Alleged losses at EPF: Monetary Board

will open itself to outside inquiry by

playing slow mode

Massive losses at EPF through imprudent bond deals

Monday, 3 April 2017

Media reports last week had referred to

an alleged loss of Rs 9.5 billion at the Employees Provident Fund
or EPF when it had made some scandalous deals with a primary
dealer company now under investigations (available at:
https://www.colombotelegraph.com/index.php/epf-scam-caused-a-
loss-of-rs-9-5-billion-governor-indrajit-protects-scammers/).

The reports had disclosed the findings of a special investigating

team appointed by the Monetary Board, on the losses that had
been incurred by EPF when it had refrained itself from bidding at
the primary auctions of Treasury bonds but buying them from the
alleged primary dealer or from those who had bought from him at
significantly higher prices.

It had been revealed that the Monetary Board had not taken firm
action against those who had been responsible for those colossal
losses. Instead, it had been reported that the Board had decided
to call for explanations from them as a preliminary step towards a
subsequent full -scale inquiry.
Brief response by Monetary Board

The not-so-good media reports prompted the Monetary Board to

issue a very brief in fact, it had only three sentences in all
statement of clarification disclosing its own side on the issue in
question (available at:
http://www.cbsl.gov.lk/pics_n_docs/latest_news/press_20170327ex
.pdf).

The statement has not denied the incurrence of a loss of Rs. 9.5
billion by EPF as alleged in the media reports. It has simply
clarified that the Board considered the report in question and
decided to take disciplinary action against any officials where
there is evidence of wrongdoing under the banks internal
disciplinary procedures.
Losses should be investigated by law enforcement agency

It appears that the Board is still waiting for evidence to take

action. Evidence will not be forthcoming on its own accord. It will
surface only if the scandalous bond transactions are investigated
by a law enforcement agency like the CID or FCID which could
examine the telephone conversations which the alleged officers
had had with outside parties during that period and compare their
actual assets with those reported in the assets and liabilities
statements filed by them.

This is costly, but the extent of the loss merits incurring such a
high cost.
Monetary Board eroding its reputation deliberately

What it reveals is that the Board has failed once again to fulfil its
obligations as the countrys prime banking institution, in general,
and as the trustee of EPF, in particular. Such a callous approach
by the Board to serious scandals in the Central Bank does not
augur well for its reputation. It also dents the reputation of the
Prime Minister under whose care the Central Bank has now been
listed as per the Governments work allocations. The longer the
Monetary Board or the Prime Minister keeps a blind eye on those
losses, the bigger would be the problem that would hit them on
their head later.

This happened in the case of the scandalous bond issue that took
place on 27 February 2015. Had the Monetary Board or the
government taken corrective action then and there, it would not
have blown into a series of massive scandals in the next 14
month period tarnishing the good name of the Central Bank, on
one hand, and making a mockery of the good governance being
preached by the present government, on the other.
Legal Eye: Justice Minister or trade unions should take the
Board to courts

The alleged losses in EPF are in fact a product of this series of

bond scandals, tolerated by the Monetary Board despite many
warnings by market participants. Now that it has come to light
through an internal investigation, the Board should take
immediate action to douse the fire. If it does not do so, it will blow
into a major fire soon.
Sensing this ominous eventuality, the writer Legal Eye has warned
of the possibility of the Monetary Board being taken to courts by
the Minister of Justice or trade unions for the breach of trust
reposed on it under the Trust Ordinance (available at:
http://www.ft.lk/article/606419/Loss-to-EPF-in-Treasury-bond-
investments--applicability-of-Trust-Ordinance-provisions-and-
Justice-Minister%E2%80%99s-role).
A trustee should protect trust money as if he protects his
own money

In economics as well as in law, a trustee has the obligation to

protect the assets belonging to a trust-beneficiary as if he would
protect his own assets. Accordingly, since he does not allow his
assets to go waste, he should not allow the assets of the trust
also to go waste. A Monetary Board with foresight cannot ignore
the warning by Legal Eye.
Monetary Board ignoring numerous warnings

In fact, the Monetary Board was warned of a series of major

scandals in the issue of Treasury bonds involving losses to the
Government as well as to EPF on a number of occasions.
However, the Board not only turned a deaf ear to them but also
was offensive to those who had pointed them out.

