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					                                                                          5/4/2003

                        World Bank Roundtable Forum


                   Transforming Public Sector Banks
                        Washington DC, April 9 – 10, 2003

              Session II : Good Public Banks/Bad Public Banks
                                 April 9, 2003


                            Presentation by –
           A S Jayawardena, Governor, Central Bank of Sri Lanka



        I thank you for the invitation to speak on the important but somewhat
neglected topic of public sector banks. By historical evolution, almost all
countries have financial systems which show a mix of private and public sector
institutions. Of these, the shorter-term focused commercial banks and longer-
term focused investment banks generally dominate the scene. In the early days
of banking, privately owned commercial banks domiciled in the major trading
nations emerged as financiers of international trade through extensive branch
networks. Since about the middle of the last century, public sponsored national,
commercial and investment banks grew to dominate the scene with strong
protection afforded by the state. With the recent shift towards competitive
market-oriented policies, the preferred status of public sector banks has been
whittled down in order to create a more even playing field. Also, the traditional
distinctions between commercial, savings, investment and development banks
have got blurred with the growing integration of the world economy. Thus,
fundamental questions have been asked with regard to the future role and the
nature of public sector banks. Hence, I must congratulate the World Bank for
organizing this important seminar for highlighting the issues arising from the
transformation of public and private owned banks around the world.


        By nature, the banks depend on public confidence in raising deposits and
investments from the public. They tend to lend several times the capital
contributed by the owners. This feature tends to limit competition in the financial
sector. They are also vulnerable to vagaries of the business cycle and therefore
have come to depend on the support of a lender of last resort, the Central Bank,
which invariably is a public institution. Government/state sponsored banks have
risen largely to meet lacuna in the financial system, arising from the reluctance of
traditional profit centered banks in entering unfamiliar and higher risk areas.
Thus, we find specialised state sponsored financial institutions in fields such as


                                         1
small savings generation, small and medium enterprise lending and longer-term
lending in markets where such term finance was not available. In other words,
public sector banks were set up with the intention of entering into areas which
were not catered to, by risk averse and short-term trade-oriented financial
institutions.


        Thus, by definition, the yardsticks by which private and public banks are
evaluated have to be different, at least in the early stages. However, with the
blurring of distinctions between commercial, savings and investment banks, and
the growth of “universal banks” which undertake a diversity of functions, the role
of state owned banks has come to be questioned on account of the perception
that fair competition among all financial institutions served the public better and
that ownership did not really matter. Hence, the idea of a “good” or a “bad”
public or private bank needs careful definition. Similarly, a “good” or a “bad”
public bank will have to be delineated with extreme care, because there are no
simple norms or criteria of measurement. Irrespective of their social obligations,
the public continues to treat profitable public banks as good and un-profitable
ones as bad, for the simple reason that an insolvent bank exposes public
deposits and investments to risk of losses. In this regard, it is easily forgotten
that the social obligations of public sector banks are generally not profitable, but
are undertaken for a larger social benefit, which is not recoverable from the
public users through the pricing mechanism. However, the association of
financial profit with success and losses with failure continues to haunt public
banks. Further, unlike private banks, public banks are often thought of as “too
important to be allowed to fail” and are maintained with substantial public
subsidies. In reality it is so, as winding up of a large public sector bank is costly
and it could even pose systemic risks to the entire financial sector.


       Thus, it is difficult to generalize the story of public sector banks. They
should be evaluated in their context. Hence, an analysis of the evolution of
public sector banks in Sri Lanka might throw some light on what one may
characterize as good or bad public banks.


