By W.A Wijewardena –

Dr. W.A. Wijewardena

Fiduciary risk: Failure to handle others’ money properly

When someone handles someone else’s money, the fiduciary obligations require him to manage that money with the same care, diligence, prudence and precaution as if he is handling his own money. If he fails, he is causing a fiduciary risk, according to the newest sub branch in political economics today. Fiduciary risk therefore makes it necessary for societies to make a proper ‘fiduciary risk assessment’ with a view to putting in place an effective mechanism for ‘fiduciary risk management’.

Misuse of money entrusted has been there all the time

The fiduciary risk is not a new problem and has been present in societies from time immemorial. For instance, during Kautilya’s time in the 4^th century BCE India, fiduciary risk was so wide spread that Kautilya had to advise his king that effective action should be taken to eliminate it since “a person handling king’s treasures cannot resist the temptation to misappropriate them just like a person with honey at the tip of his tongue cannot resist the temptation to taste a little bit”. He further said that the king cannot see it happening just like one cannot say whether a fish in water is drinking it or not. His prescription was of three kinds: introducing effective checks, balances, controls and audits in public finances, employing spies to detect those who cause fiduciary risks stealthily and punish severely, even at the level of imposing death sentence, those who have been caught in the act. He even recommended that the Treasury officials who cause losses to the king’s Treasury knowingly should be whipped in public as an example to others.

Rule of Law and good governance are the key to minimise fiduciary risks

Two events that took place in the last week have drawn Sri Lanka’s attention to the problem of fiduciary risk. In the first event, a group of trade unionists had charged the power authorities on the impending losses that had been built into the Sampur Coal Power Plant Agreement signed between Sri Lanka and India due to, according to the accusing trade unionists, the negligence of those who had assessed the power project. Though not proved and still a mere allegation, it is an instance of causing fiduciary risk when using other’s money without due care, prudence, diligence and precautions. In the second event, Kishore Mahbubani, Dean of the Singapore’s Lee Kuan Yew School of Public Policy, in delivering a talk under the Eminent Speakers series organised by the Miloda Academy of Financial Studies in Colombo, an outfit of the Ministry of Finance, had highlighted ten ground conditions necessary for Sri Lanka to be a nation of worth. Two of them are potential sources of fiduciary risk if not present in a country. They are the need for observing the Rule of Law and pursuing internal good governance practices.

Fiduciary risk generators in projects

Fiduciary risk has been such a critical issue in managing public funds that the British Government’s aid arm, Department for International Development or DFID, had thought it necessary to issue detailed guidelines as to how it should be effectively managed in all its aid projects. According to DFID, fiduciary risk arises when money allocated for a certain purpose is not used for that purpose but for something else, money spenders fail to realise the value for the money they have spent and when spending money, the money spenders do not properly account for their spending. DFID has further elaborated on the reasons for generating fiduciary risks: lack of capacity, competency or knowledge; bureaucratic inefficiency and active corruption.

Many contributors to fiduciary risk in national public finances

The above definition of fiduciary risk by DFID is relevant only to aid money which it provides to nations at national level and individual projects at local levels. But when one looks at a nation’s public finances, fiduciary risks arise from a multitude of failures in managing public finances properly from inception to the end. Who will take the fiduciary risks involved in a nation’s public finances? It is the citizens of the country who have to take the risk and bear the burden as taxpayers (when expenditures are funded through tax money) or holders of government securities (when expenditures are funded by borrowing) or sufferers from inflation (when expenditures are funded by printing money).

The following is, though not exhaustive, a list of such fiduciary risk generators relating to public finances of a country about which the taxpayers as well as aid donors should be wary of.

First, when projects are formulated, costs may be inflated in multiple times with the objective of siphoning off the funds allocated for the projects for private purposes.

Second, as DFID too has highlighted, funds may be used for purposes other than the intended or approved purpose. It is likely that when designing a given project, the intention would have been to use it for a purpose which has not been authorised and the project has been created just as a namesake.

