By Charitha Ratwatte –

Recent newspaper reports carried a story on one more financial pyramid scheme, allegedly called ‘Pandora Advertising’ in Tangalle, allegedly modelled on another in Tissamaharama, ‘Luminous Advertising,’ both in the Hambantota District.

A pyramid scheme is one by which an unauthorised deposit taker offers high interest rates to gullible depositors, paying off early depositors, with funds deposited by later depositors and at some point decamps with the money.

Charles Ponzi, an Italian American is said to have invented the scheme in New York in 1920. But author Charles Dickens, both in his 1844 novel Martin Chuzzelwit and 1857 novel Little Dorrit, wrote about such schemes.

The CBSL it is reported defines a pyramid scheme as ‘where a participant is required to contribute or pay money, and the benefits earned by the participant are largely dependent on the increase of the number of participants in the scheme or the increase of the contribution made by those participants’.

In the past few years there have been a number of such schemes such as ones managed by people named Danduwam Mudalali, Dadi Danduwam Mudalali and Sakvithi among others. The financial regulator, places full page advertisements in newspapers and uses other media to warn depositors of the dangers of these schemes. It is reported that an arrest has been made in the Panora case.

Ghana

In this context it is good news that a crackdown is taking place on such illegal deposit takers to protect the deposit making public. For example, in Ghana microfinance companies operating without the requisite licenses are being forced to comply with the law or close down operations.

The Bank of Ghana, the regulator, has been in the recent past receiving frequent complaints about mushroom microfinance firms whose officials either dupe or mismanage funds of their depositors. The depositors end up blaming the bank of Ghana for the lack of stringent supervision. last year the Bank of Ghana revised the Operating Rules and Guidelines for Microfinance institutions, increasing the minimum capital and liquidity requirements as part of its efforts to streamline their operates and bring order into the microfinance industry.

Minimum capital requirements have been prescribed for deposit taking microfinance institutions and non deposit taking ones. The regulator has licensed 435 such enterprises as of may 2014. Of these 380 being microfinance, 49 being money lenders and six registered as Financial Non Government Organisations (FNGOs). Over 200 applications are still pending. 120 applications have been rejected.

Complaints by the deposit making public in Ghana have prompted these actions by the regulator, which could well be emulated in other counties facing similar criticism of inaction by the regulator.

India’s Sahara

In India too, the Reserve Bank, has followed suit, has finally cracking down an organisation that calls itself Sahara Pariwar created and operated by Subrata Roy. For decades Sahara Pariwar has persuaded India’s poor underclass such as rural farmers, urban slum dwellers and low level government employees, such as peons, to trust it with their savings.

Sahara claims it has 80 million customers and a net worth of $ 80 billion. Sahara was founded in 1978. It claims to have an army of 600,000 agents deployed in the field who go to places where the well established players in India’s financial services sector does not dare to go, rural villages and slums which are therefore yet untouched by formal financial services.

It has dazzling public relations with an emphasis on Bollywood glamour and nationalist patriotism, designed to persuade the poor of its invincibility. It also has up to this point in time been able to outfox the regulators, using alternatively, deference and defiance.

Sahara’s Subrata Roy claims that its empire ranges from the gangster-ridden lawless badlands of India’s vast, dirt poor, Uttar Pradesh state, to the Plaza Hotel on New York’s Fifth Avenue, with its famous champagne bar and stunning view of Central Park. One way by which Sahara has outwitted the regulator is by mesmerisingly switching the products it offers to clients.

It started off in the 1970s by offering depositors lucrative prize schemes. Later it switched to housing finance, but later changed tack to become a ‘mutual benefit’ firm. In 2008 the Reserve Bank cracked down and ordered Sahara to cease taking deposits and repay $ 4.5 billion to depositors. By 2009 Sahara had once again switched to selling tricky ‘convertible bonds’ to the poor masses, which it argued did not fall within the regulatory regime of the Reserve Bank but fell under a minor government ministry.

However in 2011 the regulator made Sahara refund $ 5 billion of these bonds to depositors. Sahara was clever in that the rules imposed on their depositors had fine print, which loaded the dice distinctively in Sahara’s favour. For example, customers were bound to make daily deposits, but could forfeit years of accumulated interest if a deposit date was missed.

Deposit gathering was out sourced to a legal entity which the Reserve Bank did not have authority to supervise.

However, finally and inevitably, the law and the regulator caught up with Roy and Sahara. The Supreme Court of India on 4 March this year jailed Roy for contempt of court, after determining that Sahara had failed to comply with the order to repay the bonds, as directed.