The Background

       In view of the limited role played by “exchange banks” in financing trade,
the British Colonial Government set up very early two institutions to promote
domestic savings: the Ceylon Savings Bank (1832) and Post-Office Savings
Bank (1885). The foreign commercial banks financed the working capital needs
of the emerging export-oriented plantation sector by financing foreign owned
“agency houses” which managed the plantations, supplied the inputs and sold
the produce. A small volume of credit for the indigenous people was provided by
moneylenders at very high interest rates. The fear of confiscation of local



                                         2
enterprises by the moneylenders caused early agitation for a “State-aided Bank”
in the 1920s, and led to the formation of the State Mortgage Bank in 1931 to
redeem mortgages in default. The agitation for a state-sponsored fully-fledged
commercial bank continued until 1939 when the Bank of Ceylon was established
with government and private capital. This bank was expected to meet the current
needs of the local people at a time when the exchange banks did not consider
them creditworthy. The Agricultural Credit Corporation (AICC) was set up in
1944. Apart from these interventions, this era up to the Second World War was
one where a laissez-faire policy was followed.

       Active interventionist policies were pursued after the country regained
independence in 1948. The currency board system was superseded by the
Central Bank in 1950. The Bank of Ceylon was urged to expand rapidly despite
inadequacy of its capital-base since 1953. The World Bank recommendation for
a private sector development institution was created in the formation of the
Development Finance Corporation (DFCC) in 1955. By 1960s, the economic
policies moved strongly towards an interventionist mode and a large number of
nationalizations took place. The Bank of Ceylon’s private share was nationalized
in 1961 along with the insurance industry. In the same year the People’s Bank
was set up with partial ownership of the co-operative movement to promote
small-scale rural activity and co-operatives. By 1971, the old Ceylon Savings
Bank and the Post-Office Savings Bank were merged into a single large National
Savings Bank (NSB). By 1979, the National Development Bank (NDB), another
an investment bank was set up to compete with the DFCC with ownership by the
government and several public sector financial institutions.


       This strongly interventionist policy came to be gradually relaxed after
1977, when Sri Lanka came to adopt free open market policies. The People’s
Bank divested itself of the responsibility for co-operatives in 1978. Both the Bank
of Ceylon and the People’s Bank grew substantially under continued state
patronage and protection. This favoured position created by exclusive rights to
branch expansion and management of public sector accounts, these two state
banks grew to own 80 per cent share of the financial system. But it also led to
large-scale inefficiencies and high cost, which encouraged the entry of a few
local private banks. The post-1977 liberalisation which opened doors for foreign
investment also led to the entry of a few foreign private banks. By 1990, a
conscious decision was taken to freeze the expansion of the two state banks and
to promote expansion of domestic commercial banks. Also, out of concern at
the rising non-performing loans of the state banks, the Basel guidelines on
prudential banking came to be adopted in the country, closely monitored by the
Central Bank. By the year 2000, there were 24 private banks of which 16 were
foreign, in addition to the two state banks. The result was a substantial growth in
assets, deposits and loans of the banking system. (Please see Table 1 below).
Public banks took an early lead but have now been overtaken by private banks
despite the fact that the public banks had a significant advantage of a



                                        3
widespread branch network. They were severely handicapped by the large work
force they carry, (more than 20,000) which could be deemed to be at least 30 of
40 per cent excess.


            Table 1 : Growth of Commercial Banks during 1950-2002


                      1950    1960     1970     1980     1990    2000      2002
 Banks
  Public              -         -        2      2      2           2         2
  Private             12       13       10      19     22          24        21
 Branches
  Public              -        -       148     432    553         603       606
  Private             -        45        17      55   110         328       368
 Employment
  Public             856      1,655 4,510     16,772 20,343      20,103    19,626
  Private            n.a.     n.a.    n.a.     n.a.   n.a.       13,444    14,009
 Assets (Rs.Mn.)
  Public                343      734   2,338 18,620 88,126       368,748 386,032
  Private               858   1,197       784  7,981 44,238      308,933 401,994
 Deposits (Rs.Mn.)
  Public              -          -     1,752 13,348 59,719       223,009 278,503
  Private               811   1,057       642 3,943 28,865       222,657 294,725
 Loans (Rs.Mn.)
  Public              -        -       1,064 12,070 52,267       185,732 167,326
  Private              182      544       484  4,930 29,375      170,932 216,600
Source: Central Bank of Sri Lanka and the commercial banks

