Blaming the banks: Why a credit guarantee is better

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

By Dhananath Fernando

The Central Bank of Sri Lanka (CBSL) is in the spotlight yet again. Questions have been raised as to whether the CBSL and the banking system have been provided sufficient facilitation to contain the health crisis (that has been contained successfully at the moment) which led to an economic crisis.

The Government announced a series of economic relief packages since the beginning of the Covid-19 pandemic, including a Rs. 5,000 allowance for the most vulnerable sections of society and for the rescheduling of leases and loan facilities. Currently, the discussion is not on what the relief measures are, but rather on how we can execute them in the right way or whether we have better alternatives.

First, let’s understand the context. The CBSL offered a Rs. 50 billion refinancing facility in March, which was then increased to Rs. 150 billion in June. By the time the second scheme was announced, Rs. 27.5 billion of the original Rs. 50 billion had been given out. The CBSL offered the Rs. 150 billion credit facility to licensed commercial banks (LCBs) at 1% interest where the banks have to provide 4% interest to their customers affected by Covid-19.

Additionally, the CBSL brought the Statutory Reserve Ratio (SRR) to 2% from 4%, increasing liquidity (availability of money) in the market. The deposit that needs to be kept at the CBSL by banks as a percentage of total deposits is called the SRR. This means that when a customer deposits Rs. 100 in any LCB, the respective LCB has to deposit Rs. 2 to the CBSL which will not be paid any interest. Earlier, the banks had to deposit Rs. 4 and now it has been brought down to Rs. 2. As a result of this decision, out of the total deposits of all LCBs in Sri Lanka, 2% has been released to the market. That is depositors’ money.

The process of getting a working capital loan for a business is as follows: The businesses can apply for working capital loans from their respective LCBs and upon their approval, they send the application to the CBSL and the CBSL provides the money from the credit line they established, which is Rs. 150 billion. The CBSL provides money to LCBs at 1% and they give the loan to customers at 4%. The main question is how the CBSL got Rs. 150 billion in the first place. That was through money printing or money creation.

Additionally, banks now have more money from the reduction of the SRR, which can be used for other investments, to provide credit facilities, or as a deposit at the CBSL to earn an interest. The CBSL offers a 5.5% interest to LCBs parking excess money at the CBSL, which is called the Standing Deposit Facility Rate (SDFR). The CBSL has a similar facility where LCBs can borrow money if they run short of money, which is called the Standing Lending Facility Rate (SLFR) which is at 6.5%. A few challenges we may face in the future in this context are outlined below.

Challenge 1 – refinancing previous loans

When a loan scheme is available at a 4% concessionary rate, there can be instances when unnecessary loans will be applied for, to settle previous loans which have been taken at a higher interest rate. In the overall system, it may indicate that the CBSL and other banks have provided adequate loans under the newly established credit facility for Covid-19, but the ground reality may be that many businesses who have a solid working relationship with banks and bank managers will refinance their previous facilities.

The same has been experienced in large-scale loans under the previous Government’s Enterprise Sri Lanka loan scheme. It was reported that some established companies incorporated new companies just on paper to get the concessionary loan to refinance previous facilities. It was alleged that the majority of politically connected individuals received the loans and in most cases, the loans were canvassed to known businesses by bank managers themselves, avoiding customers who truly had financial needs. For bank managers, it is safer to provide a loan to a known business entity with a track record and good relationship, rather than taking a risk in a challenging business environment and risking underperformance in bank manager/branch key performance indicators (KPIs).

Challenge 2 – risk of market distortions and increasing expenses in CBSL

Since the CBSL pays 5.5% on deposits by the LCBs, banks have a higher incentive to simply earn a 5.5% interest with minimal administration cost, rather than providing a loan facility at 4% for the customers with a 3% interest margin, which also requires a significant amount of administration work. The banks will most likely park the excess money they received from the SRR cut and deposit it at the CBSL. This would increase the interest expenses for the CBSL. LCBs may also consider investing the excess money in bonds and other investment instruments which may distort those markets as well.

