What is bank supervision? Is NDB Bank fraud a supervisory lapse? Is the present supervision prepared to deal with future banking crises?

 

Article's background and purpose

During last few months, an extensive debate has taken place whether the central bank's bank supervision function has failed in early detection of the NDB bank fraud and resolution of the same. In contrast, the central bank management has been firmly responding that bank supervision is a prudential supervisory model and, therefore, not responsible for bank fraud risks for which bank management is responsible under Corporate Governance Directions.

By listening to this never resolvable debate, given my long standing involvement in the bank supervision function of the previous central bank under the Monetary Law Act (MLA), I feel that the present central bank talks about a revised or lightly touched bank supervision model operating under the Central Bank of Sri Lanka Act of 2023 certified on 14 September 2023.

The reason for my impression is that the previous bank supervision officers definitely would have early detected a bank fraud of such a magnitude and the Director of Bank Supervision and Monetary Board would have taken strict resolution measures under respective legal powers if the supervisory system had been the previous MLA .

Therefore, this short article is aimed at- 

• finding fault with the central bank Governing Board for the alleged supervision failure, instead of the Director of Bank Supervision, and

• revealing the inability of the central bank to deal with financial crisis situations of any sort, 

given the present status of legal provisions of the Central Bank of Sri Lanka Act and prevailing supervisory mechanism. The previous article released on this subject in Sinhala is also attached here. Article

Revelations at the latest COPF meeting held in the last week

This article was motivated by several revelations at the last COPF meeting as highlighted below (Watch the video).

• Bank supervision is a prudential supervision model and, therefore, not responsible for the NDB fraud as the fraud management is a responsibility of the bank management under the corporate governance rules.

• The central bank awaits the forensic audit report conducted by an external audit firm hired by the NDB bank to commence resolution actions. The central bank has given comments on the first draft of the audit scope and it can cover the lapses of the central bank supervisory function too.

• The bank is compliant with prudential ratios such as capital and liquidity requirements and, therefore, no risk is posed to deposits.

• The bank is required not to effect any resignation of key management personnel until the fraud is resolved.

• The central bank has required the bank to submit a strategic plan setting out how to improve the safety and soundness of the bank.

It is reported that, while the central bank is waiting for the external audit report to resolve the fraud issue, has suspended dividend payment to shareholders and branch expansion or bank growth while the fraud loss also is absorbed to the bank capital. The central bank also has announced that its emergency lending support out of public funds is available to the bank in the event of liquidity shortages.

However, the central bank to wait for external or private forensic reports to initiate supervisory actions is baseless as such audit reports are not divine findings. Instead, the central bank examiners can easily trace documents and information over the trail of the fraud from its beginning to the end including the financial flows, persons involved and the total loss to the bank. It is the breed and butter of bank examination on which the Bank Supervision Department was born and grown up under the Monetary Law Act since 1950.

Therefore, many public concerns are raised why the central bank does not remove or punish the bank directors and responsible senior managers without punishing the poor shareholders and public funds unconnected to the fraud. It is noted that nearly 30% of bank capital belongs to the state and, therefore, legal issues on loss to public funds also could surface at any time if the fraud resolution is further delayed.

It is clear that the central bank is hiding behind its unlawful prudential supervision ideology to escape its supervisory responsibilities and lapses on the fraud of this bank as well as of all other banks. Such lukewarm behaviours are the common nature of all supervisory authorities around the world.

Prudential supervision escape

The term "prudential supervision" is the central bank's escape for the supervisory responsibility of this fraud. The prudential supervision means the mechanism of the assessment of bank's safety and soundness based on certain accounting ratios such as capital adequacy, liquidity, asset quality and impairment levels that are compiled by bank accountants under accounting principles and rules that are believed to show the bank's major risk management ability.

in this context, the central bank claims that the fraud risk is a subject outside the supervision and, therefore, a responsibility of the bank management. However, banking crisis literature across the world shows that banking instability or unsoundness problems are generally sourced from fraud, bad conduct of business practices, consumer protection weaknesses, risky business models, lapses in internal controls, poor governance and incorrect financial reporting too which are of fraud nature. 

Therefore, bank supervision authorities have no formula to separate banking risks between prudential conduct and other operations to gauge the safety and soundness of banks. As the banks' safety and soundness is the prime objective of bank supervision, supervisory authorities are compelled to look for all sources of exposures to risks and bank preparedness to manage such risk sources.

Accordingly, lapses of bank supervision can be identified to the extent that they fail to detect and resolve material risks that could threaten the bank's sustainability. If the NDB bank fraud is a bank governance lapse that does not fall into prudential supervision, the central bank at the very outset should have stated that it would not intervene and the board of directors should resolve it because the central bank has the authority to remove bank boards which fail in their statutory duties.

Bank supervision under the MLA

Globally, central banks have been vested with bank supervision powers in order to oversee the safety and soundness of banks and banking system corroborated with money printing power through the lender of last resorts (emergency lending by central banks) to banks so that the banking system is largely protected from bank runs. 

