Need to Innovate | Daily News
Evolving National Credit Policy:

Timely Need to Innovate

My article in Daily News “Economic Insights” on November 7, 2018 outlined the management of national money. As money is created by credit, national credit policy is nothing but national money policy. Money is one of the great inventions in the world that have immensely contributed to the human well-being to this stage. It is a facility for economic transactions by serving as a unit of account (valuing of transactions), a medium of exchange/payments, a medium of differed payments (lending/borrowing) and a liquid store of wealth.

In evolution of current paper plus electronic money system during the past six centuries from ancient barter transactions and commodity money systems, societies have invented a large number of credit/money instruments and institutions that operate from corner villages to international financial centres. The establishment of central banks to administer monetary systems has been the core in all countries. The system has been deepening in depth and breadth of money/credit whereas the usage of currency reduces while money circulates faster. The modern ICT and business accounting have provided considerable infrastructure for the present electronic money and credit.

Credit/Money Deepening

In early stage of deepening in countries, the focus is to shift societies from informal credit systems to banking to facilitate both payments and credit intermediation.

* The next stage is the development of a wide credit delivery system outside the banking to take more risks for business innovations. A large network of non-bank financial institutions (NBFI) and money, capital and insurance markets are among them. Meanwhile, state-sponsored directed credit schemes also are implemented to target priority economic sectors of national interest and to reduce economic disparities. Central banks are in the forefront with the governments at all stages of deepening because they are the monetary administrators.

* Deposits and credit of banks and NBFI are the major part of intermediation. Government securities, corporate equity and debt, venture capital, investment trusts/hedge funds, financial and commodity derivatives, structured credit products, exchange traded funds and insurance are the outer layers of credit markets. The transaction technology has advanced from the cash ledgers and physical promissory notes to password-based electronic ledgers and the latest block-chain/online peer-to-peer platforms.

* As economies got globalized through trade and value chains, countries have got extensively open to foreign currency credit products to finance the balance of payments. That has led to phase out exchange controls and open to cross-border credit/capital markets. In this context, foreign currency has become a significant source of liquidity to the credit pyramid in countries.

Sri Lanka also has been moving through similar stages of deepening with the state policy support as outlined below.

British Policy Initiatives

The British civil service recognized the needs for domestic credit and savings and took several initiatives.

* Currency Board System in 1884 to issue local currency “Rupees” in exchange of Indian Silver Rupee and gold to replace legal tenders of Indian Rupees and Sterling.

* Ceylon State Mortgage Bank in 1931, Banking Commission in 1934, establishment of Bank of Ceylon in 1939 and Agricultural and Industrial Credit Corporation in early 1940s based on the Banking Commission’s recommendations and Co-operative Federal Bank in 1948to promote institutional credit.

* Ceylon Savings Bank in 1832, Post-Office Savings Bank in 1885 (through post-offices) and Ceylon Savings Certificates in 1942 to promote thrift around the country.

* Money Lending Ordinance of 1918, Pawn Broking Ordinance of 1942 and Trust Receipts Ordinance of 1947 to promote private money lending.

* Registered Stock and Securities Ordinance of 1918 (RSSO) and Local Treasury Bills Ordinance of 1923 (LTBO) to facilitate the credit market for Government and to establish the yield curve for credit risk premium in the wider economy.

Those continued post-independence towards early 1970s and helped the Sri Lankan civil service to introduce reforms and further improvements to the credit pyramid through state support.

Post-independent Sri Lankan Policy Initiatives

Until early 1990s, a significant state thrust was to promote money and credit in line with the British initiatives. In fact, some of new initiatives were the reforms to British initiatives.

Initial policies and research were focused on promotion of institutional credit to domestic economy and to eradicate informal sector rural indebtedness. This was needed as the colonial banking was to finance export plantation and foreign trade whereas the monetary system was foreign currency-based through international trade. Despite banking, co-operative movement (rural banking) and state credit and savings schemes, a large network of informal money lenders managed the domestic economy. Highlights of post-independence landmark policies are noted below.

1) Central Bank of Sri Lanka (CB)

The Monetary Law Act of 1949 (MLA) established the monetary system, the CB in 1950, bank regulation and wider credit distribution-based monetary policy by repealing the British Currency Board System. The CB is the pillar for providing the access to bank-based credit and money for the development of the country.

* The CB was initially empowered to carry out the national monetary policy of regulating the supply, availability, cost and character of credit by grant of credit to banks, inclusive of emergency credit to avert imminent financial panics.

