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Sri Lanka central bank-run fund's investment debate
23 Aug, 2010 06:52:02
By W A Wijewardene
Aug 23, 2010 (LBO) - An interesting public debate has sprung between the Central Bank and an opposition parliamentarian on the suitability of Bank’s investing EPF moneys in the shares of commercial banks.

While the Central Bank is defending its action tooth and nail ( Accessed on 22.8.2010), the opposition is charging that the Bank’s action is both immoral and unethical ( Accessed on 22.8.2010).

There are already signs that the debate degenerating to personal levels creating an ‘ugly scene’ which the right minded public does not enjoy or expect from either party. This type of debates on national issues is necessary, useful and salutary and, therefore, should be welcome. But, resorting to personal vituperation, directly or indirectly, in a bid to win over the debate will not do any good to EPF members or the public at large.

The Writer’s Involvement in EPF

The writer was involved in assisting the Monetary Board of the Central Bank in EPF investments first as its Superintendent from February 1996 to May 2000 and then as the Chairman of the EPF Investment Committee in the subsequent period till his retirement from the Bank in July, 2009. Since the major changes in EPF investment policy took place during this period and all those who were involved in those changes have now left the Bank creating a hiatus in the institutional memory, it will be useful if the sequence of events and the rationale of same are placed on record so that all stakeholders of EPF would get an opportunity to appreciate, in a proper sense, the changes that have taken place recently. It will also help the Monetary Board to review its own decisions and amend them, wholly or partly, if the Board considers it desirable.

Dual Responsibility between Labour Commissioner and the Central Bank

One striking feature of the EPF Act, enacted in 1958, is the introduction of the dual control system. The administration and the enforcement of the Act have been vested with the Commissioner of Labour, a governmental authority, while the maintenance of accounts, payment of benefits and investment of funds have been handed to the Monetary Board of the Central Bank, the country’s monetary authority.

Managing an EPF is not a Function of a Central Bank

The assignment of these functions relating to EPF to the Central Bank has come under criticism by authorities on central banking and multilateral lending institutions like the IMF and the World Bank on account of the obvious conflicts of interest they generate.

Three Areas of Conflicts

In the first place, a central bank which has to decide on the appropriate interest rates under its main mandate of maintaining economic and price stability cannot offer the best rate of return to EPF members when interest rates have to be reduced as a stimulating economic policy in an economic recession. Second, the Central Bank being the regulator of financial institutions acts as the ‘referee’ of the financial system, but when it manages the EPF’s investment portfolio, it has to act as a ‘player’, an awkward position for a regulator. Third, the central bank being the manager of the public debt (another conflict with monetary policy objectives) has to find money for the government at the cheapest rates, but the very same central bank has to earn the highest rate of return for EPF members as the manager of its investment portfolio.

The Safety First Principle

Thus, what the Monetary Board does as the custodian of the EPF money is not a very pleasant job, but historically it has been added to numerous functions of the Central Bank because the government could not find any other suitable institution in 1958 to entrust that responsible job with confidence. Over the years, trade unions and members of EPF too have come to appreciate what the Monetary Board has been doing and do not appear to be desirous of a change in view of the perceived safety of money with the Central Bank. Hence, the Monetary Board has to be extra – cautious when it makes investment of EPF moneys, because the ultimate barometer of its success, in the eyes of the members, is the safety of the funds. ‘The safety first’ principle is also an important guidance for the Central Bank, because EPF does not have a capital base and therefore, any losses it would make have to be charged to members which results in an erosion of the members’ hard earned savings.

The EPF Act envisaged delivering a positive real rate of return

EPF Act was enacted in an era when Sri Lanka had a low inflation regime. During 1953 – 57, the country’s average inflation was just 0.56% per annum. Hence, the drafters of EPF Act, presuming the same low inflation regime will prevail forever, stipulated in the Act that a minimum rate of return of 2.5% pr annum should be paid on the member balances by EPF. If the rate payable falls below this minimum for any reason in a given year, the Treasury will meet the shortfall by way of a loan which EPF has to repay later. Given the low inflation that prevailed, this minimum rate generated a real rate of about 2% per annum which was considered an adequate real return at a time when the average rate on twelve month fixed deposits stood at 1.75% per annum. Since, during this period, the Government Securities paid an average rate of about 3.5% per annum, paying this minimum rate of 2.5% was not considered a challenge.

The Subsequent High Inflation has eroded Real Return EPF Balances

But later events proved to be different. Sri Lanka became a high inflation country especially after 1978. The average annual inflation rate during 1978 – 1996 stood at 12.6% per annum and since the interest rates lagged behind the inflation rate, the real rate of return of the EPF members during this period was virtually closer to zero. There was public agitation and demand for higher rates of return on EPF balances. Since all the moneys had been invested by the Monetary Board on the ‘safety first principle’ in government securities or public sector debentures guaranteed by the government, there was no way for enhancing the rate of return unless the portfolio was diversified to the private sector, especially the equities in the newly emerging share market of the country.