The positive side to this is that since banks park their liquidity back in the CBSL, the risk of inflation due to excess liquidity is somewhat minimised, but it will not bring the expected economic revival post-COVID-19. The non-performing loan (NPL) percentage has already increased to 5.1% as business recovery was very slow even before the Covid-19 pandemic, due to the Easter Sunday attacks. Similar concessionary loan facilities were provided to businesses impacted by the Easter attacks and it is highly likely that NPLs will increase.

As a result, banks may have a natural reluctance to provide facilities as they have a lucrative and stable option available without risking depositors’ money. The CBSL may push banks to provide loans as much as possible due to the lack of a correct incentive structure, which will lead to an impact on the stability of the banking sector and result in loans not reaching the right target audience.

Challenge 3 – pressure on LKR compared to USD and foreign currencies

By the time the CBSL announced the SRR cut and the Rs. 150 billion credit line, there was about Rs. 223 billion excess money in the financial system. The problem was not a lack of money (liquidity) in the financial system but the reluctance of banks to absorb risk to provide the facility to the impacted customers. At the same time, the mechanism of dispatching loans was not efficient and all banks were just depending on the Credit Information Bureau of Sri Lanka (CRIB) without having a risk-based credit assessment system to determine the borrowers’ ability to settle the loans and offering different interest rates based on the risk assessment. Additionally, the delays in banks’ internal approvals may not be supportive, given the urgent need of facilities and higher demand.

Now, as a result of excess liquidity, inflation may increase and the Sri Lankan rupee (LKR) will face further pressure to depreciate, leading us towards a Balance of Payments (BOP) crisis. Bringing the SDFR and SLFR down will bring down all interest rates in the market which will result in more money (liquidity) in the market, adding further pressure on the LKR.

In summary, the reluctance of banks to take the risk to provide loans in a challenging environment by risking depositors’ money is the problem, not the lack of liquidity in the market.

A workable solution

It is challenging to find an ideal solution for very complicated problems as our economic fundamentals have not been good for decades. Most variables are interconnected so we have to make a compromise in one of the areas. As the problem is not the lack of money supply, but rather the banks’ reluctance to take risks with regard to loan recovery, a credit guarantee by the Government could have been the first line of solution. That would minimise the risk taken by the banks without adding excess liquidity to the market and distorting other market sentiments.

Ideally, the Government credit guarantee has to be backed by a foreign funding line (USD funds) and this column has been promoting the idea of a bilateral loan with a neighbouring country or active engagement with the International Monetary Funday (IMF) for a fund facility, given the international sovereign bond settlements starting from October. The government guarantee can be provided on an agreed ratio where small loans are fully guaranteed by the Government and for bigger loans, the bank and the Government share the risk, where early instalments first cover the risk of the bank and their depositors.

One bottleneck for the Government in providing a credit guarantees scheme is the past mistakes made with our state-owned enterprises (SOEs). Multiple back-to-back credit guarantees have been provided to colossal loss-making SOEs like SriLankan Airlines, Ceylon Petroleum Corporation (CPC), and the Ceylon Electricity Board (CEB). Successive governments turned to these last resorts very early to fund completely unnecessary operations and now, faced with a real crisis, we have run out of solutions.

However, in a recent interview, Dr. Nandalal Weerasinghe mentioned that the Treasury wanted to create money and support businesses instead of providing a government credit guarantee. The reasons for these instructions are yet to be clarified by the Treasury. However, Dr. Weerasinghe has alerted the potential risk of excessive money printing on banking sector stability.

When the Easter Sunday attacks impacted the economy, we never expected a global-level pandemic of this scale. The lesson is that we should not underestimate the possibility of similar pandemics and market disruptions with climate change and a dynamic global environment in the future. I sincerely hope that there will be no calamities for the next few years as there is a lot we all have been hoping to achieve for decades.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.