Best practices adopted – Non-Banking Financial Industry

• Role of board-appointed committees

Having read my article dated 14 November under the titled ‘Unmatchable dynamics of the Non-Banking Financial Industry,’ one of my fellow commission members of the National Science & Technology Commission (NASTEC) Dr. Janaka Ratnasiri, who is one of the main think-tanks in the commission and one of the finest academics I admire and respect most, voiced his concern over the bad experience Sri Lanka faced in several Non-Banking Financial Institutes taking the depositors for a ride and finally closing down with the depositors left high and dry losing the entire investment and the Central Bank of Sri Lanka (CBSL) as the regulator not adequately monitoring such institutions. He further expressed such action of a few affects the entire industry as people lose confidence in the entire industry and wanted me to elaborate on the same. 

Having figured out what Dr. Ratnasiri said, I realised the concerns that he expressed about the Non-Banking Financial Industry (NBFI) were not only his concerns but of the masses that have been agonised as a result of bad and poor practices adopted by the regulator, industry and individual companies in the past of this country. Many who are not fully conversant in the present-day set-up of NBFI should have the same concerns over my article. Hence, this series of articles will clear the doubts of many as best practices have been adapted since, to a great extent in the NBFI. Nevertheless, if someone is still having doubts over the industry, this article will certainly assist them to get over their hesitations on their own. 

All that I experience in the present day is that the NBFI is on a far better footing than in the past, with an appropriate and advanced compliance mechanism laid down by the regulator (CBSL), gradually improved dynamics of the industry over a period and refined procedures of individual finance companies.

As I mentioned  in my earlier article the infected loan portfolios and poor credit management methods, ineffective internal controls and unethical accounting practices, lack of quality human resources, fraudulent activities and illegal deposit-accepting practices, related party transactions and investments in subsidiaries, and over-valuation of assets for window-dressing of accounts are the main reasons for a finance company to go bankrupt. 

Let me explain the precautionary measures adopted in the system to mitigate such risk under the present-day scenario. These measures have been implemented as a result of the lessons learned in the past by the regulator, industry and individual companies. Many global standards have been introduced, adopted and homogenised into the system during the last decade to improve its standards and to build public, depositor and investor confidence.       

Infected loan portfolios and poor credit management methods – Precautionary measures applied

Infected loan portfolios could be gauged by looking at the Non-Performing Advance (NPA) ratio of a financial institute. If an inclined trend is seen in the NPA or its ratio, it is a negative sign. Sudden business windfalls could enhance the denominator to make the outlook of ratio positive though the portfolio is infected. Be cautious of such scenarios. If the NPA ratio has exceeded the industry’s average it is another sign to be cautious. 

However, to maintain healthy portfolios, effective and practical credit management methods are being adopted by most financial institutions at present. To name a few, strict pre-credit evaluation mechanism which is synchronised with the CRIB records and mapping them subsequently into the findings of field investigations is one most effective ways applied today by most finance companies. 

Ensuring and cross-checking the legitimacy of the documents submitted to obtain financial facilities by able credit managers and officers is another effective practice. With the introduction of risk analysing departments, Chief Risk Officers (CROs) and integrated risk management committees, the credit evaluation and credit quality monitoring process have been disciplined further. Unlike in the past large facilities which are more risk-prone are referred to the CRO and his department for further scrutiny before the funds are disbursed. 

Once the funds are disbursed, an automated procedure is in place to monitor the re-payments of the facility from day one.  As per new accounting standards (IFRS9) the movements of arrears from one bucket to another (0-1 month to 1-2 months, 1-2 months to 2-3 months) is considered as the measuring mechanism to device quality of credit or impairment of loans. 

It can move both ways. From a positive outlook to a negative outlook or vice versa. These movements are strictly monitored at the Integrated Risk Management Committee (IRMC) meeting which is held monthly and takes precautionary measures to curtail any negative trends.  

The Department of Supervision on Non-Bank Financial Institutions of the CBSL too monitors these trends to a considerable extent through monthly returns which are being uploaded to their sites online via a web-based information reporting system at end of each month by individual finance companies. 

As the functions of the IRMC is very important as far as the stability of a financial institute is concerned, I have dedicated the next section of this article to enlighten the responsibilities enforced on it based on section 8.3 of the Finance Companies (Corporate Governance) Direction No 3 of 2008. Similarly, internal auditors and external auditors too have a large scope to cover in their audit trails to measure the quality of credit, managing credit and monitoring of credit. The Audit Committee (AC) is responsible to coordinate the functions of these two units with the board of directors. Section 8.2 of the Finance Companies (Corporate Governance) Direction No 3 of 2008 explains the scope of AC. I have dedicated the last paragraph of this article to enlighten some of the important responsibilities enforced on AC. 

