Bond Scams Were Caused By A Broken Bond Market – Part III

By Arjuna Mahendran –JULY 4, 2020

Arjuna Mahendran

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” ~ (Maynard Keynes, The General Theory)

The Central Bank’s annual report for calendar 2015 contained the following paragraph on the operations of the Regional Development Department (RDD): ‘RDD invests excess funds held by it under custodial arrangements in Repo investments. As at 31 December 2015, Repo Investments amounting to Rs.1.40 Bn were found to be uncollateralized… If these investments cannot be recovered, it affects the future functions of the Department and expansion of existing projects. Further, new projects cannot be implemented. If the investments cannot be recovered it will reduce the funding base by an equal amount.’

The department had placed a form of deposit called a repurchase agreement (or ‘Repo’), which secures the deposit with some form of security, usually a government bond. Repos are popular with investors who wish to obtain the typically higher rates of interest offered by bonds while affording themselves the convenience of being able to realise the funds before the underlying bond matures. However, in this case the department had failed to check whether the underlying bonds were attached to the Repos. They weren’t. The deposits were thus left uncollateralised. The debt department of the central bank had been aware of such malpractices for several years prior. However these concerns had not been taken into account when the central bank was investing its own funds. When I inquired why central bank funds had been deposited in that manner, the concerned staff told me that they accepted the offer with the highest rate of interest. They said they accepted the highest bid for fear that the auditor-general would fault them if they accepted a lower bid.

What this unfortunate event reflected was a basic lack of coordination between departments of the central bank, in sharing and analysing data related to financial markets under their supervision. The board thereafter took several measures to address the issue. Legal action to recover the lost monies were instituted. The minimum capital for bond dealers was raised from Rs 300 mn to Rs 1 billion. The supervision of bond dealers was transferred from the debt department to another department with specialist supervisory staff. Two new departments for risk management and compliance were created in line with international norms for banking institutions.

The underlying principle adopted was for the risk oversight of operational departments of the central bank to be taken out of the concerned departments and vested in independant risk management and compliance functions, tasked with creating an inter-departmental view of risk mitigation and market regulation issues. New regulations were eventually issued by the central bank in early 2020 to tighten rules sanctioning dealers issuing Repos without attaching the underlying bonds. However, no attempts have been made to modernise the laws governing the bond market, including the Local Treasury Bills Ordinance No. 8 of 1923 and the Registered Stock and Securities Ordinance No. 7 of 1937, which predate the establishment of the central bank by several decades and are unwieldy in a digital trading environment which requires split-second regulatory oversight in real time.

It is noteworthy that the 2017 Commission of Inquiry (COI) to investigate transactions in the bond market in 2015-2016 did not see it fit to inquire into the losses made by the government in Repo instruments despite this being squarely within their mandate. No mention was made by the COI about the legal framework for handling defaults on financial instruments being in urgent need of modernisation. While commercial courts were established to expedite commercial disputes, there has been no concomitant progress on refashioning statutes relating to insolvency and bankruptcy in order to expedite the claims of creditors. This has arguably impeded the issuance of bonds by a wider spectrum of private companies, with investors preferring the perceived safety of government bonds. The COI on the Bond Market, when presented with evidence that successive issues of government bonds were issued without prior public notification in the government gazette, as required by the governing law enacted in 1937, did not pause to reflect on whether it was practicable to enforce such procedures in a modern trading environment. Nor was the wider importance of modernising the legal framework for the effective functioning and regulation of the bond market given due consideration in the COI report. In parliament, central bank matters are reviewed by a committee on ‘public enterprises’ with minimal staffing to review policy and legislation related specifically to government finance. A gaping anomaly is that parliament lacks a standing Treasury Committee to enforce its prerogative as the ultimate source of authorisation for government financial business.

It is clearly evident that the management of the burgeoning public debt of the government has become too big an issue to be managed by a single department of the central bank. The reality is that the existing central bank organisational structure conceived in the late 1940s, and hardly modernised since then, has not kept pace with developments in the financial sector. When it was established in 1950, the central bank had to research the economy and determine appropriate monetary policy, regulate a handful of banks and manage the value of the currency. The issuance and management of government debt was added as an agency function owing to the limited size of Ceylon’s financial sector at the time. Today, on the other hand, with broadly similar functional arrangements as enacted in 1950, it has to supervise over 30 banks and over 50 finance companies, myriad money brokers, bond dealers, currency exchanges etc. Meanwhile net government debt has grown in that period from near-zero to over 80 percent of GDP. Additionally, the task of managing the Employees Provident Fund was thrown in for good measure in 1959 despite protests which rightly pointed out the contradiction inherent in maximising returns for the fund while simultaneously obtaining funding for the government at low cost. In my opinion, the existing organisational structure simply cannot handle the additional workload effectively.

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