The current financial climate is ideal for asset bubbles as the economy expands rapidly and credit grows in step, following the end of a quarter century long conflict. The cost of living is falling, almost everyone has a job and interest rates have declined to record lows. The country is in an upbeat mood about the future.
People’s and private sector expectations for the future rise rapidly during periods of high growth. People aspire for larger homes, vehicles and to consume more. Firms expect to supply the growing demand by expanding. Because they are now more optimistic, businesses and individuals will shed many of their inhibitions about debt.
The economic downside of confidence-driven borrowing is that it drives asset prices up. The cost of everything from homes, used cars and listed stocks rise when leverage increases demand for these assets. Considering the relative inexperience of Sri Lankan households and private firms with prolonged low interest rates, the likelihood they will bid up asset prices to bubble territory is very real.
When they pop, asset bubbles expose old shenanigans and encourage new ones, another likely outcome at some of Sri Lanka’s weak, ill-governed subprime lending firms. Faced with rising dud loans and tightening margins, owners and managers will gamble for salvation, taking even greater risks and speculative bets. They will conceal non-performing loans in the expectation that the prices of assets backing them will somehow recover, that these loans can somehow be packaged as a security and sold, or in the expectation the financial firm itself can be sold while the muck remains hidden.
Many small subprime lending firms, commonly referred to as finance companies or Licensed Finance Companies (LFC), are badly managed and have a chilling disregard for good governance. The Central Bank – which regulates the sector – has, as result, announced a policy of consolidation that will result in the weakest players being absorbed by bigger finance companies and commercial banks or the weak firms merging with each other to form larger, better capitalized finance companies.
Some small finance companies are concealing large nonperforming loan portfolios according to directors, chief executives, senior managers and analysts who spoke to Echelon. Due to the sensitivity of their revelations to firms and because they were not authorized to speak to journalists, those who granted interviews requested anonymity.
Trust underlies any financial system. Depositors – the major industry funding source – must have the confidence that their savings are safe. Undermining this confidence can lead to industry wide crisis. A financial sector firm’s fate is sealed if it has to block withdrawals.
Conditions that erode trust already exist. A third of the 48 registered finance companies aren’t transparent with their financial performance, 19 of them haven’t published a credit rating. Two finance companies have a negative net worth, two firms are not accepting deposits as they are restructuring and another, CIFL – where massive fraud is alleged – is being unraveled in court.
The finance company’s websites, websites of the three credit rating agencies nor Echelon’s team visiting the head offices of these 19 firms were able to figure if they currently had a credit rating. Central bank has been vague about finance company non-compliance with directions, guidelines, circulars and regulations.
Proposing acquisitions and mergers (consolidation) among finance companies and with banks in January 2014, the Central Bank observed that 38 non-bank financial institutions (which also includes a few leasing companies) had weak compliance with regulatory directions.
The murkiness and the risks seem to have alarmed the regulator. In 2014 it proposed consolidation in the financial sector and reducing the number of finance companies – by forcing consolidation – in the first round of the reforms.
The Central Bank’s Non Bank Financial Institutions (NBFI) department, which regulates the sector, did not respond to Echelon’s questions about finance company compliance with regulations and the sector’s financial health.
One rule frequently flouted (Rule No.1 of 2006) by finance companies, is the requirement to publish their credit ratings in advertisements soliciting deposits. Every advertisement directly or indirectly soliciting deposits has also to be submitted to the Director Supervision, NBFI Department of the Central Bank. It is unclear if these adverts are being submitted to the Central Bank’s NBFI department, which is ignoring instances of non-compliance. Publishing credit ratings in advertisements will build industry wide trust of finance companies.
These and other regulatory rules cover all aspects of their licensing, capital, credit, investments, liquidity, corporate governance and reporting requirements. Finance companies were required to increase minimum core capital to Rs400 million by January 2015. Two finance companies have a negative net worth and don’t meet this requirement, how many more fall into this category is unclear because 12 finance companies don’t have published accounts in thepu blic domain.