These two committees are mandated by section 8.1 of the Finance Companies (Corporate Governance) Direction No 3 of 2008 under the Board appointed Committees. These two committees are required to report to the Board and the Board is required to present a report on the performance, duties, and functions of each committee, at the Annual General Meeting (AGM) of the company.

Scope of the Integrated Risk Management Committee

The composition of the IRMC shall consist of at least one non-executive director, CEO and key management personnel. They are mandated to supervise broad risk categories such as credit, market, liquidity, operational and strategic risk. The committee shall work with key management personnel closely and make decisions on behalf of the board within the framework of the authority and responsibility assigned to them by the board. 

In the case of subsidiary companies and associate companies, risk management shall be done, both on the finance company basis and group basis. The committee shall review the adequacy and effectiveness of all management level committees such as Credit Committee (CC) and the Asset-Liability Committee (ALCO) to address specific risks and to manage those risks within quantitative and qualitative risk limits as specified by the committee. 

The IRMC is responsible for the application of the Business Continuity Plan (BCP). The committee is also responsible for taking appropriate actions against the officers responsible for failure to identify specific risks and take prompt corrective actions as recommended by the committee. Finally, IRMC is responsible to comply with laws, regulations, directions, rules, regulatory guidelines, internal controls and approved policies on all areas of business operations. To have a better monitoring mechanism a dedicated Compliance Officer (CO) is selected from key management personnel to carry out the compliance function and report to the committee periodically.

Scope of the Audit Committee

The direction very clearly indicates the chairman of the committee shall be a non-executive director who possesses qualifications and experience in accountancy and or audit to make it effective. The other board members who are appointed to the committee shall be non-executive directors to avoid conflict of interest. 

External auditors 

The committee (AC) shall make recommendations on matters in connection with the appointment of the external auditor for audit services to be provided in compliance with the relevant statutes, the implementation of the CBSL guidelines issued to auditors from time to time, the application of the relevant accounting standards and the service period, audit fee and any resignation or dismissal of the auditor. 

The committee shall review and monitor the external auditor’s independence and objectivity and the effectiveness of the audit processes in accordance with applicable standards and best practices. The committee shall develop and implement a policy with the approval of the Board on the engagement of an external auditor to provide non-audit services that are permitted under the relevant statutes, regulations, requirements and guidelines. 

The committee shall, before the audit commences, discuss and finalize with the external auditors the nature and scope of the audit. The committee shall review the financial information of the finance company, in order to monitor the integrity of the financial statements of the finance company, its annual report, accounts and periodical reports prepared for disclosure, and the significant financial reporting judgments contained therein. 

The AC is also responsible in reviewing the finance company’s annual report and accounts and periodical reports before submission to the board. The CA shall discuss issues, problems and reservations arising from the interim and final audits. At least once in six months, the committee shall meet with the external auditors without the executive directors being present.

Internal auditors 

The committee (AC) shall review the adequacy of the scope, functions and resources of the internal audit department with regard to the internal audit function of the finance company. It ensures that the internal audit function is independent of the activities it audits and that it is performed with impartiality, proficiency and due professional care. The committee shall consider the major findings of internal investigations and management’s responses thereto. The committee shall have full access to information and authority to obtain external professional advice and to invite outsiders with relevant experience to attend, if necessary. 

The board shall, in the annual report, disclose in an informative way details of the activities of the audit committee. The committee shall review arrangements by which employees of the finance company may, in confidence, raise concerns about possible improprieties in financial reporting, internal control or other matters.

Conclusion

Considering the facts disclosed above it is evident the depth to which the risks such as credit, market, liquidity, operational and strategic that are inherent largely in the Non-Banking Financial Industry are mitigated in building quality portfolios. These two committees namely the IRMC and AC along with newly introduced best practices which I stated at the beginning of the article are geared to mitigate risk and align the industry on par with the accepted compliances and practices.  Further, other industry threats such as reputation risk, interest rate risk, business risk, and compliance risk and cyber security risk are also being monitored by these committees on regular basis to safe guard the interest of depositors and other stakeholders. Most of these methods were not in existence in the past and as a result, the failed finance companies couldn’t sense the risks approaching them. 

[The writer is the founder of Infornets, a non-profit-oriented organisation formed to share credit-related information and financial knowledge to less informed people, locally and internationally. He counts 36 years of experience in the Non-Banking Financial Industry of Sri Lanka. He is a former CEO/General Manager of a Non-Bank Financial Institution and a present Commission member of the National Science and Technology Commission (NASTEC). He holds a Master’s Degree in Business Administration from the UK. He is a Member of the Institute of Management of Sri Lanka. He can be reached via [email protected] or www.infornets.com.]