13th July, 1997

A Central Bank for the 21st Century

By a special correspondent

Central banks the world over have undergone transformations in their organisation and functions over the years. The new Labour Governmet in Britain decided to surrender the government's control over interest rates to the Bank of England to give the Bank operational responsibility for setting interest rates.

In a further move the Bank was stripped of its supervisory and regulatory functions which were handed over to a new regulator. In a more recent move, the governor and the bank's monetary policy committee are to be held accountable if they fail to meet a specified inflation target.

In another part of the world, it has been announced that certain changes would be made by law to enable the Bank of Japan to make monetary decisions faster and more flexibly than hitherto which will help it to gain greater credibilty in the financial market. How about the Central Bank of Sri Lanka?

The Bank has stood the test of time without having undergone major transformtions, although there have indeed been changes which have effectively expanded the Bank's supervisory, regulatory, developmental and promotional roles. Yet it would appear that more needs to be done as the Bank aproaches its 50th, anniversary of its establishment in the year 2000.

The Presidential Commission on Finance and Banking was given a wide remit, which included most importantly, the performance of the Central Bank and recomendaitons as regards the need for any reform of the constitution and organisation of the Central Bank "in keeping with modern developments," and improvements required in the exercise of its functions and responsibilities, particularly as regards the provision of liquidity to facilitate growth, consistent with financial and monetary stability.

The Commission has in response to these terms of reference made a host of recommendations. Although these recommendations have received some publicity in the media, there does not appear that a public discussion on the recommendations has taken place.

Some of the recommendations have been implemented through legislation such as bringing within the regulatory control of the Central Bank, financial institutions such as the National Development Bank and the Development Finance Corporation of Ceylon.

Previously these institutions came within the supervisory powers of the Bank only if they were declared banking institutions by the Minister. Now regulatory control is exercised through the substantive law in the form of the Banking (Amendment) Act 1995.

Another recommendation which has been implemented is the requirement that licensed commerical banks should appoint auditors from a list issued by the Director of Bank Supervision of the Central Bank.

There are, however, quite a few recommendations which have not been implemented. Some of these appear to be controversial. It would be necessary to have them studied in depth before any action is taken.

The first of these concerns the incorporation of the Central Bank of Sri Lanka. The Commission took the view that the incorporation of the Bank "would be conducive to legislative good order as well as organisational clarity and efficiency."

The Commission observed that since it is the Monetary Board which is incorporated (and not the Central Bank as such), there is an excessive diffusion of authority, functions and powers between the Minister of Finance, the Monetary Board, the Central Bank, the Governor, the Deputy Governor, the Director of Economic Research and the Director of Bank Supervision.

Moreover, the Commission observed that there is a division of powers and functions between the Board and the Governor. Furthermore it said, the authority to elicit information is shared among designated (in the Monetary Law Act) officials of the Bank. The Commission felt that the division of powers and authority could be more conveniently and advantageously centralised and vested in an incorporated Central Bank. Whether such incorporation would be conducive to good order, needs to be carefully examined.

It may be important that certain functions should be specifically assigned to, and discharged by, designated officials such as the Director of Economic Research and the Director of Bank Supervision. The Exter Report on whose basis the Central Bank was founded states that the Economic Research Department is given special recognition in the law in order to emphasise its importance.

The Department of Bank Supervision, the Report says, is specifically mentioned both because of the importance of its work and because it is essential that the functions, authority and powers of the Department be accurately and carefully defined.

These Departments are the only two departments of the Bank specifically provided for in the Act because their functions are very specific. The functions are, of course, discharged on behalf of the Central Bank. If these functions are vested in the Central Bank as such and an official (or officials) is (are) designated to carry out these functions (not necessarily the Director of Economic Research or the Director of Bank Supervision) it could detract from the importance of the role of the Central Bank in the fields of economic research and banking supervision which has been anchored as it were, to the powers accorded to these departments by law.

Another recommendation, perhaps no less controversial, concerns the composition of the Monetary Board. At present the Monetary Board consists of three members, the governor, the secretary to the ministry of finance and the member appointed by the president. The Commission says that the overwhelming view of those who made representations to the Commission was that a three-member board was too small.

The Commission is of the view that with the increase over the years of the functions and responsibilities of the Bank and their extension to a multiplicity of economic and financial activities the size of the Board should be enlarged.

The Commission recommends a board of five which, besides the governor and the secretary to the ministry of finance, would have three other non-official members. The Commission envisages that these three members should be persons with knowledge and experience in agriculture, industry, commerce or finance and banking or persons from academic and other professions.

John Exter, in his report, argued for a three-member Board. He says that experience in many countries has shown that a small board is likely to be more effective than a large one. He goes on to say "greater prestige attaches to the membership on a small board, thus making it easier to attract outstanding men."

"In contrast with large boards where responsibility tends to be so diffused that members do not take sufficient interest, a small board makes for a healthy concentration of responsibility." he says further.