Cornering the bond market by a primary dealer

For instance, just six days after the scandalous bond issue of 29
March 2016, this writer warned the Board of another bond scam
that had taken placein an article in this series published on 4 April
2016 (available at: http://www.ft.lk/article/534654/Dilemma-in-
monetary-policy--Monetary-Board-being-caught-in--The-Devil-s-
Alternative--). This was the transaction that had led to alleged
losses in EPF. This is what this writer said in the article under
reference: In the recent past (that is, mid-March 2016), the
Central Bank, presumably with the approval of the Monetary
Board, tried to suppress the interest rates in the market by
rejecting all the bids at successive Treasury bill and bond
auctions. But this is not a strategy which the bank can follow
continuously since it requires the bank to compromise its
monetary policy by financing the Government through newly
printed money. Hence, on occasions, it has to allow the auctions
to determine the rates as well as the quantum of funds to be
raised. In those auctions, rates invariably go up forcing the bank
to sell bonds below their face value causing a loss to the
Government.

In a recent such auction, as reported by the financial website

EconomyNext (available at:
http://www.economynext.com/Sri_Lanka_long_bond_yields_plunge
-3-4641-3.html ), a 15-year bond carrying a fixed rate of 11% and
maturing in 2030 has been sold at a rate of 14.23% or below its
face value. Within three days the yield rates pertaining to these
bonds, according to the web, have plunged by about 2%,
increasing their market prices significantly. It has allowed the
original bond investors to earn a massive capital gain which could
have been earned by the Treasury had the bonds in question been
issued at the prevailing secondary market yields.

The price movement of the bond in question is presented in chart

3. It is a deep well around 29 March enabling the buyers to buy
the bond at bargain prices and sell back at higher prices to state
agencies which also had a collusive role in the affair. The
Monetary Board should not have approved of this transaction
without even winking an eyelid. Now that the scandal has come to
light, it has to bite the bullet.
Monetary Board becomes offensive
Instead of taking this warning in its true spirit and taking action
against wrongdoers, the Central Bank went on an all-out offensive
against this writer. In its response, it had tried to decry the
warning by projecting it as one made by a mere retired
employee of the bank (available at:
http://www.ft.lk/article/536676/Central-Bank-responds-to--
Dilemma-in-Monetary-Policy--Monetary-Board-caught-in--The-
Devil-s-Alternative-?-).

But the board was warned once again by this writer on 25 April
2016 that EPF too had had a collusive hand in the scandalous
transaction. The article said that the board itself had created
arbitraging profit opportunities for predatory primary dealers.
Pumping bond prices and dumping on EPF

This is what the article under reference said: When the Board
cancels all the bids at the primary auctions for government
securities, it disseminates information across the market that in
the forthcoming auctions, the Board would accept a higher
volume of funds than the one announced to the market. Then
there is a pressure for bidding at low prices which mean at high
interest rates. The Board before 2014 prevented such practices by
primary dealers by getting EPF to come to the primary market at
appropriate yields.

The market was at that time abuzz with stories that EPF had
refrained itself from bidding at the primary auction but buying at
high prices from those who had bought those bonds in the
primary market. It had paved the way for the predatory primary
dealers to corner the market and make massive profits. In fact the
subsequent events proved that it was true. The leaked onsite
examination report on Perpetual Treasuries had corroborated this
market story.

The analyst commenting in EconomyNext has documented the

interest rate developments in the Treasury bond market prior to
and before the Treasury bond issue in question in late March
2016. The results are shown in Graph 1.

He also had graphically presented how EPF had been

manipulated, perhaps without the Boards knowledge, to permit
some predatory primary dealers to dump their pumped-up bonds
on EPF. This is shown in Graph 2.

These two graphs reproduced by this writer alone on 25 April

2016 would have been sufficient for the Board to spring itself into
prompt action, but it did not choose to do so.