Generate value for money 

Third, the handlers of public finances may not generate value for the money they have spent. This may take two forms. In the first instance, those who run public enterprises may not maximise profits but just make some profits to hide their inefficiencies or do creative accounting to show profits. Secondly, they may actually make losses and keep on justifying those losses on the ground of providing a national service that may free them from creating surpluses. Though today’s society appears to be tolerating these justifications, Kautilya, the 4^th century BCE Economic Guru in India, did not look at such losses kindly. He said that those who make losses in king’s businesses not only eat up the resources of the king, but also the genuine labours of the people who are employed in such enterprises. Hence, the king should put a stop to it.

A mere output or outcome not sufficient

Fourth, the public expenditure programmes may fail to produce the targeted output of the programmes. For instance, suppose that a certain health expenditure programme targets to vaccinate 100,000 children against mumps. If the number of children vaccinated at the end of the programme is less than that, the programme has failed to attain its targets.

Fifth, even if the physical target of a programme has been achieved, the programme may still fail to generate the required outcome. The outcome-phenomenon in this case concerns the quality of the targets earmarked under the programme. For instance, as a result of the vaccination carried out, if a large number of children have ended up with vaccination related other diseases, then the outcome of the achieved output has been sub-standard in terms of the quality of its delivery.

Public expenditure should create impact

Sixth, an associated fiduciary risk may take the form of failure to create the intended impact even when a quality outcome has been delivered. In the above example, the ultimate objective of the vaccination programme is not just quality delivery, but developing a healthy child who will one day become a useful contributor to the wealth of society who according to economists is called a productive human capital unit. To create this impact, the vaccination is necessary, but not sufficient since there are other factors that contribute to the development of such a worker. The expenditure programmes should therefore be connected to all other programmes aiming at that goal.

Spreading disinformation

Seventh, fiduciary risk is created when officials involved in public expenditure programmes do not record the spending properly thereby distorting the accountability of spending and preventing the assignment of losses to those who have been responsible for making them. This deliberate act of disregard to procedures is worsened further when attempts are made to hide the true facts or come up with disinformation campaigns to mislead the public. The danger of such acts is that all those who have an interest in putting the systems into proper order will not get an opportunity to implement the necessary remedies in time.

Corrupt practices

Eighth, the actual commission of corrupt practices by those who implement public expenditure programmes not only increases costs but also creates a bad example for other public servants as well. When such corrupt practices are tolerated with total impunity, it activates a bad law in economics known as Gresham’s Law, named after the 16^th century British Royal Advisor, Sri Thomas Gresham, who advised the Queen Elizabeth, the First, that she should not issue coins of cheap-value metal to circulation with the same face value as gold coins because “the bad money so issued will drive out the good money”. Similarly, the chances are that corrupt public servants, if permitted to continue with impunity, will drive out honest public servants by making everyone corrupt.

Wrong priorities are the killer

Ninth, fiduciary risks arise when wrong priorities are used by policy makers when allocating public moneys. In developing countries, specifically in Africa, a common problem highlighted by writers has been the use of scarce public resources often raised through high-cost borrowings to boost the personal ego and self-importance of ruling despotic leaders. These public projects implemented without a proper priority assessment will end up as failures to improve the living standards of people on a continuous basis meaning that a selected group will benefit during the implementation stage but fail to create incomes and wealth for the people at large thereafter.

Principal-Agent Problem

Thus, there are many instances of creating fiduciary risks in managing public expenditure programmes. Though DFID report has attributed them to lack of capacity or knowledge, inefficiency and corrupt practices, the main reason for the occurrence of this malady in public finance is the existence of a problem known as “the Principal-Agent Problem” in economics. In this problem when applied to public finances, the Principal – the taxpayers – want the agents – the politicians and the public servants – to produce the best outcome and through it, the greatest impact, out of approved public expenditure programmes at the least costs possible. This is known in economics as cost-efficiency. But the agents have other things in mind, namely, how they could maximise costs and make their living better instead of making the lives of the principals better. This problem was highlighted by the American economist William Niskanen in early 1970s when he came up with an economic theory of bureaucracy in which public servants had been eternally maximising their personal wellbeing and not the welfare of people.

