A brief description on Sri Lanka's controversial bond issue

1. Sri Lanka’s controversial bond issue:
ethics, judgement and governance in
financial services
Fresh look at bond saga in Sri Lanka - Strategist 27/07/2015

2. The purpose
 This presentation is an attempt to shed light on the
potential dark side of a recent bond issue in Sri
Lanka. While relying on secondary information we
also review some “unusual” events that have taken
place. Like in many other countries regulators in
Sri Lanka cannot make an absolutely safe
environment for financial services. Financial
services sector in general and central banking in
particular depend on, to a large extent, on ethics,
judgement and morals of participants. Here we
look at whether it is the system or the responsible
persons have failed.

3. Background
A recent government bond issue by the Central Bank
of Sri Lanka has become a key discussion topic in Sri
Lanka and overseas. The issue appears to have the
hallmarks of mismanagement at best and fraud at
worst. Many academics and professionals have
participated in the discussion. The estimated
accounting loss is estimated at Rs 6 billion. However,
most of the analysts have not taken into account the
resultant reputational damage and likely negative
impact on future bond issues and economy in
general.

4. Sri Lanka’s controversial bond
issue in perspective
 SL’s controversial bond issue is almost
unprecedented
 When a central banker had come under
scrutiny governments have acted swiftly to
remove or suspend them
 Sri Lanka was slow to act
 Nigeria’s Central Bank governor was
suspended by the president for financial
irregularities. Stern action was taken.
http://www.bbc.com/news/world-africa-
26270561

5. Governance and compliance
 There seems to be governance issues at high level
 Communication of facts has failed and/or facts
were communicated but ignored by the
policymakers and lawmakers
 Processes and procedures may not have been the
best but they were sufficient
 Real issue appears to be the failure to comply with
existing processes and procedures
 Lawmakers were at best slow to react and at worst
covering up

6. Wrong start - political appointee not a
central banker
 Appointment of a foreign citizen – unusual move
 Candidate with commercial experience but very
little central banking experience at senior level
 Candidate was not aware of the procedures of the
Central Bank
 Knowledge and skill of monetary policy setting was
also questionable.
 Consideration was not given to internal candidates
 Politics was a hindrance to rational thinking and
decision making
 Recruitment and appointment process was flawed

7. Triple “mistakes” – Volume, Price,
Duration
 Importance of metrics ignored - one cannot
manage what one cannot measure
 Volume: before purchase one needs to know how
much to purchase. This should have been
documented. It is the policy of any treasury
operation. Transparency was lacking.
 Communication of the volume is paramount to
market efficiency – foundation of financial
markets.
 It appears reasonable effort was not made to
communicate the volume needed in an impartial
manner

8. Triple “mistakes” – Volume, Price,
Duration
 It appears that some of the participants were
aware of the volume. This disadvantaged the other
participants
 Bank staff have raised this issue
 Once again market efficiency was compromised

9. Determining price - know thy price
 Trading price or price range should be realistic
 It should be meaningful relative to the prevailing
market conditions
 Efficient markets should deliver efficient prices
 Extreme price volatility is a sign of market
distortions
 Up to 300 b.p. (basis points) above the market is
an unacceptable variation
 Price does not reflect the prevailing interest rate
structure. Global interest rates are stable.

10. Determining price – market efficiency
 Market distortion created by “unlimited information
to limited number of participants” created a
privileged position for some
 Arms length rule was not followed
 Prudent person rule was violated
 Relationship between the governor and a
participant was not disclosed
 Related party transaction gives rise to insider
trading claims which in turn is a serious offence
 Punishment for insider trading is a prison sentence
in many countries

11. Determining price – use of available
information
 Price is relative to the prevailing environment
 Prevailing environment should have been analysed
using available information
 Dealing and research teams had the required
information
 Did decision makers “intentionally” ignore the
information and recommendations?
 In a well-developed central banking system why
was the communication so poor between the
governor and his advisors? Was advice ignored?

12. Duration – transparent information
 Duration is basic information that any treasury
manager should know
 Duration of the portfolio should have been
analysed and discussed in debt management
strategy meetings
 Yield curve – relationship between interest rates
and time to maturity of the bonds – should have
been available in documents and on computer
screens (or even mobile phones)
 Given the published information available better
decisions on duration could have been made.

13. Duration – internal strategy ignored?
 Required information was available
 Duration was clear
 Current interest structure and expectations were
reasonably clear – global interest rates were
unlikely to increase sharply
 Shorter duration bonds would have been more
appropriate to the requirements
 Available information has not been taken into
account

14. Unusual Trinity – Was interest of CBSL
compromised by Governor/Son-in-law
relationship?
Central Bank
of Sri Lanka
(CBSL)
Perpetual
Treasuries
(PT)Bank of
Ceylon

15. Triple failures
Failure 1: Related party was not
disclosed
Failure 2: Unusual related party
transaction was not disclosed giving
rise to an insider trading claim
Failure 3: Expert advice ignored

16. Dealer (PT) using another dealer
(BOC)
 One cannot help but question this relationship
 Perpetual Trustees used another dealer
 An “unusual” move
 Why did a state-owned bank (BOC) act as a dealer
to a dealer(PT)?

17. Slow response from regulators
 Regulators’ response has been slow
 Only after extreme pressure from the lawmakers
the Prime Minister agreed to a parliamentary
enquiry
 It is reasonable to assume that “political obstacles”
forced regulators go slow.

18. President the Whistleblower
 President identified the problem
 Some may argue that the President of Sri Lanka
does not possess the required knowledge without
giving credit to his senior advisors
 Common procedure is for the CB Governor to step
down.
 Failure to do so created further interest on this
controversial bond issue

19. Did the President stop short of his
duty by the country?
 Nigeria’s President Goodluck Jonathan suspended
the Central Bank governor for “financial
recklessness” and “far-reaching irregularities”
http://www.ft.com/cms/s/0/9c09b882-9a18-11e3-a407-
00144feab7de.html#axzz3hK7ZGemd
http://www.economist.com/blogs/baobab/2014/02/trouble-
nigerias-central-bank
 Should Sri Lanka also follow Nigerian example?
 President’s inaction is unexplained to the market

20. Unprecedented damage is
underestimated
 There are estimates of Rs. 6000 millions
of damage
 These estimates do not take into account
the reputational damage and resultant
increase in interest rates for future issues
 Also they do not take into account cost of
high interest to the wider economy and
resultant drag on the economy as a whole