In the same spirit, the MLA set up the bank supervision as a central bank function with separate powers authorized for the Director of Bank Supervision and the Monetary Board supported also by emergency lending provisions whereas later amendment to MLA introduced deposit insurance function as a major safeguard to depositors and to prevent bank runs.

Therefore, the MLA itself established the Bank Supervision Department and the post of Director of Bank Supervision with specific powers. In addition, the Monetary Board was empowered to issue Directions/regulation and drastic resolution interventions in problem banks on reports submitted by the Director of Bank Supervision. Further, the supervision was not narrowed down to any specified model such as prudential model and it was up to the two authorities to practice it as required from time to time. In this broad mandate, it has become customary to cover in the bank supervision all types of banking risks such as credit, liquidity and operations and risk management systems. Therefore, everything of banks under the sun was touched in bank supervision.

This is well understood from the following note made by John Exter in his report of the establishment of the central bank in Sri Lanka in 1950 on the purpose of bank supervision.

 "Supervision of banks by the central bank or some other supervisory authority has proved in the experience of many countries to be an important means of contributing to the soundness of the banking system. Banking is an economic activity which affects the public welfare to an unusual degree; it touches in one way or another almost every phase of a country's economic life. Sound banking is essential to healthy and vigorous economic development. Supervision of banks helps to protect the public against mismanagement, bank failures and loss of confidence in the banking system. It helps to protect depositors and stock-holders against loss and frequently enables bank directors and officers to manage the affairs of their banks more wisely and intelligently."

Therefore, the supervision was intended to avoid mismanagement of banks caused by any source arising from fraud or risky business models or unsound operating systems and practices that can cause losses to bank funds, i.e., assets or liabilities.

The MLA divided bank supervisory operations in to two activities. Those are periodical examinations and continuous supervision.

Periodical examinations

These examinations are conducted at least once in every examination period as determined by the Director of Banks Supervision where examiners visit banks and examine books, records and systems for assessment whether bank is safe and sound as required by the Director of Bank Supervision. These examinations usually detect a lot of bank fraud.

Continuous supervision

This is the constant supervision of banks based on periodical financial and other information required from banks by the Director of Bank Supervision. The supervisors also will visit the banks to verify such information and examine identified concerns whenever necessary. Relevant bank supervisors even examine media reports and rumors relating to specific banks and cause necessary resolutions. The purpose of continuous supervision is to ascertain the true condition of affairs of banks as determined by the Director of bank Supervision from time to time.

As a part of the continuous supervision mechanism, bank summary financial data sheets were complied in the central bank web-based bank reporting system and were available online to respective continuous supervisors. These sheets help the supervisors to detect unusual financial transactions or trends of banks, peer groups and banking system at the first glance and to elevate underlying bank concerns after verification to respective senior supervising officers. Therefore, it is hard to think that the continuous supervisor of the NDB Bank would have missed the early signal of the reported fraud if the stated continuous supervision system had been in place as before.

 Purpose of supervision

The Director of Bank Supervision to satisfy that the bank is insolvent or likely to default the demands of depositors or that its continuance in business is likely to involve loss to its depositors or creditors. Therefore, the Director of Bank Supervision has the legal authority to form an opinion or judgement on the overall condition of the affairs of banks falling under its supervision.

However, the Director of Bank Supervision has an interim process to resolve any concerns before taking this view for drastic intervention in respective banks.

Emergency lending and deposit insurance

In terms of the MLA, emergency lending and deposit insurance powers were very liberal as contingency backups to deal with financial crisis situations.

Bank supervision under the Central Bank of Sri Lanka Act

The supervisory system highlighted above that was evolved for 73 years from 1950-2023 legally elapsed as the MLA was rescinded by the Central Bank of Sri Lanka Act in September 2023. Therefore, I am of the view that the failure in early detection and resolution of the NDB fraud is due to the lapses in the new legal provisions as highlighted below.

Non-availability of a specific bank supervision function

• The new Act provides for supervision for financial institutions covering both banks and non-bank financial institutions licensed by the central bank at equal foot and, therefore, specific bank supervision function is not available although banks are the systemic financial institutions.

• Examinations will be conducted by central bank employees or other qualified persons authorized by the central bank as required by the Governor. Therefore, if the Governor does not specifically instruct the authorized officials to what to examine and what to look for, the authorized officials cannot be blamed for failure to detect bank problems. Therefore, this fraud examination is also the responsibility of the Governor for not involving specific bank examinations.

• Department of Bank Supervision and Director of Bank Supervision which operated under the MLA are no longer in operation. Therefore, those at the present central bank should operate within terms, powers and supervisory systems designated and approved by the Governing Board and Governor while bank examinations are specifically authorized by the Governor. However, there is no public information to assess whether the present bank supervision model and processes have been approved for them by the Governing Board or by the Governor.

