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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » Management failure cause collapse of finance companies - Professor Kenedy

Management failure cause collapse of finance companies - Professor Kenedy

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Redbulls

Redbulls
Director - Equity Analytics
Director - Equity Analytics
Reliable financial reporting, timely disclosures, effective and efficient director boards and accountable management practices are needed to make possible growth of stronger capital markets opines Professor Kennedy talking exclusively to Ceylon FT on the recent fall of financial institutions in Sri Lanka.

In the recent past crashes of financial institutes were visible very prominently in Sri Lanka. In a country which boosts and talks very zestfully about economic growth and economic stability these crashes give some dreadful signals of the authenticity of such claims.

Professor Kennedy draws some insights into this citing some references to recent global financial occurrences.
Professor Kennedy D. Gunawardana, is Professor of Accounting Information Systems and Chairman of Board of Management Studies Faculty of Graduate Studies, University of Sri Jayawardenepura (USJ) and also the course coordinator for the PhD programme of management of the same university.

Here are excerpts of the interview.
Q: In the recent past in Sri Lanka many financial institutes crashed and closed down. At this rate the general public could lose their faith in the financial institutes as 'no trust worthy' why do you think this happened?

A: First go back to the recent history of financial crises, the collapse of Lehman Brothers, a sprawling global bank, in September 2008 almost brought down the world's financial system. It took huge taxpayer-financed bail-outs to shore up the industry. Even so, the ensuing credit crunch turned what was already a nasty downturn into the worst recession in 80 years.

Massive monetary and fiscal stimulus prevented a buddy-can-you-spare-a-dime depression, but the recovery remains feeble compared with previous post-war upturns. GDP is still below its pre-crisis peak in many rich countries, especially in Europe, where the financial crisis has evolved into the euro crisis. The effects of the crash are still rippling through the world economy: witness the wobbles in financial markets as America's Federal Reserve prepares to scale back its effort to pep up growth by buying bonds.

All these factors came together and started with the folly of the financiers. The years before the crisis saw a flood of irresponsible mortgage lending in America. Loans were doled out to 'sub prime' borrowers with poor credit histories who struggled to repay them. These risky mortgages were passed on to financial engineers at the big banks, who turned them into supposedly low-risk securities by putting large numbers of them together in pools. Pooling works when the risks of each loan are uncorrelated. These factors are common here itself.

Trust, the ultimate glue of all financial systems, began to dissolve in 2007—a year before Lehman's bankruptcy as banks started questioning the viability of their counter parties. They and other sources of wholesale funding began to withhold short-term credit, causing those most reliant on it to founder. Northern Rock, a British mortgage lender, was an early casualty in the autumn of 2007. In Sri Lanka too the situation is similar to this. More and more financial institute's failure will erode the trust people place upon the institute.

Q: As the Central Bank of Sri Lanka is the watch dog of the financial institutions how can this happen without its knowledge?
A: Failures in finance were at the heart of the crash. But bankers were not the only people to blame. Central bankers and other regulators bear responsibility too, for mishandling the crisis, for failing to keep economic imbalances in check and for failing to exercise proper oversight of financial institutions.

The regulators' most dramatic error was to let Lehman Brothers go bankrupt. This multiplied the panic in markets. Suddenly, nobody trusted anybody, so nobody would lend. Non-financial companies, unable to rely on being able to borrow to pay suppliers or workers, froze spending in order to hoard cash, causing a seizure in the real economy. Ironically, the decision to stand back and allow Lehman to go bankrupt resulted in more government intervention, not less. To stem the consequent panic, regulators had to rescue scores of other companies.
But the regulators made mistakes long before the Lehman bankruptcy, most notably by tolerating global current-account imbalances and the housing bubbles that they helped to inflate. Central bankers had long expressed concerns about America's big deficit and the offsetting capital inflows from Asia's excess savings.

Ben Bernanke highlighted the savings glut in early 2005, a year before he took over as chairman of the Fed from Alan Greenspan. But the focus on net capital flows from Asia left a blind spot for the much bigger gross capital flows from European banks. They bought lots of dodgy American securities, financing their purchases in large part by borrowing from American money-market funds. The question we have to ask is isn't this happening in Sri Lanka as well?

Q: You went on record recently saying companies fall due to bad management. In the case of these financial institutes isn't the bad management due to the Central Bank? Isn't this sufficient proof qualified and able people should lead CB?

A: There is increased evidence from official development institutions and private economists around the world documenting the linkage between more rapid—and stable—economic growth on the one hand, and sound financial systems on the other.

Despite numerous privatizations over the past decade, publicly owned banks and other State-owned financial institutions still serve the majority of individuals in developing countries, according to presentations by James Hanson, George Clarke, and Robert Cull of the World Bank.
State-owned financial enterprises are less prevalent in developed economies, with very few exceptions, such as Germany and, to a lesser extent, the United States, with its large government-sponsored entities supporting residential home ownership that have implicit government backing, according to David Marston of the International Monetary Fund. Public ownership of these financial institutions and others has been rationalized on several grounds:

• To ensure that economic growth is consistent with national objectives. This is a clear rationale for socialist economies, but even in private economies there is a view that governments have better knowledge of socially beneficial investment opportunities than private banks.

