From Daily FT
Central Bank making losses in two consecutive years
There is an ominously dangerous Trojan horse that has been
placed in the Central Bank by its previous administration led by the so-called
Monetary Board which still continues in perpetual succession. That horse is the
mounting losses it has made consecutively for two years in 2013 and 2014 under
its management.
The implications of the bank’s losses in 2013, amounting to
a staggering Rs. 39 billion – about half a percent of GDP – when its
comprehensive operations are taken into account were discussed by this writer
in an article in this series under the title ‘The questionable governance when
a loss-incurred Central Bank has made a profit transfer to the government’ (available
at:
http://www.ft.lk/2015/03/02/questionable-governance-when-loss-incurred-cb-has-made-a-profit-transfer-to-government/
).
Now the latest Central Bank Report for 2014, published
recently, has disclosed that the bank has continued to make losses even in
2014. Accordingly, the bank’s ordinary operations have resulted in a net loss
of Rs. 32.3 billion in 2014 against a loss of Rs. 24.3 billion in the previous
year on this account.
However, these ordinary losses have been somewhat partly
offset by an increase in the fair value of securities held by the bank,
bringing down the net loss to Rs. 21.6 billion in its overall operations. Three
salient features could be noted in this alarming regression of the Central Bank
in the two years under reference.
First, the losses in ordinary operations have increased from
Rs. 24.3 billion in 2013 to Rs. 32.3 billion in 2014, posing a serious threat
to its risk management. Second, the losses in 2014 have spread to both the
foreign and domestic operations of the bank whereas in 2013, they were confined
only to its foreign operations.
Third, over the two-year period from January 2013 to
December 2014, capital funds of the bank have depleted from Rs. 182.5 billion
to Rs 81.7 billion, marking a drastic reduction of Rs. 101 billion or 1% of
GDP. A Central Bank degenerating to such a financial depth puts the nation –
the collection of its stakeholders – on red alert.
Smart accounting practised in 2012 to show thumping
profitability in Central Bank
The story of the Central Bank making losses in 2013, as
discussed in the above mentioned article is as follows. In 2012, there was
smart accounting done by the Central Bank to show in its final accounts a
thumping profit by selling its gold reserve at high prices just before the end
of the accounting year. Accordingly, the gold reserves which had been bought by
the bank in the past at low prices were sold at the prevailing market price of
about $ 1,600 per fine ounce.
According to the statistics maintained by the World Gold
Council, the total of such sales in 2012 had amounted to 10.4 tonnes of gold.
With these sales, the bank had made a huge profit, unprecedented in its
history, of Rs. 50 billion out of its foreign exchange operations. In order to
show that its gold reserve had not depleted, the bank had repurchased gold at
the prevailing high price of $ 1,600 per fine ounce mainly in December 2012.
The World Gold Council data show that the bank’s total
purchases in 2012 had been 13.8 tonnes and out of that, 9.8 tonnes had been
purchased in December alone. Thus, as at the closing of accounts in 2012, there
was no depletion of the gold reserves. This was a wild speculation by the
Central Bank that gold prices would continue to go up in the market, enabling
it to make a similar killing in 2013 as well.
Market defeats the bank’s smart accounting
But market prices of gold changed in the opposite direction
in 2013 reducing the price from $ 1,600 per fine ounce in the previous year to
$ 1,200 per fine ounce as at the end of 2013. When the estimated gold reserve
of 22.95 tonnes as at the end of 2013 was revalued at the new prices, it
resulted in a massive mark to marker loss for the bank. Thus, the smart
accounting done by the Central Bank in 2012 was completely defeated by the
market in 2013.
Despite the bank making a thumping loss in 2013, the subsequent
information has revealed that it has made a profit transfer to the Government
by recalculating profits in terms of the provisions in the Monetary Law Act or
MLA. Here, the Monetary Board appears to have read MLA not in its spirit but in
terms of the literary meaning it has conveyed. This is not what a Monetary
Board expected to exercise prudential diligence in its decision making should
have done.
Need for exercising prudential diligence by the Monetary
Board
In 2005, when the Bank made a loss of Rs 6.2 billion due to
the losses arising from the revaluation of foreign exchange reserves at the
prevailing exchange rate, the board was required to decide whether a profit
transfer should be made to the Government.
In this instance, the Government had included a profit
transfer of Rs 2.5 billion from the bank in its budget for 2006. However,
exercising prudential diligence, the Monetary Board, headed by Governor Sunil
Mendis, decided not to make a profit transfer to the Government despite the
continuous demands of the Treasury. The position taken by the Board was that when the
Central Bank has made losses, it was against the spirit of MLA to make a profit
transfer to the government.
