Price stability and financial system stability are key responsibilities of the Central Bank of Sri Lanka (CBSL). Hence, it has to ensure that the financial system operates in a safe and sound manner in the interests of the national economy. Financial Intermediaries (FIs), including banks and non-bank financial institutions, play a vital role in an economy by collecting funds from depositors and investors and by providing access to finance through lending to borrowers.

In most companies registered under the Companies Act, the shareholders’ capital provides the main funding base for the operations of the company. However, in banks and finance companies, which are the main deposit taking institutions, the shareholders’ capital is only a fraction of the deposits accepted from the public. Given this, the monetary authority of a country has an even greater responsibility in supervising and regulating such institutions as there is also a need to safeguard depositors’ funds. Public confidence is of critical importance in maintaining the stability of the financial system. Effective fund management practices, on both a system-wise and on an individual basis, are essential in achieving and maintaining public trust and confidence in the financial system. An additional point of importance is that the failure of one financial institution would not only affect that institution, but also have a contagion effect on other financial institutions. Hence, failure of finance companies could create significant public costs and consequences due to the broader macro-economic implications, such as contagion risk and impact on the payment system. A systemic financial crisis will result in the loss of large amounts of money in a very short period, which in turn would fuel immense inflationary pressure in the economy.

Therefore, the FIs are, in a sense, public goods, and a failure of FIs will adversely affect monetary conditions and the economic well-being of the public. Poor corporate governance can lead the market to lose confidence in the ability of a financial institution in managing its asset and liabilities, including deposits, which could, in turn, trigger a liquidity crisis or run on deposits.

The OECD defines corporate governance as "a set of relationships between a company’s management, its board, its shareholders, and other stakeholders through enhanced performance." Corporate governance for a banking organisation is of greater importance than for other companies. Effective corporate governance practices are essential for achieving and maintaining public trust and confidence in the financial system. FIs also typically have access to confidential customer information and review and analysis of customers’ investments, risk exposures and financial statements in the light of these sensitivities, at least minimum standards of corporate governance are more necessary for FIs than for non-financial firms. Unfortunately, voluntary observance of good corporate governance principles has not been generally observed.

It is in this context that the CBSL has issued directions on corporate governance for licensed banks and proposes to introduce a direction on Corporate Governance for finance companies. The Exposure Draft on corporate governance for finance companies has been issued, soliciting views, comments, and suggestions from the stakeholders of finance company business and the general public in the interests of stability of the banking and financial system.

Registered finance companies and specialized leasing companies are the major categories of non-bank financial institutions regulated by the CBSL. Finance companies cater to a diverse and important customer base that may not have access to bank finance due to their lower creditworthiness. Finance companies, therefore, may engage in business with relatively a higher risk than banks. Financing of vehicles is a prominent investment of these companies. More than 70 per cent of advances granted by registered finance companies are represented by leasing and hire purchase, which are the main sources of finance for acquiring vehicles, for business or personal purposes. Hence, finance companies face a greater risk related to their business activities and in turn, a higher cost of funds.

Sri Lanka has an unpleasant experience in the history of finance companies during the late 1980’s and early 1990’s. During this period, 13 finance companies failed and the Central Bank granted Rs. 2,723 million worth of refinance/direct loans to these companies. A large part of these loans were not repaid. The Monetary Board of the CBSL vested 9 companies under the Finance Companies Act and 6 of these have been liquidated, while others are currently under liquidation. Of the 4 companies which were not vested, 2 were handed over to another finance company for rehabilitation.

In the late 1980’s, the political and macro-economic conditions in the country were unstable. Finance companies also had moved away from the traditional hire purchase business to new types of businesses such as leasing. Despite this, the outstanding value of the hire purchase lending recorded an increase of Rs. 336 million in 1988 and stood at Rs. 2,939 million at the end of that year. Non settlement of advances also increased. One reason for the increase in the outstanding level of non-settlement of advances were the disturbances that prevailed at that time in the country, especially in the years 1988 and 1989. Another contributory factor for nonsettlement was inefficiency in the management of the failed finance companies. It is clear that the credit evaluation and management processes were weak and not at acceptable levels. Due to these reasons, interest and other charges in arrears to the principal outstanding rose drastically from 37 per cent at end 1987 to 45 per cent at end 1988.