       Inadequate capitalization continued to haunt public sector banks, but they
managed to expand their business by the implicit protection of government
ownership. However, by the 1990s their non-performing loans reached critical
levels which was compounded by government directed write-offs of small farmer
loans, inability to foreclose on public sector defaulters and long legal delays in
loan recoveries. As a result, the state banks had to be re-capitalised twice. First,
in 1993, government issued 30 year bonds for Rs. 24 billion at 12 per cent
interest, in lieu of which the banks issued shares to the government, which
formed a part of their assets. On the second occasion, in 1996, Rs. 19 billion of
bonds were issued by the government at 14 per cent interest to meet the
inadequate provisioning for bad debts and the deficits in their pension funds.
This enabled the banks to meet capital adequacy requirements. The banks were
expected to enter into agreements with the government to turn their businesses
around and repay the government bonds. This attempt was not entirely
successful. Since then, the government has decided to bring private sector
professional management to banks and has now invited proposals for a public



                                         4
private partnership for the People’s Bank. The Bank of Ceylon which has
performed much better is expected to come up with restructuring proposals.

       More decisive events took place in the field of investment banks, when the
NDB and the DFCC were privatized. The NDB has ventured to take over the
local branch of a foreign commercial bank and intends to merge commercial and
investment banking activities in one institution. Similarly faced with a decline in
availability of long-term funds, the DFCC too has decided to go into partnership
with a commercial bank. The Sri Lanka’s laws provide for differential treatment
of commercial banks and investment banks (called “development banks”) and the
laws are now being changed to meet the global trend of banks undertaking
diverse activities as “universal banks”.


       Of the other public sector banks, the National Savings Bank emerged as
the largest savings bank, having inherited a government guarantee of its deposits
as long as 60% of its investments were made in government securities. Without
any experience in credit, it confined itself to investing in government paper. The
SMB and the AICC were merged in a State Mortgage and Investment Bank,
which has confined itself to mortgage housing finance.


The Role of Public Sector Banks



       The following table (Table 2) gives the latest information on the structure
of financial institutions in Sri Lanka in terms of their assets.




             Table 2 : Assets of the Financial Institutions (End 2002)

                        Institution                               Rs. Bn.        %




                                        5
Central Bank of Sri Lanka                                                    304     14.6
                              Institutions Supervised by the Central Bank
Deposit-Taking Institutions                                                 1,224    62.8
 Licensed Commercial Banks                                                   942     49.6
   State Banks                                                               466     28.5
   Domestic Private Banks                                                    356     14.9
   Local Branches of Foreign Banks                                           120      6.2
 Licensed Specialised Banks                                                  241     11.4
 Registered Finance Companies                                                 41      1.8
Other Institutions                                                           351     14.7
 Employees’ Provident Fund                                                   315     12.9
 Primary Dealers                                                              22      1.1
 Leasing Establishments                                                       15      0.7
                              Group Total                                   1,574    77.5
                          Institutions not Supervised by the Central Bank
Deposit-Taking Institutions                                                   20      1.0
 Co-operative Rural Banks                                                     15      0.8
 Thrift and Credit Co-operative Societies                                      5      0.2
Contractual Savings Institutions                                             122      5.6
 Approved Private Provident Funds                                             46      2.3
 Employees’ Trust Fund                                                        41      1.8
 Insurance Institutions                                                       35      1.6
Other Specialised Financial Institutions                                      28      1.3
 Merchant Banks                                                               16      0.8
 HDFC Sri Lanka Bank                                                           5      0.2
 Venture Capital Companies                                                     3      0.1
 Unit Trusts                                                                   4      0.1
Group Total                                                                  170      7.9
                              Total Assets                                  2,050   100.0




       The commercial banks (50%) and the investment banks (11%) dominate
the financial system. The state-run national Provident Fund is an outlier
accounting for 13%, investing predominantly in government securities. The Bank
of Ceylon and the People’s Bank account for about 29%. Along with other public
sector banks – the National Savings Bank (9%) and the SMIB (1%), the public


                                                  6
sector banks account for about 52% of the assets of the financial system and
about 55% of GDP in 2002. The current share of these two state banks of 29%
reflects a notable decline from about 37% 10 years ago.