The Court observed that ‘every order was consistently and systematically disobeyed’. The pleas submitted by Sahara were ‘patently false’. Sahara has tried to subject the Court to ‘calculated psychological offensives and mind games,’ the Court observed. But to date Sahara’s finances remain a mystery. One possible explanation is that its claimed customer base is partly fictitious, that the fictitious names are a front for politicians’ and other business tycoons’ black money.

In 2012, the Reserve Bank asked Sahara to provide the identities of its depositors. Sahara responded by dispatching a motorcade of 127 vehicles with 32,000 cardboard boxes, haphazardly put together, which officials are still trying to sort out!

Useful lessons

The Sahara case has some useful lessons for regulators worldwide.

The first is that given time, political space and determination, regulatory institutions can get their task properly done. The Rule of Law prevails, if allowed to. The Reserve Bank of India, the Securities Regulator of India and the Supreme Court, finally got their man. But as Lord Wellington famously said of the Battle of Waterloo: ‘It was a damned close run thing’! One regulator, who worked on the Sahara case, says he got over 100 telephone calls from a virtual ‘who’s who’ of India asking him to go easy on the case!

Second, regulators need to move away from the existing rules-based, nit-picking system of regulation, which can be easily circumvented and is enforceable only through a judicial process in which delays are endemic and unavoidable – to a regulatory system based on broad legal principles based on ‘best practice,’ which will give officials more flexibility to deal with crooks who try to use the system and process, to outwit the regulators.

The third lesson is that in India and all other developing countries, where the financial services sector is a ‘work in progress’ and this includes Sri Lanka and even China where Shadow Banking, outside the formal sector is a massive problem – need to rapidly expand the outreach of their formal financial system. In India less than 35% of adults have bank accounts, and less than 1/3 of household savings ends up in the formal financial system.

Pawn brokers and village money lenders are the preferred sources of funds by India’s poor. The Reserve Bank hopes to encourage the creation of a new generation of simple banks focused primarily on deposits and payments. Regulators and the law have to be very nimble, creative and responsive to safeguard the public.

Generally, when pyramid financial schemes collapse, there is a violent reaction by depositors. We have seen this in Sri Lanka. In India, when a ‘chit fund’ recently imploded in Kolkata, destroying the savings of hundreds of thousands of poor depositors, there were around dozen suicides, one actually by self-immolation.

The Sahara customer base is so far quiet, either they are satisfied by the regulators action or they don’t exist! The reputation of MF, worldwide, has been under attack recently, especially on the issue of over-borrowing and resultant over-indebtedness by MF clients. In India microfinance institution in Andhra Pradesh, was under stress in the recent past, which resulted in much hardship to depositors and politicians and regulators taking a long hard look at the sector.

Sri Lanka

There are concerns in Sri Lanka on the prudential regulation of deposit taking and other microfinance institutions (MFIs) and some ethical issued arising from their mode of operation. Probably arising from these concerns, of access to micro credit increasing indebtedness and creating social stress, the District Secretary (DS) of the Batticaloa District in the Eastern Province of Sri Lanka, summoned a meeting of Micro Finance Institutions (MFI) operating in the District on 1 April. A representative of the Central Bank was also present.

Representatives of MFIs present at the meeting say that the DS declared that Non Government Organisations which do not have permission from the Central Bank shall not implement MF programs. The DS also is reported to have stated that a Registration Certificate of a Company shall not be treated as license for the provision MF services.

On 4 April the Director Planning, Batticaloa District Secretariat issued a series of guidelines under reference

BT/DPS/FFP/Micro 2014 by which among other things, the maximum rate of interest for ‘micro credit activity’ was fixed at 12% per annum. Further the letter stated that MFI have to work with the GA’s approval and with Divisional Secretaries (Div Sec) recommendation.

The letter banned weekly collection of instalments. The MFI’s were advised to avoid ‘duplication of beneficiaries’. Each and every MF loan should be recommended by the Div Sec. The MFI ‘should be registered under Central Bank’s Guidance’. Individual house visits to collect loan instalments or to evaluate loan application are not allowed. All NGOs in MFI activities should get special permission for MF activities. MF loans for consumption were prohibited. It is nowhere stated under what legal authority the Government Agent/District Secretary has issued these orders.

The Lanka Microfinance Practitioners Association (LMFPA), the apex organisation, took this issue up with the authorities in the Ministry for Economic Development and it was suggested that a meeting be held to discuss the matter with the District Secretary, Batticaloa. Newspapers reported the crisis faced by both lenders and borrowers in the Batticaloa District by the sudden imposition of these draconian rules, most of which have no legal basis. Subsequently it is reported that microfinance institutions have been permitted to resume lending and collecting instalments in Batticaloa under certain conditions, after the LMFPA met the DS. But the legal basis for the District Secretary to impose such regulations is not known.