At this stage, the Monetary Board which decided to diversify the portfolio faced two types of problems: first, a legal problem and the second, a capacity problem.

The Investment in Private Securities: The Legal Problem

The legal problem was that it was not clear whether the Board could invest EPF monies in private bonds and equities, because the Act had not defined what was meant by ‘securities’. The prevailing wisdom at that time was that the eligible securities included only the government securities, because that was the only securities which EPF had chosen for investment since its formation in 1958. This interpretation is understandable because in 1958 when the EPF Act was enacted, there was no private debt securities market in Sri Lanka, though company shares were traded as private transactions on a very limited basis by the Share Brokers’ Association. But after 1980s, such a private debt securities market was developed in the country and an investor could earn a competitive rate of return by tapping that market after putting appropriate safety measures in place. A guiding light in this connection was shed by the ETF Act enacted in early 1980s. By going by the general commercial interpretation, this Act had defined securities to include private securities as well. Hence, the Monetary Board sought the opinion of the Attorney General on the definition of securities stipulated in the EPF Act.

AG’s Opinion: Securities includes Private Securities as well

The Attorney General having considered the general commercial definition of securities and the developments that had taken place in the country’s economy since 1958 ruled that ‘securities’ in the EPF Act includes private debentures and company shares as well. However, the learned Attorney General drew the attention of the Monetary Board to the requirement of introducing safety measures for the protection the members’ money when the Board decides to invest in private debentures and the need for refraining from making speculative types of investments. This latter proviso was made by the Attorney General having taken into account the legal responsibility of a trustee or a custodian that such trustee or custodian should ‘exercise the same care and caution when he invests the moneys belonging to the beneficiaries as the moneys owned by him’.

EPF’s Capacity Enhancement Problem

The capacity problem was that EPF lacked in – house skills to study the market, analyse the risk involved in different types of shares and debentures, keep a track of the market developments and make an appropriate exit if a particular share or a debenture becomes risky for the Fund. This was the job to be performed by trained investment analysts and fund managers. In addition, it was necessary to organise the EPF’s investment activities on the basis of the international best practices where the functions are separated into front office, mid office and back office and the suitable audit trails are introduced to detect frauds and irregular practices in trading.

The Training of Fund Managers

The Board, therefore, decided to strengthen the fund management capacity of EPF by recruiting a large number of intelligent young people on contract and training them in all aspects of investment. Two batches were taken and the first batch was trained under technical support from the US AID and the second batch by the Sri Lanka Branch of US based CFA Institute. The trainees were encouraged to acquire CFA Charter and many did so. They provided a useful service to EPF and in some years managed to make super profits for the Fund through trading in government securities and shares. But, the signals given to them regarding the continued job prospects in the Bank were not encouraging and by 2008, many chose to leave the Bank. Today, out of the 40 odd such young people trained, only three are reported to remain in EPF.

Financial Sector Shares: Potential Insider Trading

When the Board decided to invest in the share market, a new problem came up in the form of ‘potential insider trading’ in the case of shares of banks and financial institutions supervised by the Bank. This is because, the Monetary Board, being the supervisor of banks and other financial institutions, had access to more detailed and advance information relating to them compared with other investors. Hence, if the EPF invests in the tradable shares of these institutions, the Monetary Board as the investor opens itself for scrutiny by another regulator of the financial market, namely, the Securities and Exchange Commission. Even though the Board may have created firewalls between the investment decisions and subsequent ratification by the Board, an outsider may not view it in that flavour. Any move by EPF to buy or sell a tradable share of a bank or a financial institution may give the wrong signal to outside investors that the EPF would have done so with advanced superior information. That may create an unhealthy ‘herd behaviour effect’ in the share market and subsequently, the Monetary Board may be criticised by the market for creating that unhealthy development.

Self – Constraint of the Monetary Board: No Banking Shares

Therefore, the Board decided to impose a self – restraint on itself in the Investment Policy Statement to avoid charges being levelled against it by the market and another regulator of the financial system. If the Monetary Board is taken to courts by SEC on the charge of potential insider trading, it would not only be an embarrassment for the country’s leading financial regulator, but also a cause for the erosion of the confidence and the trust which the market has on the Board. Therefore, the Board announced in the Policy Statement that it will not invest in the tradable shares of banks and financial institutions which are supervised by the Board; further, in the general share acquisitions, it also announced that it will not acquire more than 5 percent of the issued share capital of any company because the EPF, being a passive investor aspiring to improve only its rate return, has no interest in managing companies in the country. To strengthen this further, the Board also adopted a code of ethics for investment in shares under which it was announced that EPF shall not engage in speculative type of investments. Both these documents should be in public domain, but the writer could not find them in the EPF website:

The Board can change its rules, but disclose them to the market

These are not laws, but ethical and moral rules which the Board has imposed on itself. The Board can, therefore, at any time, depart from them with suitable justification which should also be announced to the market in advance. In fact, the Board made such a decision once when the National Development Bank was converted to a commercial bank and the Central Bank’s holding of shares of NDB was transferred to EPF as an ‘investment for return only’. Such a clearly laid down procedure is necessary to prevent interested parties from using EPF funds for attaining their personal goals. Hence, it is absolutely necessary for the Monetary Board to disclose fully to the market what it intends to do regarding the investment in tradable banking shares. As the largest fund in the country, the EPF, and as the good practice setter for other financial institutions, the Monetary Board cannot and should not attempt at investing in banking shares without due consideration of the risks involved.