        The public sector banks which accounted for about a third of financial
assets in 1950 expanded rapidly after 1961 with the nationalization of the Bank of
Ceylon and the creation of the People’s Bank under the new policy of using the
financial system to actively finance agriculture and industry, mobilize greater rural
savings and to promote cooperative activity. As a result, by 1980 the share of
the public sector had risen to be 80%. As seen from earlier Table 1, there has a
predominant growth of the branch network during this period. Their deposits
grew twenty fold between 1980 and 1990 and quadrupled during the next
decade. They became major lenders in the economy, accounting for two thirds
of the loans given by commercial banks by 1990.


       This over-rapid expansion of the two public sector banks evidently created
major problems. The Bank of Ceylon which expanded cautiously from its
inception was directed to accelerate its expansion in the 1960s. The newcomer,
the People’s Bank too expanded in strong competition to the Bank of Ceylon.
Both banks also became active financiers of a large number of state enterprises
which carry government guarantees, explicit or implicit. Although training of staff
was intensified, this expansion considerably diluted the bank’s higher
management capacity. Their management controls were strained to the utmost.


        The non-performing loans kept growing rapidly. Regular government
directed lending, specially to rural agriculture, had to be written off also at
government insistence. The large public sector borrowers figured prominently
among non-performing loans and in view of their public character and
government guarantees, they were not classified as non-performing, and were
continuously recycled. Notable were large facilities provided to petroleum,
electricity and defence establishments. In fact, with the government facing with
an acute fiscal pressure, there was a growing tendency for the Treasury to resort
to state bank finance to meet government expenditures under these categories.
On the other hand, several large loans came to be granted to private firms
without due appraisal and exceeding authority.            Evidently, there was a
breakdown of credit discipline in the two banks, particularly in the People’s Bank.

       Table 3 : Capital Ratios and Loan Quality of Banks

                                             1996     1997     1998     1999    2000    2001
                                                                                         est.
  Core capital ratio(min.4 %)1/
   State commercial banks                     10.1     8.0      8.2      3.7     2.3     -0.4
   Private domestic banks                     10.2    10.1     10.1      9.9    10.3      9.4


                                         7
   Foreign banks                                   13.3      15.5         14.2   15.6   14.1   16.1
   All commercial banks                            10.5       9.7          9.7    7.8    7.3    4.8
   Specialized banks                                 …         …          19.6   18.5   28.4     …
  Risk-weighted total capital ratio(min. 9 %)
   State commercial banks                          10.7      10.5          8.6    8.8    4.3    0.1
   Private domestic banks                          11.8      11.0         12.5   12.2   11.4   10.4
   Foreign banks                                   13.8      13.1         13.9   12.5   12.5   16.0
   All commercial banks                            11.5      11.0         10.7   10.6    8.3    7.8
   Specialized banks                                 …         …            …    18.2   17.3   23.4
  NPLs/Total advances
   State commercial banks                          18.9      20.2         19.5   18.3   15.4   18.2
   Private domestic banks                          12.0      12.4         13.4   15.9   14.9   15.7
   Foreign banks                                    8.3      10.4         12.7   10.7   12.7   13.2
   All commercial banks                            15.4      16.4         16.6   16.6   15.0   16.9
  Total advances (percent annual growth)
   State commercial banks                            …        9.7         13.0   11.9   19.3   10.3
   Private domestic banks                            …       23.0         22.8   20.8   20.7   13.8
   Foreign banks                                     …        6.7         -0.3   15.3   -1.6   -5.7
   All commercial banks                              …       13.2         14.4   15.4   17.4   10.1
   Source: Central Bank of Sri Lanka based on quarterly bank reporting.
   1/ Weighted by total advances


       The non-performing loans of state banks were consistently above 18% of
total advances since 1996, in contrast to private domestic bank record of 12-15%
and foreign banks of 8-13 per cent. Risk weighted capital ratios of state banks
were below the required norm of 9 per cent since 1998. The average interest
differential between borrowing and lending rates has been around 6 per cent for
the state banks, which was much higher than the spreads in most banks in Asia.
The high spread was largely the result of the high proportion of NPL of about 18
per cent of total loans and advances, which could be higher if frequent
evergreening of government borrowing is reckoned. Thus, their inefficiencies
came to be, followed by private banks as well, raising lending rates, which were
already high on account of high administrative overheads, to very high levels.
Needless to say, this would have discouraged investment.