* Under sections 82 to 85 of the MLA, the CB can grant commercial credit up to 180 days, production credit up to 270 days and other advances up to 270 days. In periods of deflation, such credit may be extended up to one year. Emergency credit is flexible under section 86 of the MLA. In 1963, new previsions 88A to 88G were enacted to the MLA to set up a medium and long-term credit fund (MLTCF) out of CB’s reserves to grant credit to banks for productive purposes up to 15 years. The MLCTF was a major mechanism to implement development credit schemes as part of the monetary policy up to early 1990s. In 1980s, a sectoral-based national credit plan was monitored in the monetary policy.

* The flagship rural refinance scheme by the CB was the New Agricultural Credit Scheme in 1967 for paddy cultivation. This further advanced as Comprehensive Rural Credit Scheme in 1973 and New Comprehensive Rural Credit Scheme (NCRCS) in 1986 to cover other food crops and co-operative banks assisted by the state extension services. The development of domestic agriculture is mostly owed to this credit scheme which was scaled down to a state interest subsidy scheme in 1994. Foreign funded SMI credit scheme in 1980s implemented through the CB also immensely helped development credit delivery and local enterprises. At present, the CB operates 14 small state sponsored credit schemes with total funds utilized of Rs. 13.6 bn and two CB’s credit schemes of bout Rs. 4.6 bn. as at end of 2017.Accordingly, the NCRCS has shrunken to 72,000 farmers in the whole country in 2017.

* The CB established Development Finance Department (DFD) in 1974 and Rural Credit Department (RCD) in 1981 to actively implement a large number of refinance credit schemes up to 2000 to improve delivery of credit to rural agriculture and SMEs. For better coordination of such credit country-wide, 6 Regional Offices (RO) of the CB were set up since early 1980s. However, as these credit operations were phased out since latter part of 1990s, RCD and DFD were replaced with the Regional Development Department in 2000 to implement few refinance schemes, mainly on state funds. The RO became almost dormant with infrastructure and maintenance cost, other than coordination of ad-hoc financial literacy/entrepreneurial development meetings and supply of regional logistics to the CB.

* In 2006, the CB imposed a minimum level for bank credit to agriculture as 3% of total credit of respective banks by end of 2007 which was gradually increased to 6% in 2009 and 10% in 2010. This is a lose policy as it covers any credit that can cater to agricultural activities, i.e., growing, trade, transport, other services and housing. Banks can easily comply with the requirement by classifying any credit as agriculture whose credit supervision is rare.

* The monetary policy is now highly lean and passive to facilitate credit needs in the overnight inter-bank market based on targets of interest rates (policy rates) monitored by the CB to control overall credit/money growth in the economy. Therefore, the CB now does not have regard to sectoral credit needs of the wider economy in contrast to the MLA.

2) Development Bank Credit

* The establishment of People’s Bank (PB) in 1961 was primarily for domestic retail credit by linking with the co-operative/rural banking movement scattered around the country. However, after the PB got to mainstream banking, it distracted the Co-operative movement and diverted to commercial credit. Due to large losses in commercial credit, a major restructuring process was followed since 1990s. Meanwhile, rural banking system followed a new track that could not strengthen the system. The nationalization of Bank of Ceylon in 1961 also was for domestic economy interests.

* Development Finance Corporation of Ceylon in 1955 and National Development Bank in 1979 were flagship development banks set up with state sponsored funds. Their lending processes and institutional culture were project appraisal, credit follow up, restructuring of sick projects, etc., on development/project-based credit. However, the CB passively allowed both banks to become commercial banks in 2015 and 2005.

* Since 1985, 17 Regional Rural Development Banks (RRDB) were established by the CB with its capital and management to promote rural development banking in respective districts with flexible and decentralized decision-making. Initially, they were supported by a large number of CB’s refinance schemes until their rural deposit mobilization improved. RRDB with branches located in corner villages changed the landscape of rural and SME credit. The CB also passively let RRDB to get into political arms to appoint the Board of Directors and divested CB’s capital to the Government. As a solution to subsequent financial difficulties, RRDB were first merged into 6 Regional Development Banks on provincial basis in 1997 and national level RDB in 2010. Its next phase probably will be a retail commercial bank as the CB’s current national credit policy is highly market-based.

* A state credit system spanning from Janasaviya in 1989 to present Divinaguma/Samurddhi banking has remained for poverty alleviation/microfinances.

3) Housing Credit

Housing Loans Board in 1949 and National Housing Fund in 1954 were the early initiatives for specialized housing credit. Establishment of State Mortgage and Investment Bank in 1975 by combining The Ceylon State Mortgage Bank and The Agricultural and Industrial Credit Corporation, Housing Development Finance Corporation in 1984 and grant of housing loans on the security of the EPF balance to members facilitated housing development being a major socio-economic development initiative in post-independent Sri Lanka.