• Accordingly, if the currently approved bank supervision model is purely prudential supervision which excludes bank fraud, the present post of Director of Bank Supervision is not responsible for the NDB fraud. Instead, the Governing Board/Governor is responsible for narrowly defining the scope of bank supervision to exclude fraud.

• The authority of resolution actions provided for in the Act is with the central bank/Governing Board and, therefore, the Director of Bank Supervision should not be blamed for delays or failures unless the Governing Board has specifically authorized the specific actions with the Director of Bank Supervision.

Prudential supervision not interpreted in the Act

• Continuous supervision of financial institutions is to ascertain the true condition of affairs of financial institutions whereas resolution actions for a bank are to be instituted upon the satisfaction that the bank is insolvent or likely to default the demands of depositors or continuance in business is likely to involve loss to depositors and creditors.

• However, whether this view is arrived at prudential ratios is not clear as the Act does not interpret the prudential supervisory mechanism.

Non-availability of emergency lending facility to banks

• The MLA contained highly liberal emergency lending provisions to banks who confront liquidity/financial crises or panic. However, the new Act provides for this facility in a very restricted manner up to 91 days to solvent banks/financial institutions. 

• Accordingly, this facility beyond 91 days up to 182 days or strait up to 180 days in instances of financial stability issues can be granted only if the government provides a guarantee. In that context, the central bank cannot provide liquidity for such problems or likely insolvent banks/financial institutions under its normal monetary operations connected to policy interest rates as such financial institutions are normally subject to concerns over solvency levels. 

• Therefore, the supervision without emergency lending powers cannot ensure the system stability as it cannot resolve liquidity crisis situations.

Concluding remarks

• Bank supervision is a statutory function that should be supported by definite legal provisions and interpretations. Therefore, its scope, powers and actions cannot be arbitrarily defined or narrowed down to satisfy the needs of relevant supervisory authorities for their convenience.

• The current bottleneck in resolution of the NDB Bank fraud is a result of lapses in the Central Bank of Sri Lanka Act and supervisory mechanisms implemented by the central bank Governing Board as there is no specific bank supervision authority provided for in the Act. Although Banking Act provisions can be used alternatively, primary governing law is the Central Bank of Sri Lanka Act.

• So-called "prudential supervision ideology" and waiting for the report of the forensic audit conducted by the NDB's private auditor to institute fraud resolution actions by the central bank/supervisor are nothing but escape actions of the central bank Governing Board.

• However, the ultimate responsibility is to be borne by lawmakers who have passed a poorly-baked legislation for the central bank. Therefore, lawmakers should not plainly target the Bank Supervision Department without knowing the ground facts and legal provisions.

• The central bank should not be complacent about their authority over banks in modern banking of electronic and Gen-Z era as bank runs can be created out of thin air outside prudential accounting ratios that the central bank resorts to detect and resolve bank problems and early warnings. The best example is the depositor run on the Islami Bank in Bangladesh created in the last week by a group of persons protesting against the appointment of a former central bank Deputy Governor as the bank's chairman on the public concern that he was a person forced to step down from the central bank during the recent Gen-Z protest campaign against the country governance system. The central bank first responded that this was a bank operational issue in which the central bank supervision would not intervene. Finally, the central bank delay and negligence in resolving this trivial governance issue caused a run on the bank where the central bank had to provide emergency lending to the bank and remove the full Board of the bank. The issue would have been resolved at the very outset if the central bank had dismissed the particular appointment as the concern was very valid in corporate governance. This happened despite the knowledge of the central bank that the Bangladesh banking system as a whole is highly fragile and illiquid due to past management and financial fraud and now lingers on the central bank's excessive liquidity support provided through money printing.

• Further, the supervisory delay in resolving such bank problems and connected media reports normally cause immense tensions and risks to business and management of the banks which could even threaten the solvency and existence of the banks where the situation could become a bigger supervisory issue and systemic shock.

• Finally, waiting for the poor CID and judiciary to detect and punish those responsible for the fraud while the white collar management and supervisory authorities continue to take time by enjoying privileges despite their enforcement powers. The recent Supreme Court judgement on alleged Treasury bond auctions reveals why both entities and officials should be prosecuted together for fraud on the principle of "Directing Mind and Will" of the entities and the execution of the same by relevant officials of the entities.

• Therefore, this bank fraud incidence is an eye opening early warning of the central bank's inability to deal with banking crises and system instability issues possible in the future, given the systemic concerns and legal lapses prevailing at present as highlighted above.

(This article is released in the interest of participating in the professional dialogue to find solutions to present economic crisis confronted by the general public. All contents in the article are based on the author's research and views on the subject which have no intension to personally discredit characters or ideologies of any individuals.)

P Samarasiri

(BA Hons Economics, University of Colombo, MA Economics, University of Kansas)

Former Deputy Governor, First Central Bank of Sri Lanka

(35 years of experience in staff class in the Central Bank, inclusive of Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 13 Economics and Banking Books and a large number of articles published.)