The Central Bank has been functioning with a three-member Monetary Board since its inception except for a brief period from 1974 when an amendment to the Monetary Law Act brought in a fourth member, the "person holding the office for the time being as secretary to the ministry in charge of the subject of planning and economic affairs."

It would appear that the three-member board has over the years been able to cope with the discharge of the ever increasing responsibilities of the Bank.

It could however be aruged that these responsibilities particularly in the field of finance and banking call for some sort of expertise to be readily available for the deliberations of the Board and therefore, the membership of the Board should be extended to include persons directly involved in industrial and commercial ventures.

The diversification of the economy, the complexity of monetary and financial issues, the growing dominance of private enterprise, the growth of commercial activity and the vast strides in financial technology are arguments for expanding the Board to include a wider expertise and participation.

As the Board is constituted, at present, there is no private enterprise or banking expertise and this has been so for most of the time. Besides five members do not make a large board.

But there is a matter which needs to be considered. It is whether the presence of such persons on the Monetary Board as the Commission recommends could cause leakages of sensitive information to the market. This is not to say that the appointed members are not persons of probity. Our financial sector is small and its players are usually known to each other. Willy nilly there could very well be an exchange of information between these persons and their fellow businessmen.

The Commission has in another recommendation suggested that the disqualifications for appointment as a director of a commerical bank contained in the Banking Act be made applicable for appointment as Governor. These disqualifications have to do with the person concerned being declared insolvent or his serving or having served a sentence of imprisonment or his having been convicted of a fraudulent or illegal act. The Commission has added a further disqualification for appointment as Governor, the commission of acts of moral turpitude on the part of the proposed appointee. These recommendations, which have not been implemented, need consideration.

It may be equally important to consider whether qualifications for appointment as Governor should be statutorily laid down. Exter observes in his report that in many countries such as Argentina, Canada, Mexico, New Zealand and South Africa, the Governor should be (variously) a person of "proven financial experience," a person "possessed of actual banking experience" or a person of "recognised financial and banking experience."

But perhaps it is now too late to introduce qualifications for appointment as Governor. The nine persons who have held gubernatorial office were persons of varied experience in the fields of banking, economics and administration. The present incumbent is an eminent economist.

An important recommendation of the Commission concerns the provisional advances which the Central Bank is authorised to make to the Government. The Monetary Law Act stipualtes that the Bank may make direct provisional (ways and means) advances to finance expenditures authorised to be incurred out of the Consolidated Fund.

Exter observes in his report that many central banks and national economies have come to grief because governments have had too easy access to central bank credit.

Accordingly limitations were imposed in the Monetary Law Act that every advance should be repaid within six months and, more importantly, advances outstanding at any time shall not exceed ten per cent of the estimated revenue for the financial year in which they were made.

The Commission has recommended that while this ceiling should be retained for the provisional advances to government, there should be an overall limit to net credit to government of 25 per cent of the actual average revenue of the government of the most recent year applicable to provisional advances, the purchases by the Central Bank of Treasury Bills and of rupee securities, and that this limit be statutorily imposed. The recommendation needs to be carefully considered.

Among the other recommendations which have not been implemented is the introduction of a mandatory deposit insurance scheme to be adminsitered by the Central Bank and made applicable to all categories of deposit taking institutions that are subject to the supervision of the Central Bank. The Bank has an insurance scheme for banking institutions, but it is a voluntary one and so far the participation has been limited.

Another recommendation was that the approval of the Monetary Board and the Minister of Finance should not be required as now for the opening, closing and the relocation of branches of a bank.

But far from implementing this recommendation the Banking (Amendment) Act of 1995 stipulated that the approval of the deputy governor is required for the establishment of mobile banking units.

Yet another recommendation of the Commission was that the Bank's involvement in financial institutions be restricted as far as possible to avoid conflicts between different policy objectives. To this end the Commission advocates the Bank's disengagement from the share ownership of the National Development Bank (NDB) and of the Regional Rural Development Banks (RRDBs).

The Central Bank continues to own a small percentage of the shareholding in the National Development Bank (NDB) but it is understood that it expects to divest it shortly. The Act to establish the new regional development banks the successors to the RRDBs envisages that the Central Bank makes a capital contribution to the new institutions.

As the Central Bank of Sri Lanka approaches its 50th anniversary it would be useful if consideration is given to whether certain improvements are called for as regards its organisation and its functions especially in the light of views expressed by the Finance and Banking Commission.

The Commission has commented laudably that the Central Bank has "acquired a reputation as a well-run institution that has contributed positively to Sri Lanka's economic development."

That it continues to do well depends on such changes as may be found necessary to its constitution, its organisation and its functions in the varied role it has been assigned by the Monetary Law Act and other relevant legislation.

The 50th Anniversary would be a fitting occasion to launch a reformed Central Bank that could be at the apex of a vastly different financial system of the 21st century.

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