Although the deadline is past it is not clear if all other firms have met the minimum core capital requirement. Abusing people’s trust by misleading them about the financial health of the firms or by diverting corporate resources for personal ends hurts the industry and particularly those finance companies with excellent management and good governance.
For instance, ETI Finance says on its website that it “is one of the leading and strongest finance companies registered under the Monetary Board of the Central Bank.” Financial statements and a credit rating could not be found in the public domain. In 2013, Fitch Ratings downgraded the firm from BB- to CC and withdrew the rating a few months after. Its sister company, Swarnamahal Financial Services is listed on the stock exchange, so its financial reports were available. The company had a Rs1.2 billion rupee negative net worth. However, no credit rating is available.
The Finance Company PLC, another company without a published rating, describes itself on its website as the “premier finance company of the country in the non-bank finance business” with an “illustrious 74-year journey”. This company has a Rs9.7 billion negative net book value.
[pullquote]Many small subprime lending firms, commonly referred to as finance companies or Licensed Finance Companies, are badly managed and have a chilling disregard for good governance. The Central Bank – which regulates the sector – has, as a result, announced a policy of consolidation[/pullquote]
Subprime sector challenges are diverse and complex but broadly stem from three areas. Firstly, the current economic conditions are unlike any the sector has faced previously. Secondly, challenges stem from weak governance and readiness by directors and Chief Executives to bamboozle depositors and debt providers, offering far lower risk premiums than those deserved for the real risks of deposits or lending to these firms.
Thirdly, the Central Bank’s coercive consolidation among finance companies, has thrown up new challenges.
Finance companies are growing credit at almost double the rate at which bank credit is growing. In 2013 finance company loans grew 17.3% compared to 8.8% growth at banks and in 2014 loan growth topped 16% compared to 13% at banks.
Sri Lanka’s banking and finance system is flush with cash but lending opportunities have been dearer for banks. The decline in deposit interest rates boosted finance company net interest margins in 2014. Deposits also grew 22.7%, as people became yield sensitive in 2014.
Ten percent of deposit taking institutions’ assets in Sri Lanka are held by finance companies, and the share is growing rapidly. At Rs414 billion in 2014, they hold 8.1% of savings and fixed deposits in the country. The 48 finance companies also accounted for 14.1% of loans outstanding in 2014.
Subprime borrowers are the most likely to default on loans during downturns because they tend to have much less equity invested. When asset prices fall, borrowers walk away from loans with an outstanding settlement greater than underlying assets worth. This was demonstrated when lead by the global gold price decline, finance company dud loans increased by 20% percent in 2014 to Rs44.3 billion when borrowers abandoned gold backed loans. ‘High lending rates and the gold price fluctuation affected pawning (gold backed loans)’, the Central Bank’s 2014 annual report revealed.
“Subprime sector lends to indisciplined people,” a Chief Executive of a finance company contends, “they don’t understand finance.” After the crisis, finance company gold backed loans shrank to 22.6 billion in 2014 or 3.5% of lending from almost 5% of lending in 2013.
A low interest rate and the looming asset bubble will challenge finance companies in ways that many firms are only beginning to understand. Subprime lenders will take the first and biggest hit when a bubble pops. The fact that finance company loans are mostly asset backed (leases and hire purchase loans are more than 80% of lending), can also lead to a false sense of security.
Liquidity is fickle and the excessive confidence can blindside a firm to their excesses. The sector’s regulator warns LFCs are operating with very high short-term assets and liability mismatches. “This situation needs to be addressed by these institutions as it could have negative repercussions during challenging times. Further, the business model of some of these companies incorporates a high cost of funding, resulting in inefficiencies,” it noted.
Unlike banks, finance companies cannot seize defaulters securities pledged to obtain a loan without court sanction (unless it’s lease or higher purchase lending). Obtaining legal order is a lengthy, costly and onerous process. On the other hand, banks have access to Parate rights which allows them to seize and auction defaulters securities. Because they are in the fringes of the financial system subprime borrowers – defined as persons or organisations with a low credit score – sometimes get a bad rap as greedy and irresponsible. That’s not often the case.