However, according to the data published in the Central Bank
Annual Report 2014, a transfer of profits amounting to Rs. 11.5 billion –
consisting of two parts – has been made by the bank in that year. One was a
profit transfer of Rs. 3 billion based on its financial performance in 2013
which was a loss but recalculated as a profit by technically following MLA. The
other was an advance profit transfer of Rs. 8.5 billion out of the profits to
be made in 2014. This advance profits transfer, as per the disclosure in the
accounts, has been made after the external auditors had certified that the bank
would make profits in each of the quarters involved. The Monetary Board had
taken cover behind these audit certificates to justify its action. However, in
doing so, it had failed to exercise prudential diligence as the Monetary
Authority of the country.
Prudential diligence requires Monetary Board to build the
bank’s capital reserves
What is this prudential diligence which the Board has to
exercise? That is to maintain its long-term solvency by building up its capital
reserves as an additional cover of the money it has issued. In terms of MLA,
the bank should build reserves first out of profits before it would consider
making a profit transfer to the Government.
This restriction has been placed on the Monetary Board by
law, as John Exter has argued in his Report to the Government of Ceylon on the
establishment of a central bank known as the Exter Report (p 22) to prevent the
Central Bank from making profits through its domestic operations and generating
a secondary expansion of money in the economy. This is because in the first
instance, it has already created money and in the second instance, it would
boost up that money.
A profit transfer through such a mechanism would jeopardise
its goal of stabilising prices and the exchange rate. However,, there is
another reason for the Monetary Board to be cautious of transferring profits to
the Government. That is, if the capital funds of the Central Bank are being
depleted, it should not hasten such depletions by transferring profits to the
Government.
The gradual depletion of Central Bank’s capital funds should
put the nation on red alert
In terms of MLA, the Central Bank should have a capital
cover equivalent to at least 15% of its domestic assets. The objective here has
been to restrict the unwarranted growth of the Central Bank’s domestic assets
and thereby prevent the erosion of the protection given to the holders of money
it has issued.
In this context, given the unanticipated episodes of
financial turmoil today, the maintenance of the minimum requirement as the
protective cover for the money it has issued is considered inadequate.
Accordingly, the Monetary Board led by Governor A.S. Jayawardena decided in
2002 as a part of the bank’s modernisation program to increase this cover over
the time up to 100% of the bank’s domestic assets. This target was reached in
2007 when the capital funds amounted to 103% of the domestic assets of the
bank.
However, since then, it started falling reaching 45% in 2011
and 41% in 2013. In 2014, this has fallen to 19% barely above the minimum legal
requirement. It is strange that the Monetary Board which is expected to
exercise its prudential diligence did not notice this decline in the capital
funds of the bank when it decided to make a profit transfer of Rs 11.8 billion
in 2014. In 2015, the budget of the Government expects the Central Bank to make
a profit transfer of Rs. 23 billion to the Government. It is interesting to see
whether the Central Bank would accede to this request by jeopardising its
capital base and thereby driving it to eventual bankruptcy.
Losses in 2014 are from both foreign and domestic
activities
The vulnerable position of the Central Bank today can be
ascertained by analysing the losses it has made in 2014. It can be seen that,
since the bank’s monetary policy has not been changed, the seeds that
contributed to losses in 2014 are still pretty much present looming over its
financial performance with a gloomy shadow in 2015 as well.
The losses in 2014 have come from both the external sector
and the domestic sector of the Central Bank. Though the interest income from
foreign investments has increased in Rupee terms from Rs. 18 billion in 2013 to
Rs. 22 billion in 2014, after correcting for the exchange rate depreciation it
has increased in dollar terms only marginally from $ 138 million to $ 168
million. Thus, the overall portfolio has generated more or less the same rate
of return on average at 2%.
Given the interest rate decline close to zero in the Euro
Zone in the current year and no prospect for rate hikes in USA in the immediate
future, the Bank is in a very vulnerable position to increase its interest
yield on foreign investments. In this scenario, it is likely that the foreign
operations of the bank may result in a loss in 2015 as well.
Central Bank’s net interest outpayments to commercial
banks
The net loss on foreign investments amounting to Rs. 8.5
billion has been reinforced by a bigger loss on the domestic side of the bank’s
operations. There, the major contributor to the loss has been a massive interest
outpayment by the bank amounting to Rs. 17.7 billion. This is mainly due to the
new monetary policy adopted by the bank in early 2014 in which it did away with
using Government securities for its open market operations to siphon off the
excess liquidity in the market.