        The Bank of Ceylon was relatively more insulated from outside political
pressure where professionals ran the bank with the Chairman and the Board
essentially determining policy. In the People’s Bank, despite express provision
by law to the contrary, the Chairman assumed executive powers and Board
members took active part in credit decisions. Thus, it did not take long for
political patronage to creep into the People’s Bank, which culminated in ill-
considered credit decisions and rapid growth in non-performing loans. The Bank
of Ceylon too came to be affected by outside pressures but because of its long
established traditions, it was able to moderate such outside pressures.

        Evidently, the management control too slackened considerably under
political and trade union pressure. Also there has been inadequate training and


                                              8
absence of lateral recruitment of professionals. In the People’s Bank trade
unions did not permit any lateral recruitment. Although merit and performance
was given some recognition at the Bank of Ceylon, People’s Bank trade unions
registered performance related advancement.

       By 1990s, it became quite apparent that the People’s Bank was insolvent
and that the Bank of Ceylon would face serious problems if non-performing
government loans were reckoned. Proposals were made that the NPLs of the
two banks should be transferred to an asset management company and the
remaining operations be adequately capitalized. Unfortunately, the government
faced severe cash constraints and it was unable to find the required resources.
Hence, the two re-capitalisations of the banks were undertaken by the issue of
non-redeemable long-term government bonds, which did not provide any liquidity
to the banks and did not relieve them of their non-performing debt burden. To
make matters worse, the government pre-empted the part of the interest of these
bonds as a dividend from the two banks. However, this had a sobering effect on
the two banks and they slowed their lending activities considerably. The situation
was compounded by restrictions imposed on the two banks in expanding their
branch network, which deprived them of sources of new deposits. The local
private banks made use of this opportunity to expand their branch networks,
mobilize more deposits and move aggressively in lending in the urban and the
rural sectors. In this regard, other private banks had a conspicuous advantage
that they were not over-staffed as the two state banks. In fact, the administrative
expenses of the two state banks at 88% of total expenses were extraordinarily
high. The influx of new foreign banks and the expanding local banks tended to
take away the best customers of the two state banks and they came to be
saddled with a lot of problem-customers.

        As part of the restructuring strategy of the state banks, the government
reached understandings with them that there will be no political interventions;
that any directed lending will be fully compensated from the government budget;
and the banks were made to enter into memoranda of understandings with the
government to achieve minimum targets on equity, return on assets and
reduction of non-performing loans. Unfortunately, these undertakings were only
partly fulfilled and evidently that there was no strong commitment on the part of
the state banks to fulfill their obligations. There was a penalty that non-
performance of the agreed terms would lead to removal of the Board of Directors.
This provisioning had a salutary effect in the government replacing the boards
with professionals and experienced persons.

       Simultaneously, several studies showed that the problems of the state
banks were deep-rooted and needed fundamental correction. Experience
expatriate managers were brought into both banks with instructions that both
should come up with serious restructuring proposals. In the case of the People’s
Bank, it was decided that problems were too deep-seated to be rectified by
cosmetic measures. Hence, the government decided to invite competent private



                                        9
sector participation in the ownership and management of the bank. In the case
of the Bank of Ceylon, where the problems were less serious, the bank was
requested to come up with restructuring proposals of its own.

       The investment banks, the DFCC and the NDB, faced the problem of
inadequate sources of long-term finance in the fledgling capital market, where
most longer-term funds were pre-empted by heavy government borrowing to
finance high budget deficits. As a result, they became dependent on Small and
Medium Enterprise Credit windows of international financial institutions, with
foreign currency risks assumed by the government. They made a success of this
operation, but with the subsequent drying up of these sources of finance, they
came to be privatized, with capital support by the new owners. Their original
longer-term borrowing will soon need repayment and they have come up with
proposals for entering commercial banking, in order to diversify their operations.
The NDB has acquired the local operation of the ABN-AMRO bank and the
DFCC is negotiating a partnership with a local commercial bank. The NSB
continues as a predominantly savings bank with most investments in government
paper. It will need to acquire credit administration experience if it is to reduce its
dependence on government paper upto 60% as originally envisaged.
Alternatively, it will have to map out a longer-term strategy as a universal bank by
shedding the government guarantee of deposits. That will depend on the
government’s financing needs.

