Central Banks mad rush to mandate

credit: Shocking banks is not in accord

with PMs Social Market Economy

Mandating credit allocation without

fanfare

Monday, 13 February 2017

The Central Bank of Sri Lanka has, without fanfare or publicised

press conferences, issued a one and a half page long circular to
commercial banks urging them to maintain a minimum
percentage of their total loans for six sectors identified as
priorities in the said circular (available at:
http://www.cbsl.gov.lk/pics_n_docs/09_lr/_docs/directions/bsd/BSD
_2017/BSDCircularNo1of2017.pdf).

The title of the circular says that it is issued in accordance with

the implementation of the proposals relating to financial services
announced in the Budget 2017. Hence, the banks Monetary
Board appears to have yielded itself to the wishes of the Finance
Minister Ravi Karunanayake who had of late taken interest in
controlling banks which do not come within his purview in terms
of the work allocation of the new Government.

An unsavoury intervention in the market

What the Central Bank has introduced by way of implementation

of the Budget proposals is collectively known as mandatory credit
allocations. When the proposal in question appeared in the
Budget along with many other interventions proposed by the
Minister, this writer wrote in an article in this series that it was an
unsavoury attempt by the Minister at grabbing for himself the
legitimate powers of the Monetary Board (available at:
http://www.ft.lk/article/580074/Budget-2017--Significant-
improvement-if-not-marred-by-policy-inconsistencies-and-
interference-with-the-Monetary-Board).

This is what this writer said about the proposal relating to

mandatory credit allocations by banks: The Minister of Finance is
planning to introduce mandatory credit allocations to commercial
banks in accordance with priorities which he has identified......It is
also proposed to issue a directive to commercial banks that they
should lend at least 15% of the deposits they mobilise in a
particular area to within that area itself. (These two) proposals will
lead to corruption because bank managers would devise
ingenious methods to allocate funds to fathers in law and sons in
law. This is the experience which India had with such mandatory
credit allocations.

This writer then suggested: These are serious issues and it is

hoped that the government would take appropriate action to
correct these howlers, inconsistencies and undue interferences
with the Monetary Board before it is passed in Parliament.
Going ahead with mandatory credit allocation

Despite this warning, there has not been any attempt by the
Minister of Finance or the Central Bank at revisiting the proposal
in the Budget to ascertain its validity, consistency and suitability.
Instead, the Central Bank has issued a circular to commercial
banks under the hand of its Director of Bank Supervision
expressing its wish that all banks may take appropriate
measures to implement the following:

nDistribution of credit to identified sectors: Credit granted by

banks may not be less than the following percentages of total
loans - 10% for medium and small enterprises or SMEs, 10% for
exports, 10% for tourism, 10% for agriculture which is already
being followed by banks, 5% for youth and 5% for women. Thus,
50% of the total loan book of banks should have been allocated to
borrowers in these six identified constituents or sectors.

nEnhancing banking services: Under this category, three

directives have been issued by the Central Bank to commercial
banks. First, credit granted by bank branches in the business
development in the respective area may not be less than 15% of
the deposits mobilised by each branch within the same area.
Second, banks may streamline the procedures for granting credit
so that loans of less than Rs. 5 million should be finalised within
one month. Third, at least one branch in each district should be
kept open for all seven days of the week except on religions
holidays.
An ever changing definition of SMEs

The Central Bank, following the national policy framework for SME
development, has defined SMEs as those with an annual turnover
not exceeding Rs. 750 million. Banks will find it difficult to remain
within this definition since all enterprises which may cross the
threshold limit will not be considered as SMEs and when it occurs,
they will have to go looking for new borrowers who could be
treated as SMEs.

That involves an additional cost of loan processing. Thus, it is in

the interest of banks to concentrate on enterprises which are well
below the threshold limit to avoid additional costs of borrower
appraisal.
Central Banks continued reluctance to impose mandatory
credit allocations

The original Monetary Law Act or MLA had not empowered the
Central Bank to direct commercial banks or any other financial
institution to maintain a minimum percentage of loans which they
shall grant to any identified sector of the economy.

The architect of MLA, John Exter, did not think that it was
necessary. The Monetary Board too did not feel that the Central
Bank should go for such mandatory credit allocations to identified
sectors despite its counterpart in neighbouring India, namely,
Reserve Bank of India or RBI, had done so from around 1967. The
frustrating experience which India had with such priority sector
lending made the Monetary Board consistently go by that
decision.

However, this was changed in 2006 when the Rata Perata

Government of 2004 thought that banks should lend a minimum
of 10% of their loans and advances to agriculture. Accordingly,
the Central Bank has now been empowered under Section 101(1)
(c) of MLA to fix the minimum percentage of loans to be
extended, to any identified sector of the economy, by the
commercial banks or licensed specialised banks.

The Central Bank invoked the provisions of this section in the case
of agricultural loans under which commercial banks were required
to maintain a minimum quantum of loans to borrowers in this
sector at 10% of their loan book.

However, the current circular has not made use of the powers
which it enjoys under this section but simply has informed
commercial banks that they may provide the minimum
percentages of loans to those six identified sectors or borrowers.
But banks are required to report back and if they do not meet with
the minimum requirement, the Central Bank has the choice of
issuing formal directions to them by invoking the provisions in
MLA.
Economic rationale of using mandatory credit allocations

The economic rationale for introducing mandatory credit

allocations rests with what is known in economics as the
divergence between private interests and social interests. Under
the free market economy system, private interests should
naturally lead to the allocation of resources for meeting the
requirements of society as demonstrated by collective demand for
banking services.