Instead, it introduced a new standard deposit system under
which excess banks were to place their excess money with the Central Bank at
6.5% per annum. Since the country was in an excess liquidity position
throughout the year, this new policy has resulted in a massive interest
outpayment in the bank. As such, while the Central Bank has incurred a massive
loss, it has enabled the commercial banks to report thumping profits. The total
of both the foreign and domestic operations of the bank have brought in a net
operating loss of Rs. 20.3 billion in 2014 as against a net operating loss of
Rs. 12.8 billion in 2013.
An ominous increase in consultancy fees
These operating losses in 2014 were further augmented by a
substantial increase in the operating expenses of the bank. Accordingly, the
operating expenses have increased from Rs. 9.4 billion in 2013 to Rs. 11.3
billion in 2014. The main culprit? It is not the salary bill of the bank which
has in fact declined from Rs. 5.5 billion to Rs. 5 billion between the two
periods. The culprit comes from a massive increase in the administration and
other expenses of the bank which have more than doubled from Rs. 2 billion in
2013 to Rs 4.1 billion in 2014.
In this category, as a note to the accounts has revealed,
the increase has exclusively been due to an extraordinary expenditure called
‘Consultancy, Communication, Advisory and Professional Fees’. These expenses
which have been a pittance of Rs. 17 million in 2013 have shot up to Rs. 2,051
million in 2014.
Have the consultancy fees brought value for money?
The nation has a right to know what these consultancy,
communication, advisory and professional fees are and what benefits they have
brought to the country. The Monetary Board which is expected to set an example
to other financial institutions about the proper disclosure policy cannot just
hide it in a brief note to the accounts.
The note is so inconspicuous that only through much labour
that one could find it in the accounts of the bank. The auditors too, both the
Auditor General and the private external auditors hired by the Auditor General,
cannot just certify it and remain silent because they are required to do an
audit on the ‘value their client had received for the money he has spent’.
Though the bank has been silent on this massive extraordinary expenditure, one
could speculate that it may be in connection with what was reported in the
media as bank’s hiring some US media firms to do propaganda for the bank and
the former Managing Director of the IMF as a consultant. Such hiring can be
done by the bank only for its main objectives, namely, economic and price
stability and the financial system stability, and not for any other purpose.
The Monetary Board, if it acts in the best interest of the good governance it
is to establish in the financial sector, owes the nation a detailed
explanation.
Central Bank’s pension fund too is in peril
The bank’s total losses should be more than what has been
reported since the gap of Rs. 3.5 billion in its Pension Fund has not been
filled in its accounts for the year. This has made the bank’s pension fund too
vulnerable to failure bringing a huge credibility risk on the bank.
Depletion of capital funds
The Central Bank’s capital funds have depleted to a bare
minimum today. If this continues and its networth falls below the minimum
statutory requirement of 15% of its domestic assets, the taxpayers have to bail
out the Central Bank. This happened in the case of the Central Bank of the
Philippines in early 1990s (available at:
http://www.ft.lk/2013/12/02/even-mighty-central-banks-can-go-broke-if-imprudent-policies-are-adopted/
).
But bailing out of bankrupt financial institutions has now
become costly to taxpayers. Instead, it has been suggested that it be replaced
with a ‘bailing-in’ strategy under which the costs are to be passed onto those
inside banks (available at: http://www.ft.lk/2013/05/27/handling-bankrupt-banks-gone-are-the-bail-outs-and-enter-the-bail-ins/
). What it means is that the Monetary Board should be directly accountable for
the unsavoury regression of the Central Bank which was made a strong
institution through the modernisation project implemented in the Bank under the
leadership of Governor A.S. Jayawardena.
Monetary Board members should know their responsibility
to the nation
There is a learning lesson out Central Bank’s financial
fiasco. That is, as this writer had argued in a previous article in this series
(available at:
http://www.ft.lk/2015/03/30/central-banking-18-governor-and-board-members-are-trustees-and-not-owners-of-the-central-bank/
), those who aspire to become the Governor or Monetary Board Members should
know how to read MLA in its spirit and not in mere literary terms. It also
places a responsibility on those who appoint them to select such members based
on merit rather than on political loyalties.
(W.A Wijewardena, a former Deputy Governor of the Central
Bank of Sri Lanka, can be reached at waw1949@gmail.com )
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