Even prime borrowers go to the subprime sector when they are unwilling to share detailed financial information, seek a larger facility than a bank would grant or are offering a low down payment. A borrower can be a prime and subprime borrower at the same time or at various times in an economic cycle. A mortgage borrower from a bank might obtain a car lease from a finance company because the bank wouldn’t lend any more money. Finance companies exist because commercial banks, which provide over 85% of the loans in Sri Lanka, don’t service a segment they estimate are too risky, costly and beyond their ability to evaluate and risk manage.
If finance companies continue to outgrow banks, in five years their share of deposit taking institution assets will almost double to around 20%. Their lending share – already at 14% – will account for a quarter of the combined commercial bank and finance company total.
The scale can pose a significant systemic risk because of the relative unsophisticated nature – compared to banks – of finance company operations.
“In a finance company you can hide an elephant in a two feet by two room,” sneers a chief executive at one such firm about the ease with which some firms abuse the trust of their stakeholders. “Stock in trade is money and you can play with it, in so many ways. Can the CEO take 100 million out? Of course, so long as he can work with a director and the CFO.” In small closely held finance companies the owners,their friends and family are board members and sometimes also hold key management positions.
The Central Bank says of family owned finance company businesses that “they have been entrenched in systems centred around family legacies and out-dated processes. A few of these companies have been subject to poor corporate governance and therefore poor integrity,” it said in its 2013 Financial System Stability Report published in June 2014.
Untrained staff, under-resourced managers and indifferent employees, frequently ignore simplistic controls at finance companies. Fraud and irreconcilable book values are often challenges at finance companies where systems are nowhere near as robust as ones at commercial banks.
Finance and leasing company bad loans rose marginally to 6.9% of lending in 2014 but in many small firms dud loans are much higher than reported.
Following a recent acquisition of a competitor at a premium over net assets, a finance company discovered that borrowers were disputing the outstanding amounts on some of the largest loans.One borrower had filed action against the finance company claiming the loans outstanding are inaccurate and misleading.
“If your firm had been run badly the recoveries guys can get-together with the client,” a director of this firm revealed on condition we did not identify him. The borrower claimed, the firm’s recoveries guy offered to ensure that “the files go missing,” for a Rs2.5 million kickback. Some of the loan’s crucial documents are missing, according to the director. They estimate the acquired firm’s non-performing loans top 15% of lending, almost three times the reported figure in the books.
In addition to impacting profit, large non-performing loan provisions erode capital, increase the cost of new capital and leads to credit downgrades. Shareholders irked at a stock price decline may demand directors and management be replaced. The motivations to keep non-performing loans low are obvious and some chief executives and boards seem to have taken that task to heart.
Good corporate governance, on its own, will not protect finance companies from fraud or excessive risk taking. Fraud or negligence by wayward employees cannot be eliminated but it’s a risk that can be managed. However, only good corporate governance can ensure that finance company owners and managers are not hiding skeletons.
Non-performing loans are often rescheduled after a new agreement with a borrowing having trouble keeping up with payments. However commercial banks apply international accounting rules to classify non-performing which are far more robust than the 50% loan loss provision applied when a loan is six months overdue and 100% provision for a year without payments, applied in finance companies.
Experienced finance company directors, a chief executive and senior managers who spoke to Echelon said ‘ever greening’ is easy, and practiced at firms facing high dud loans. To prevent a large loan falling in to default firms divert cash settlements from other loans as payments to the defaulted loan. They can also create fictitious small loans – grant a facility and create a stream of inflows to the non-performing loan.
“Documentation is just a file. It’s just paper, nothing else. You can put anything in those files. Business registrations, customer signature, national ID copies, CRIB reports, everything is there,” says the chief executive who has been unraveling such ‘evergreening’ at the firm he manages. “The big loan is being serviced, the others are new loans, so no problem.”
“You don’t have to be very smart to hoodwink the auditor or the guy doing due diligence,” he adds. Commercial banks have layers of procedures, including dual signatures, access controls, IT systems and early warning systems that make such ‘evergreening’ impossible.