4) Savings Mobilization

National saving movement was streamlined by setting up the National Savings Bank in 1971 by merging the British savings movement of Ceylon Post Office Savings Bank, Ceylon Savings Bank and Savings Certificates scheme to fund the government. The bank was later permitted to lend for housing and retail purposes to its depositors. While all deposits are Government guaranteed, bank’s investment in government securities should not be less than 60% of its deposits. However, Post Office savings network disappeared later whereas they became payment agents for some private banks.

5) Other Supervised Credit Products

Housing Loans Board (1949), Local Loans and Development Fund (1949), legislations on pawn broking (several amendments to the ordinance of 1942), finance business (1988 and 2011), finance leasing (2000), hire purchase consumer credit (1982) also promoted credit landscape though NBFI at various degrees of risks.

* Emergence of finance companies and finance leasing companies produced a layer of financial intermediaries with considerable risks to the credit pyramid as they were permitted to take-deposits and promissory notes-based investments virtually repayable on demand to fund risky businesses. Ideally, such credit should be financed by capital and long-term debt that allow to take higher risks. The sector has survived two crises (1987/89 and 2008/09).

* Pawn broking which is essentially a private credit product was permitted to banks who have wider banking products for business. Banks also were permitted to carry on finance and leasing businesses. In this context, the banking system is now open to wider credit risks that should normally be taken by the outer credit pyramid or NBFI. Although the CB legalized microfinance in 2016, it has not been able to streamline microfinance which evolves to be a national menace.

6) Credit, Capital and Insurance Market

* Government securities and stock market have not been able to develop even to a basic level with standard products although they are old with a fair legislative environment (Securities and Exchange Commission Act of 1987, LTBO and RSSO) supported with liberalization of foreign capital.

* Insurance business which prevailed primarily at foreign hands since the British rule has got into state dominance with the establishment of Insurance Corporation of Ceylon in 1960 and regulatory framework under Regulation of Industry Act of 1962. Insurance is a source of wholesale credit while helping to cover risks of accidents and businesses.

7) Retirement Funds

Employees’ Provident Funds (EPF), Employees’ Trust Funds (ETF) and private provident and pension funds provide a significant source of compulsory savings. The use of these funds to develop private markets and dealing activities at substantial risks to members has been under constant criticisms since early 2000s. The use of provident funds to develop risk-taking private capital markets and dealers is not acceptable in common sense. The loss to the state guaranteed EPF due to such investments is reported to be huge that neither the fund manager (CB) nor the Government is accountable to reimburse losses to members where modern business accounting covers up such losses. The wisest option is to use such funds to finance government securities so that the funds are protected while banking and credit market are free to the private sector funding.

8) Credit Regulatory System

Mortgage Act of 1949, Banking Act of 1988, Debt Recovery (Special Provisions) Act of 1990, Recovery of Loans by Banks (Special Provisions) Act of 1990 and Credit Information Bureau of Sri Lanka Act of 1990 mostly facilitate the safety and soundness of the banking system and credit discipline for wider national interests.

Need to Get Ready for New Economy

Nearly 7 decades of post-independence have been spent on policies to further improve the access to institutional savings and credit to promote domestic economy, primarily through the banking system. The last decade appears to be towards market-based bank credit.

There is no dispute over the improvement of access to institutional credit for the domestic economy due to above policy initiatives. The rural indebtedness to informal sources has declined to 14.7% in 2016 from 92.2% in 1957. However, questions remain whether present national credit policy and products are capable of promoting a modern credit pyramid to take risks to finance business expansion and innovations that are essential for the country’s next phase of economic and market development. The country’s economy has been unable to reach a globally competitive position to stay relevant to global supply chain without being vulnerable to short-term capital flows.

Money/credit is a highly regulated public good. Therefore, the regulatory system is responsible for a fair money/credit pyramid capable of serving all public with different risk appetite and skills in the wider economy. Therefore, the present Sri Lankan civil service led by the Treasury has to take the leadership to innovate the present money/credit pyramid for a new digital economy. We need to review the whole credit pyramid based on several guiding principles, rather than looking for ad-hoc and uncoordinated tinkering. A new framework such as the post-financial crisis US Dodd-Franck Act with business-friendly principles and rules is necessary to overhaul the credit delivery system fast. This could be the best policy package to be announced for development goals in the next one to two decades aligned to the global value chain with a sustainable real business base in the country.

(The writer is a recently retired public servant as a Deputy Governor of the CB and a chairman and a member of 6 Public Boards. In his nearly 35 years’ service in the CB, he also served as Director of Bank Supervision, Secretary to the Monetary Board and Senior Deputy Governor and authored 5 economics and financial/banking books published by the CB and more than 50 articles)


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