        In the 90s, the Central Bank initiated a set of “Regional Rural
Development Banks” which were capitalized by the Central Bank for essentially
micro-lending in rural areas. The ADB helped in training a special cadre of rural
bankers for this purpose. However, the progress of these small banks was below
expectations and they were merged into six banks as Regional Development
Banks (RDB), with additional capital from the two state banks, NSB and the EPF.
Their management was improved by inducting experienced bank managers as
chief executive officers, and diluting the powers of politically appointed chairmen.
With improving profitability, it is anticipated to dispose the shares among people
in the region.




Strengths and Weaknesses of Public Sector Banks

       The pioneering enterprise of state banks in mobilizing savings by
expanding beyond the urban centers has considerably helped in deepening the
financial market. As there were inadequate opportunities for lending of these
resources in the areas where they were raised, they came to be lent in urban
centers. Although this policy has attracted criticism as a “diversion” of resources,
it should be noted that benefits of investment in a small country are not likely to
be confined to narrow areas. Also the region specific remit of the RDBs is



                                         10
expected to minimize any diversion. Altogether, public sector commercial banks
increased their deposits twenty fold during the last twenty years. Of course,
private commercial banks did even better. But when considering the mobilization
of the NSB as well, the public sector banks together showed a superior
performance.

      They were successful in introducing novel and attractive savings and loan
schemes which account for their success. Introduction of lending on the pawning
of jewellery was a notable example. Of course, the implicit guarantee of
government ownership also would have helped. The fact that the state banks
have been able to gain deposits even at times when their viability has been a
subject of public discussion reflects a strong goodwill in the country these
pioneering institutions have built up overtime.

       The state banks have also been credited for having developed an
indigenous entrepreneur class at a time when nationals had little or no access to
commercial banks. In the absence of a domestic share market, commercial
credit became indispensable for new business expansion, informal credit being
prohibitively expensive. In the early days, lending had to be strongly supported
by collateral, which limited access to the wealthier classes. But the pioneering of
project-related lending by the state banks did create greater opportunities for
investment. Capital needs of agriculture and industry came to be met largely by
the state banks, partly on account of government policy.       But    faced    with
growing loan defaults and outside pressure for lending, state banks increasingly
resorted to high collateral or curtailed their lending. This made banks very
conservative and reluctant to take project risks. Without collateral it became
common for banks to extend a series of temporary overdrafts which attracted
very high interest rates. These high interest costs later came to be a drag on
business.

        Generally, the public sector banks which were very aggressive in
mobilization of deposits and credit distribution often failed in credit markets,
particularly in the area of credit risk evaluation and loan recovery. As mentioned
earlier, they came to rely primarily on availability of collateral but not their quality
or the prospects of a credit proposal. Long delays in debt recovery in the judicial
system also encouraged the banks to seek high collateral.


       The support of the widespread co-operative sector too could be
considered as a positive contribution of state banks. They once formed an
important sector in rural areas benefiting large numbers. However, their role
declined with the private market orientation of the country and the People’s Bank
had largely withdrawn from this sector. The state banks are also credited with
having promoted a lot of new medium and small scale activities such as the
poultry industry.