This situation has come about currently in Sri Lanka today due to the fact MF seems a lucrative profit centre among financial service providers, there being no comprehensive prudential regulatory mechanism in place. All financial service providers ranging from licensed commercial banks, finance companies, non government organisations, cooperatives, money lenders, pawn brokers, cheetu schemes (Rotating Savings and Credit Associations [RoSCA]), registered voluntary social service organisations, etc. are promoting themselves as providers of MF to the poor and the marginalised.

Long history of microfinance

Sri Lanka has a very long history of microfinance; the first cooperative rural bank took in savings deposits and gave out its first small loan, what is today fashionably referred to as micro credit, in the early 1900 at Menikhinna, in the Kandy District. The Government has from time to time promoted microfinance, for example through the Central Bank’s Isuru Project, the Janasaviya Trust Fund (JTF) and its successor the National Development Trust Fund (NDTF). The Sri Lanka Savings Bank now has a special window for wholesale lending to microfinance institutions, using the NDTF loan repayment funds, after the latter was wound up.

The current incarnation is Divi Neguma, the Divi Neguma Act defines Microfinance as: ‘A type of banking service that is provided to employed or low income individuals or groups, who would otherwise have no other means of gaining financial services’. This is the only legal definition available in an enacted law. The definition is far from satisfactory. One recent estimate put the number of MFIs at 16,400. Microfinance has an important role to play in gender empowerment in Sri Lanka as it is estimated that over 70% of depositors and borrowers are women.

While the Central Bank of Sri Lanka is the primary regulating authority for banking and financial services, the Commissioner of Cooperative Development at the National level and his Provincial counterparts, the Registrar of Companies, ROSCAs (cheetu), money lenders, pawn brokers and all other legally recognised providers of financial services have designated regulators, under which the institutions under their purview have been set up.

The risk in Sri Lanka is that this is one area which is virtually prudentially unregulated, in comprehensive terms. Microfinance institutions which are not caught by the laws and regulations applying to financial service providers such commercial banks, finance companies, cooperatives, money lenders, pawn brokers, RoSCAs (cheetus), Divi Neguma, etc. Some of these have a prudential regulator, others have ‘in house’ regulators – practically how effective, one may question.

But others – companies, voluntary social service organisations, trusts, NGOs, etc. are legal entities which are not prudentially regulated in financial terms. But they have been allowed to continue financial operations, although technically in violation of the recent Finance Business Act, in terms of a newspaper notice placed by the Monetary Board!

Draft Bill No. 03

The Central Bank, recently under the caption Microfinance Institutions, has stated: ‘The CBSL was involved in preparing legislation for the regulation of microfinance institutions. There are several categories of microfinance institutions that are registered under various laws, but are not regulated or supervised according to prudential criteria. Hence, to safeguard the interest of depositors and customers and also to strengthen the governance and service delivery of these entities, it was decided to bring them under a common regulatory umbrella.’

In terms of a Microfinance Bill, hereinafter referred to as – ‘Draft Bill No. 03’ – on microfinance announced recently as having been approved by Cabinet, the Monetary Board of the CBSL is the regulator for MFIs. This is a welcome step. In Sri Lanka although there is no legal definition as to what specifically falls with the definition of ‘microfinance’ (except in the Divi Neguma Act), the Draft Bill No. 03 provides a definition, differing from the Divi Neguma definition.

In Part II section 10(2) of the draft law it is stated that ‘microfinance business’ is ‘the acceptance of deposits and providing financial accommodation any form and other financial services mainly to low income persons and micro enterprises’. The discussion on the first and second draft bills on MFIs in Sri Lanka has resulted in the Draft Bill No. 03 being a great improvement on its predecessors. The CBSL itself has admitted that ‘several categories of microfinance institutions that are registered under various laws, but are not regulated or supervised according to prudential criteria’.

Need for prudential regulation

Whatever the controversies, at a global intellectual or at operational level, in places like Batticaloa and Hambantota Districts, the fact remains that microfinance is a financial instrument, which almost all financial service providers in Sri Lanka are presently utilising, in one way or another.

The Central Bank itself has recognised the need for prudential regulation. Give the rampant Ponzi/Pyramid type scandals in the financial sector of late; leaving the microfinance sector unregulated, in comprehensive terms, is a high risk strategy, which compounds the dangers, which micro savers and micro borrowers face.

As has been pointed out, this sector is not a new development in Sri Lanka, but has a long history, going back to the 1900s. The continued lack of prudential regulation is a betrayal of the legal and moral obligation of the regulator of which cognisance must be taken at the highest level, including the Higher Judiciary which has to ensure the Rule of Law, as in India. The financial service regulators in Ghana and in India, in the Sahara case, have set an exemplary example of responsible conduct which should be emulated.