Sri Lanka’s existing mechanisms to tackle fiduciary risks

Sri Lanka has created a number of mechanisms to overcome these problems. Budgets presented by governments are to be approved by people’s representatives after subjecting them to the most vigorous probing and criticisms. Here, the parliamentarians are expected to go by their ‘conscience-call’ rather than their affiliation to a given political party. Once a budget is approved, the Ministry of Finance takes responsibility for its implementation. The Secretary to the Ministry of Finance has been designated the Chief Accounting Officer of the Government to ensure the proper accountability of the use of public funds. Once the expenditures are incurred by spending agencies, they are being audited by the Auditor General of the country. The Auditor-General’s report is being reviewed by two select committees of the Parliament – in the case of central government departments, the Committee on Public Accounts or COPA and in the case of semi-government institutions, the Committee on Public Enterprises or COPE. The nation has created a central bank to review the government’s economic policies apolitically and objectively as an ‘impartial spectator’ and autonomy has been given to the central bank to do its job properly.

Sri Lanka’s failure

However, the past experience has been that these mechanisms have not been effective in exercising an effective control over public finances of the country. Parliamentarians vote by political party lines and not on the basis of the conscience-calls they are having. Hence, the citizens are betrayed at that point. Though the Ministry of Finance and its Secretary are required to ensure proper accountability, they are handicapped by a lack of capacity, knowledge, bureaucratic inefficiency and the undesirable political overriding of the public service that has prevailed in the country since 1970s. The Auditor-General does only a financial audit and even then as a post-mortem examination. COPA and COPE are outnumbered by government party parliamentarians who are reported to have taken a defensive line when irregularities in handling public funds have been pointed out as if they are criticisms leveled against them. The Central Bank’s role as an impartial spectator has been diluted over the years with the Bank seeking to take ownership of policies implemented by successive governments.

Sri Lanka’s score declined in Open Budget Index

Sri Lanka’s track record as a prudential budget implementer has deteriorated over the last few years as demonstrated by the score it has earned in the Open Budget Index compiled by International Budget Partnership, a global think tank seeking to improve budget transparency. Of the four indices published since 2006, Sri Lanka’s budgetary process score has in fact improved progressively from 47 in 2006 to 67 in 2010. Though this gain has been encouraging, in the 2012 index, Sri Lanka’s score has fallen to 46 mainly on account of the failure to maintain transparency in handing public finances. Sri Lanka’s performance in 2012 has been found to be moderate with respect to Legislative Strength and the Strength of the Supreme Audit Institutions of the country and weak with respect to public engagement in budgetary processes. According to the index report, most of the good practices which the countries scoring high marks have been adopting do not exist in Sri Lanka. Even when they exist, they have been found to be weak.

Improving the budgetary transparency

Of twelve good practices which are globally accepted today, only three exist in Sri Lanka but in a weak form requiring much improvement. They are the formal requirement for public participation in budgetary processes, the articulation of the purpose of such participation and the development of suitable mechanisms by the governments for having such participation in actual practice. The missing factors in Sri Lanka are much more alarming. They include communication by Auditor General of the audit findings beyond the publication of audit reports, public hearing of the macroeconomic framework in Parliament, Public hearing of the individual agency budgets, Opportunities for public to give evidence during public budget hearings, mechanisms for participation of the public during the budget execution, consultation by Auditor-General in preparing the audit agenda, feedback on the suggestions made by public, release of the Parliamentary reports on the budget hearings and feedback by the Auditor-General on suggestions made by the public during public consultations.

These core requirements are needed to be put in place immediately if the country is interested in improving its fiduciary risk management mechanisms.

*W.A Wijewardena can be reached at waw1949@gmail.com