• To ensure that underserved groups or sectors, such as agriculture and small businesses, receive credit.

• To respond to financial crises, which have hit developed and developing countries alike. In some of these cases, government ownership is temporary, but in some cases it lasts for significant periods.

Among government officials around the world there is support for some government ownership of financial institutions based on one or more of these rationales. Economists generally, however, are skeptical of all these rationales except for the last one.
This is the better way to protect the community, better to take some State ownership from financial and public banks which are not part of the government organization.

Performance of public sector banks

With rare exceptions, public sector banks have performed poorly by conventional financial measures, such as returns on equity or assets, the extent of nonperforming loans, and expense levels, according to James Hanson. In principle, these banks may fare better if their broader social missions are taken into account (for example, when they finance roads or sewers), because the benefits to the entire economy may exceed those to the specific borrower. But in practice these banks tend to extend much if not most of their credit to a large borrower, which suggests that social returns are not larger than private gains.

Public sector banks often provide subsidized lending and directed credit to special industries or enterprises identified by the government. They also can burden their governments with large contingent liabilities arising from explicit guarantees or the implicit assumption that some of these banks are 'too big to fail.' In China, for example, nonperforming loans of major financial institutions at the end of 2003 stood at 2,440 billion RMB (the Chinese currency), equivalent to about 18% of the loans of these institutions and 21% of gross domestic product, according to a study by Nicholas Lardy of the Institute for International Economics. Furthermore, as much as 90% of these might be regarded as a government contingent liability. Public sector banks have also demonstrated a poor collection record with their borrowers, especially in bad economic times, and thus tend simply to 'roll over' their loans.

Country experiences with State-owned financial institutions


China is perhaps the best-known example of a country with dominant public sector banking. Most of its banks are owned by the central, provincial, or local governments, and nonperforming loans to other State-owned enterprises loom large in its economy. The outlook for the Chinese banking sector is mixed, according to Nicholas Lardy. On the one hand, the official returns on assets of China's State banks dropped precipitously during the 1980s and 1990s, while nonperforming loans grew rapidly during the mid-1990s, reaching 25% of total bank loans by 1997.

On the other hand, Chinese officials in recent years have recognized the importance of dealing with the banks' problems. They therefore have reduced the government's involvement in the banks' allocation of credit and have created four asset management companies to deal with the nonperforming loans.

The results so far are impressive—nonperforming loans have declined significantly (largely because many were transferred to the asset management companies), while the banks appear to be more efficient. Yet the outlook remains guarded: lending by Chinese state-owned banks soared in 2003 and early 2004 and was initially resistant to attempts to check the expansion, which raises the risks of higher nonperforming loans in the future.

Indonesia had well-known problems with its state-owned banks and connected lending among its private banks before the Asian financial crisis of 1997-98. Since then, the state-owned banks have been recapitalized by the government (their bad debts taken over by a separate agency), and prospects for them may now be somewhat brighter, judging from a presentation by Hendrawan Tranggana, Managing Director of compliance at Bank Rakyat Indonesia. Two economists from the World Bank—P. S. Srinivas and Djauhari Sitorus—paint a somewhat darker view; although recorded profitability may have improved, large uncertainties remain about the magnitude and ultimate cost of the banks' nonperforming loans.

Q: Looking back into the down fall of Daduwam Mudalali Galle, Sakvithi, Pyramid scams, Golden key up to the latest Central Investments and Finance PLC (CIFL) enormous amounts of money which was deposited was lost by the depositors ( Public) but it is released to the market. This money is there in the market. What are the implications this has to our money flow in the economy. Has it improved and is the public benefited?

A: The answer is to apply corporate governance and acquire certain stakes from private ownership, this stake controlled by the government and when the company loses, the government can release those funds to the beneficial parties, and this is socialism theory. This is what China is applying. This will protect depositors and it does not harm the country as a whole. The only part is the government must be efficient to handle this amount. It is the duty of the government who are voted by the people to protect the rights of people.

Corporate Governance (CG) concerns the system by which companies are directed and controlled. It is about having companies, owners and regulators become more accountable, efficient and transparent, which in turn builds trust and confidence. Well-governed companies carry lower financial and non-financial risks and generate higher shareholder returns. They also have better access to external finance and reduce systemic risks due to corporate crises and financial scandals.

Reliable financial reporting, timely disclosures, better boards and accountable management also facilitate development of stronger capital markets. They improve a country's ability to mobilize, allocate and monitor investments and help foster jobs and economic growth. Better supervision and monitoring can detect corporate inefficiencies and minimize vulnerability to financial crises.
http://ceylontoday.lk/22-43324-news-detail-management-failure-cause-collapse-of-finance-companies-professor-kenedy.html

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