The Charge of ‘Potential Insider Trading’ should not be dismissed lightly

It is these ethical and moral rules which the Board had imposed on itself which the critics have charged that the Board has violated in the recent past. Hence, instead of taking a defensive stand and trying to justify its action tooth and nail, it behoves the Monetary Board to review its own action and decide whether it is worthwhile to take the risk of being charged for ‘potential insider trading’ by another regulator or an interested private party.

The Best Course: Palm out investments to outside Fund Managers

The best course of action for the Monetary Board is to farm out the function of investing in the tradable shares of banks and financial institutions to an independent fund manager if it feels that EPF cannot ignore that high return sector when investing in the country’s share market.

(The writer can be reached on

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5. Concerned Public Sep 15
Thanks Mr W for the useful articles. I would like to add following comments.

The CBSL has inside information not only about the banking and financial sector but also about all other sectors of the economy. The Bank has legislative power vested by the Monetary Law Act to demand any information from any individual or institution. In fact, the Bank uses this authority and collects market sensitive information from all sectors of the economy for economic analysis and policy making purposes. Therefore, one can argue the Bank has conflict of interest when the EPF invest in non-financial sector shares as well.

In addition, as correctly pointed out by Mr W, there are other three areas where the bank has been having conflicts of interest during last 60 years of its operations. With regard to the EPF, most serious one would be the EPF investing its 96% of funds in government securities where the Bank not only set policy interest rates but also conducts auctions and has discretionary powers to intervene and set outcomes of the auctions.

In this situation, important question would be how the the CBSL has addressed such conflict of interests having proper mechanisms. Mr W knows lot better about it than general public like us. The general public has not been concerned about this issue at all in the past and the CBSL has built up credibility by managing such conflicts of interest in a very professional manner. In my view, the general public believes no matter whoever appointed to the Monetary Board, the CBSL has a highly professional, well qualified staff that make sure such things would neither adversely affect interests of general public nor the bank's credibility.

Mr W is one of the best examples of such a professional. Once he was the chairman of the monetary policy committee and bill auction committee, his daughter worked for one of very active primary dealer company. It is well known how he maintained his integrity by not divulging any market sensitive, millions worth information even to his daughter given the fact that both were living in the same house.

It is because of this credibility that this debate has not attracted much public interest. Only one politician, who has personnel problems with some central bankers because the bank proved his predictions on inflation, exchange rates, external reserves and monetary policy were wrong, has raised this issue. I, as a member of general public and a member of the EPF, strongly believe that the CBSL is the only institution which has public confidence in managing this huge public fund. Let them handle it professionally.

Giving even a small part of the Fund to be managed by so called “independent party” would be a disaster. It will only serve interests of such politicians not that of general public. We had enough from episodes such as Golden Key and Sakvithi etc.

Sad part of Mr W’s article is that he indirectly invites someone to take the CBSL to courts and charge for “potential insider trading”. It seems that he reveals information only partly aiming at such objective. If it is the case, the CBSL should be charged for investing the EPF in government securities and other shares as well. Mr W should also be responsible for such insider trading.

4. W.A Wijewardena Aug 26
My intention of documenting the details of what happened was to educate all the stakeholders, namely, critics, EPF members, fund managers and the members of the public so that any debate on the subject will take place with 'informed knowledge'.

This was considered necessary because of the hiatus of the institutional memory in EPF.

Everyone should realise that the Monetary Board has the freedom to decide on the best course of action relating to EPF investments taking the emerging factors into account and a policy which the Board has taken in the past should not be viewed as one carved in stone.

However, when doing so, it behoves the Board to take all the facts into account and disclose what it plans to do so that the market is not misguided.

I also did not want another regulator or a private citizen to take the Board to courts one day on the ground of alleged 'insider dealing'.

3. nathan Aug 24
I quite agree with DR. harsha de silva


2. AA Aug 24
Most large Pension funds in the world whilst setting strategic asset allocation targets (Debt/Equity/RE/PE) contract out the lion share of micro security investing function to outside Managers. Such actions would avoid conflict of interest situations and will also help bolster the private fund management industry.
1. harsha de silva Aug 23
Mr wijewardene:

i am glad you thought it fit to state the facts behind this issue in this day and age where professionals and intellectuals find it in their best interest to keep quiet.

in fact there is no better person to have clarified the issue.

in this background, i hope the central bank will at least now do the right thing.