Successful fraud is about creating false confidence and making people believe in something that does not exist. Fraud cannot be eliminated but chief executives can treat it like any other risk that needs managing. However for small finance companies here, commercial bank-type processes buttressed by tamper proof IT is unaffordable. “You want to become an animal? Then run a finance company, it’s the shittiest business,” bemoans the chief executive about the challenge of running a finance company. “You don’t know whom to trust,” laments a finance company director. Central Bank noted in its Financial Systems Stability Report 2013, that balance sheets of many registered finance companies (RFC) were weak, processes were not cost effective and governance was still a problem. The Central Bank noted that since the 1990s the RFC sector saw periodical failures because of poor corporate governance.
Despite expressing these reservations, the Central Bank in the past has allowed past masters of bamboozling investor money – like controversial Roscoe Maloney – to be appointed directors of finance companies.
[pullquote]“Yo u want to become an animal? Then run a finance company, it’s the shittiest business,” bemoans the chief executive about the challenge of running a finance company. “Yo u don’t know whom to trust,” laments a finance company director[/pullquote]
Finance companies controlled by the government, through its ownership of state banks, have had as directors people with no useful skills or a track record of successful stewardship of even a corner store. Controlling interest of three finance companies have been acquired by commercial banks. Many finance firms have acquired others. Ones that have found merger partners are preparing for consolidation (refer the table). In November 2014, the Central Bank announced that 22 non-bank financial institutions (including leasing companies) were consolidating operations. Two months later, at its annual Monetary Road Map 2015 presentation, Central Bank announced that the Monetary Board had approved 35 consolidation plans in the financial sector.
Those that paid premiums – to their horror – are now discovering skeletons. “We now treat this as a bailout. We paid money for our freedom,” reasons a finance company director who estimates his firm paid the equivalent of 2.5 times net asset value to acquire a competitor when the concealed bad loans are written off. In 2014 when the acquisition was completed the firm paid what they thought was 1.75 times net book value. Central Bank had issued a price-guidance that finance companies may be valued at between 1.4 to 1.7 times their book values. “But the companies we had short listed demanded 2 to 3 times their book values which was more than what we were prepared to pay,” said a senior manager at one finance company. “The Central Bank kept breathing down our necks.” “People who did the due diligence were just completing an assignment,” says a director about the Central Bank paid for due diligence reports that were the basis on which many firms based their negotiations.
“These accounting firms were never going to be the buyer, they only had to submit the report before the deadline.” Due diligence reports have clauses indemnifying the accountants of any loss that may arise due to any decisions made based on their reports.
One finance company, which ignored the sloppy due diligence reports of the Central Bank-appointed accounting consultants, discovered horrors. “We used IFRS methodology to determine loan risk. All big loans were classified individually into separate buckets and smaller ones bundled together into one bucket. We were then able to better analyse the loan quality and determine their future repayment ability,” an official from the firm said. Unless bad loans were deliberately kept off the books, he maintained this method was reasonably sound. “We had to look at bad loan provisioning very carefully. When provisions are not made the book values remain high. Since a partial payment of a loan instalment does not amount to a bad loan, we had to analyse all these carefully”. This finance company didn’t make offers to acquire any of their competitors they examined.
Small finance companies that scrambled to find partners because the Central Bank warned any that didn’t would be considered a threat to financial systems stability and be forced in to a merger – are ruing their haste.
“There was never a market for this many finance companies, it was a political circus,” contends an industry analyst about the number of finance companies increasing from 35 in 2009 to 48. Many specialised leasing companies were granted finance company licenses too. Newest Capital was the last finance company license awarded on the eve of its policy about turn that demanded consolidation. Senkadagala Finance, a listed finance company, acquired Newest Capital.
Sri Lanka has a rich history of finance company failures. During 1988 to 1990, 13 registered finance companies failed. In 2002 a savings bank called Pramuka Bank failed. In 2009 eight Ceylinco group related companies had liquidity problems when Golden Key, an illegal Ceylinco owned deposit taking firm collapsed. In 2013 CIFL – a finance company -collapsed. None of these finance company failures were a result of difficult economic times. They were due to a combination of bad governance, weak internal controls, fraud and weak regulatory oversight. The symptoms haven’t changed.