Graph 3 shows the bond yield and price relating to this bond a
week prior to and after the auction date, namely, 29 March 2016.
The buyers have bought the bond on 29 March by driving the
price to a level of Rs. 77 per 100 rupee bond. Within days, the
price has moved up to its original level allowing the initial buyers
to make a big killing on the market. The victims have been EPF
and other State-controlled funds.
Whistleblower gives a wake-up call to Monetary Board

The Monetary Board, assisted by the banks senior management,

was still adamant and did not take any corrective measure. Thus,
the robbing of EPF by predatory market participants continued
unabated. But the Board could not keep its silence any more after
a whistleblower blew the fuse by releasing to the public domain in
October 2016 an internal onsite examination report prepared by
the staff of the Department of the Supervision of Non-Bank
Financial Institutions or DSNBFI on primary dealer Perpetual
Treasuries.

The report alleged that Perpetual Treasuries had preyed on EPF by

dumping Treasury bonds which it had bought at low prices
through three intermediary financial institutions. The report had
suggested to the Monetary Board that a full-scale inquiry should
be made on the alleged losses to EPF.
Leaked onsite examination paper provides sufficient
evidence for Board to act

This writer drew the attention of the Board to the emerging

reputation risk arising from the shoddy deals which EPF had made
with the primary dealer in question in an article in this series
(available at: http://www.ft.lk/article/572608/Whistle-blowing-on-
Perpetual-Treasuries--Embarrassing-but-vindication-of-CB-s-
supervisory-staff ). This is what this writer said about the whole
scandalous deal.
Using Central Banks money to do bond business

According to the leaked onsite examination report, Perpetual

Treasuries had even made use of the interest rate anomaly
created by the Monetary Board headed by Governor Mahendran.
Despite the pressure for market interest rates to rise, the
Monetary Board sought to swim upstream by reducing the Central
Banks lending rates from 8% to 7.5% in April 2015. This was
done by the Board when the interest rates in all government
securities had gone up by about 2% or 200 basis points in March
2015 due to the high rates of the scandalous 30-year Treasury
bonds issued by the bank in end-February, referred to above.

Naturally, when the Central Bank cuts interest rates, the market
rates should come down, but as the leaked onsite examination
report has shown, they have moved in the opposite direction
increasing interest rates by about 5% or 500 basis points to about
13% in the case of 10-year bonds for example by March 2016. Yet
the bank maintained its low lending rate of 7.5% throughout.
Boards anomalous interest rate policy has helped primary
dealer in question

This writer warned the Monetary Board in an article published in

April 2016 in this series that its anomalous interest rate policy
would breed opportunities for market participants to borrow at low
rates from the Central Bank and lend at high rates to the
Government, a process known as arbitraging (available at:
http://www.ft.lk/article/534654/Dilemma-in-monetary-policy--
Monetary-Board-being-caught-in--The-Devil-s-Alternative-?).

The Board turned a blind eye to this warning. But the leaked
examination report says that that was exactly what Perpetual
Treasuries had been doing in order to make super profits. In April
and May, 2016, according to the report, Perpetual Treasuries had
used the intra-day liquidity facility and Reverse REPO facility of
the Central Bank available at 7.5% to borrow cheap money from
the Central Bank and lend to the Government at high interest
rates prevailing in the market. It had made capital gains of Rs 4.7
billion out of these transactions in just two months. Thus, the
Monetary Board, through its naivety, immaturity and
irresponsibility, had permitted one primary dealer to make super
profits by taking advantage of its lack of supervision and
anomalous interest rate policy.
Finance Minister and EPF had borne the costs?

Who had borne the costs? In the first place, it is Finance Minister
Ravi Karunanayake who had been forced to borrow at high
interest rates. Then, it is the investors who have bought these
Treasury bonds from the chain of market transactions created by
Perpetual Treasuries at higher prices than those prevailing at the
primary market.

The supervision team has not identified these secondary losers,

but it has pointed its fingers at EPF which is also functioning
under the management of the Monetary Board. The supervision
team has recommended that an inquiry should be conducted into
the investment pattern of EPF to ascertain whether it was also a
collaborating party to these scandalous bond deals.
Opening a can of worms?

The alleged loss to EPF is massive and should not be tolerated. If

the Board fails to take necessary corrective action to rebuild its
lost reputation, it opens itself to another outside inquiry. Such an
inquiry, opening up a can of worms within the Central Bank, will
be embarrassing to the Board as it has already happened by the
revelations at the Presidential Commission on bond issues.
(W.A. Wijewardena, a former Deputy Governor of the
Central Bank of Sri Lanka, can be reached at
waw1949@gmail.com)
Posted by Thavam