If a particular sector needs credit, such a need is communicated

to banks by prospective borrowers by queuing at banks and
making their needs known to them. Hence, if there is a demand,
the market should allocate resources to meet the demand. In this
case, private interests become identical with social interests.
Structural issues leading to divergence between private
interests and social interests

However, there can be a divergence between the two if there are

structural deficiencies in the system. One such structural
deficiency is the lack of information to prospective borrowers
which sectors are profitable.

Another is the lack of technical knowhow and skills to undertake

businesses in the proposed areas. A third is the inability of
borrowers to present their case in a way acceptable to bankers. A
fourth is the lack of the needed security and collateral with
borrowers as demanded by banks. A fifth is the perception of
banks that the identified sector is not a profitable sector or the
borrower is not credit worthy.

Then, the credit flows fall short of the socially desirable levels.
Instead of taking measures to address the structural issues,
politicians think that they can sort the problem by directing banks
to mandatorily lend to these sectors.
Undesirable consequences of mandatory credit
allocations

But such directions lead to many undesirable consequences.

Hence, before they are issued, it is necessary to examine all the
consequences they might bring about and how such directions
would in fact defeat the very purpose of introducing them. Such
examinations should be done by specially appointed technical
groups as has been done in neighbouring India.
Indias frustrating experience in priority sector lending

India had introduced mandatory priority sector lending from 1967

emphasising that commercial banks should increase their
involvement in the financing of priority sectors as identified at
that time as agriculture, exports and small scale industry.
However, by 2005, it was felt that the whole program should be
revisited with a view to making amendments if necessary or
completely do away with the system.
To address these issues, an internal working group consisting of
senior officers was appointed by RBI in 2005 and its report is
available on the RBI website (available at:
https://www.rbi.org.in/upload/content/pdfs/66391.pdf ).

The report has emphasised that the experience of most

countries around the world showed that directed credit
programmes suffered from abuse and misuse of preferential funds
for non-priority purposes, increased the cost of funds to non-
preferential borrowers, involved a decline in financial discipline
that resulted in low repayment rates, and contributed to the
government being burdened by unpaid loans and huge arrears.
Moreover, once introduced, directed credit programmes proved to
be difficult to discontinue.

The report has tabulated the international experience with regard

to mandatorily directed lending and found that it has failed in
Brazil, China, Indonesia, Nepal and the Philippines, the countries
which had experimented with the system. In India, the demand
has shifted from mandatorily directed lending to microfinance as
an effective method of addressing issues involved at the
grassroots level.

Since then, RBI has simply modified the system from time to time
while retaining the system as a credit allocating method for what
has been identified as priority sectors, because once introduced,
it cannot be taken away without causing political turmoil.

In this background, Sri Lankas entry into directional credit is

fraught with many practical as well as systemic issues.
Shocking commercial banks with a suggestion for a
mandatory credit allocation

The circular has shocked commercial banks which had not been
prepared to undertake such a feat without advance notice. The
staffs of banks have not been trained to identify creditworthy,
viable loan proposals which prospective borrowers might present
to them. Hence, the introduction of a mandatory credit allocation
system without consulting banks or appreciating their practical
problems has been a real shock to them.

The result of such a shock treatment is that neither the Central

Bank nor the government would be able to realise the targets or
objectives of introducing mandatory credit allocational system.
Treating all banks alike

Another deficiency is the disregard of the specialities which banks

may have attained over the time in lending to particular sectors
when uniform mandatory credit disbursements are imposed on
different banks. For instance, one bank may have developed
speciality in extending credit for the export sector, while another
bank may have developed skills in granting credit to youth. A
third bank may have specialised itself in lending to agriculture.
Now, when all these banks are treated uniformly for minimum
credit disbursement targets, it would be an advantage for some
banks, while it is a stressful experience for some other banks. It,
therefore, leads to develop distress in failing banks, while
remunerating handsomely those banks which enjoy an advantage
in lending. India, having well recognised this disparity in the
lending behaviour of banks, has allowed the banks which have
done well in a particular area to sell their excesses to banks which
have remained below the minimum lending goals (available at:
http://indianexpress.com/article/business/banking-and-
finance/priority-sector-lending-certificate-guidelines-banking-on-
reforms/ ).
Stress on the loan book

A third deficiency is the stress which the proposed mandatory

credit allocations might build on the loan books of banks. The
priority lending to the six indentified sectors will just occupy a half
of the loan book of commercial banks. It would completely disrupt
the risk management practices which these banks have already
introduced since a half of their loan book representing lending to
priority sectors is now outside their control. The corollary of such
a lending system is the distress it would create in banks leading
to the accumulation of a large number of defaulted loans by
them. The resultant financial instability will impose an additional
burden of the government to bail out the problem banks.
Giving rise to fraudulent practices

Mandatory credit allocations also lead to fraudulent practices in

banks. As also noted by the working group appointed by RBI to
study the priority sector lending system, bank managers might
use the new facility to direct credit to undeserving customers or
their own kith and kin. It is difficult for a central bank to monitor
such corrupt practices.
Betrayal of Social Market Economy Policy?

The present Government is following a social market economy

policy under which the role of the Government is limited to
facilitating the market to function as the leader of economic
development.

The Prime Minister has been very emphatic about following this
economic policy to deliver prosperity to people. Hence, the action
taken by the Ministry of Finance and the Central Bank to impose
mandatory credit minimums, an unworkable intervention in the
market, has not only shocked the banks but also betrayed the
Prime Ministers social market economy policy.
(W.A. Wijewardena, a former Deputy Governor of the
Central Bank of Sri Lanka, can be reached at
waw1949@gmail.com)
Posted by Thavam