A common salient feature of a number these failed finance companies was that share ownership and management were concentrated in a few hands, in the form of so called "family businesses". A family business is a company owned, controlled and operated by members of one or several families. A family business may have non-family members as employees, but the top management and strategic positions are often allocated to family members. Sometimes, family participation in a business can strengthen the business because family members are very loyal and dedicated to the family enterprise. However, managing a business, particularly succession planning, can present some unique problems. Often, family interests conflict with business interests. For example, if a family member who is less competent than a non-family member is in a higher position, his substandard performance may have a negative impact on the overall performance of the company.

Problems generally associated with family owned business become aggravated in the event of FIs managed by a family. Table 1 indicates that most of the failed finance companies were managed by either family members or by a small number of shareholders.

The capital of the FIs is always much less than the total deposit liabilities and other liabilities of the company. This creates an incentive for the management to take higher risks in their investments and use funds directly for personal purposes in their businesses, especially if the finance company under reference is a member of a financial conglomerate. The boards of such companies have opportunities to use funds in the following questionable ways:

1. Areas where conflicts of interests exist

2. Lending to officers, employees or directors. The Basel II Framework suggests that where internal lending occurs, it should be limited to lending consistent with market terms or terms offered to all employees and may be restricted to certain types of loans. Reports of insider lending should be provided to subject to review by internal and external auditors and supervisors.

3. Providing preferential treatment to related parties and other favoured entities.

4. Authorise excessive remuneration to family members, who are members of the board or are managers of the company.

As shown in Table 2, conflict of interest had played a crucial role in the failure of the finance companies. One such example is the behaviour of a finance company prior to the date of vesting. As there were previous loan balances to be recovered, funds appear to have transferred or loans have been released continuously to its loss making related companies by this finance company.

International experience too has shown that the risk of engaging in fraudulent activities is second only to credit risk as a cause of failure in the history of the financial sector. It has been estimated that in the 1950’s and 1960’s, three thirds to three fourths of bank failures involved frauds. The overall implications of fraud extend well beyond direct losses to FIs. When management engages in fraudulent behaviour, it also signals lack of commitment to the business and carelessness in dealing with risks faced by FI. Employees’ fraud and mismanagement often go hand in hand. Internal fraud is often hard to detect because the schemes are elaborate and perpetrated by people the bank trusts. Internal fraud encompasses everything from extravagant consumption of perks to illegal loans to management. Inappropriate loans to insiders and to their families and friends have led to numerous conspicuous failures of FIs. One difficulty in dealing with fraud is that whenever it is encountered, internal audit is almost always neutralised.

These finance companies that failed in the 1980s and 1990s faced liquidity problems as customers withdraw their deposits due to lack of confidence and increasing non-performing loans. Table 3 indicates that during the period under review, total liabilities to deposit ratio had dropped significantly.

Finance companies, especially failed companies, had tried to increase their deposit base by offering high interest rates, thus facing an additional burden by way of increased cost of borrowings. Interest rates offered for deposits were recorded at more than 30 per cent during this period, while many borrowers were less creditworthy due to non-availability of credit information. High interest rates create an incentive to less creditworthy borrowers to choose riskier projects after obtaining loans.

The failure of financial intermediaries has serious implications on monetary policy too, as the Central Bank or the government often has to bail out failed financial institutions. The bailing out usually leads to an increase in money supply and then increased inflation in the country. The burden of inflation is ultimately borne by the general public, with the most economically vulnerable segments of society being the worst affected. The CBSL had grant a total amount of Rs. 2,723 million under refinance/direct loan schemes during the period considered. Of these loans, the total amount repaid to the CBSL by failed finance companies was only Rs. 327 million. The total outstanding capital was at Rs. 2,396 million. These injections by the CBSL to stabilize the financial system, directly contributed to increasing reserve money by more than 20 per cent in 1989 and 1992 as indicated in Table - 5. The amount injected by the CBSL accounted for 9 per cent of the increase in reserve money during the period 1989-92.

The outstanding amount that should be paid by failed finance companies contributes to the demand pressure in the economy.