                                          11
       Whereas public ownership created confidence and prestige for state
banks in deposit mobilization etc. it also appears to have been a negative factor.
For instance, the banks were subject to government and Treasury regulations
which were totally unsuitable for running of commercial enterprises. New laws
permitted the government to give directives to the banks which greatly affected
their commercial freedom. They were continuously pressurized to take additional
staff on political recommendations, where as they were precluded from recruiting
professionals at critical managerial levels. Since the civil conflict of 1983 they
have also been saddled with the large contingency of security staff. They were
unable to relate their wage systems to performance because powerful trade
unions could negotiate extraordinarily generous compensation packages,
irrespective of the profitability of the institution. In fact, the ratio of administrative
expenses to earnings in the Bank of Ceylon and People’s Bank stood at 88 and
86 per cent respectively, which are very high ratios by international standards.
The comparable ratio for private banks remained at about 64 per cent. Thus,
incentive for better performance which is characteristic of a private institution
vanished from the public sector banks. Public ownership also entailed audits by
the government’s auditor, who followed traditional government norms of
compliance audits, which focused inadequately on commercial viability and
performance. Hence, with the reforms, state banks were required to seek audits
by private audit firms.


Problems of reforming Public Sector Banks

       In some, public ownership of banks proved to be helpful in developing a
broad-base and deeper financial system in early stages when the system was
not adequately developed. But once the financial system matures, the public
ownership per se with its attendant conflicting objectives and rigid regulation
makes it difficult for public sector banks to operate as commercially viable
enterprises, specially when vast social obligations are thrust upon them. At that
stage, it is necessary to ask whether there is a paramount need to continue with
public ownership. If the social obligations could be achieved across the board
through central bank regulation, a level playing field could be created where all
banks, irrespective of ownership, could operate in a competitive situation. Public
ownership of banks in such a situation could be justified only if such a
competitive situation is not considered feasible. Sri Lanka’s experience appears
to suggest that a competitive situation can be created if the social obligations are
clearly identified in advance and are fully paid for by the taxpayers.

       The Sri Lanka situation also shows that it is not easy to achieve this
competitive ideal because of several factors. First, governments are reluctant to
compensate banks for undertaking non-commercial obligations, particularly
because of fiscal constraints; Secondly; governments are inclined to use public
sector banks to achieve political objectives; Thirdly, authorities tend to use
public sector banks for distribution of favours and patronage; Fourthly,



                                           12
application of public service rules and regulations to public sector banks thus
hampers banks in engaging in commercial activity; Fifthly, clear guidelines
regarding the multifarious objectives of public sector banks are not published;
sixthly, accountability of public sector banks to the depositors and the public is
weak; seventhly, lack of sufficient information regarding the operation of public
sector banks is made available to the owner, the government and the supervisor,
the central bank.

       Comprehensive and detailed information about the operation of a public
sector bank, which should not be different from what is expected from a private
sector bank, should be available in the public domain so that all the stakeholders
can evaluate their performance as against their objectives. In the banking sector,
this may prove difficult because of market sensitivity of this information. In Sri
Lanka, difficulties of public sector banks have been regularly brought to the
notice of the government confidentially, but it has been found difficult to get
authorities to act promptly on the identified weaknesses or necessary reforms,
unless there is an emerging crisis.

       Given these problems, a “second best” approach could be considered.
This could consist of -

      1.     Publication of quarterly financial results by the bank. Open review
             of such reporting by a committee of Parliament and a committee of
             the depositors.

      2.     Prompt publication of audited annual reports and income
             statements, which will also be reviewed by the same groups.

      3.     Clear estimation and identification of social obligations of public
             sector banks in the annual reports and financial statements, giving
             reasons for their adoption.

      4.     The owners and directors of public banks to issue a statement in
             their annual reports that the bank will be able to proceed as a
             “going concern” in the next year.

      5.     Stipulation by the government or the central bank of best practices
             of corporate governance for banks and a report by the bank
             regarding compliance.

      6.     Reporting on non-performing loans by categories with a note on
             how the bank intends to recover the loans and what provisions will
             be made if they are not recoverable.

      7.     Creation of a public relations office in each bank which will provide
             information to the public in a time-bound manner.



                                       13
        As banks are institutions that accept public deposits and investments on
trust, it would be fair to expect all banks to follow the above practices and to
make the required information available to the public.

       In a matured financial system where social obligations are identified and
compensated, the question of who owns a bank could become irrelevant as long
as there is effective competition. This should be the long-term objective in the Sri
Lanka situation.




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