Monetary System Reforms: Sri Lanka Is To Follow The West

By Hema Senanayake - January 7, 2014

Hema Senanayake

Central Bank of Sri Lanka (CBSL) has now made a few announcements in this New Year. Central Bank Governor Cabraal, during the Central Bank’s annual policy speech, said, “Smaller private banks with less than 100 billion rupees in assets should grow or merge during a reasonable period.”

You cannot make banks to grow artificially; they have to grow with the businesses in real economy or in “fictitious businesses” in the financial sector. In view of this what Cabraal was telling is that small banks and non-banking financial institutions must be merged or be sold out to big ones. In regard to mergers, the proposals must be submitted to CBSL by June 2014. This is the first announcement. The second announcement is an intension. It says that CBSL would consider foreign acquisitions of existing banking institutions.

In view of above two announcements, within a few years there will be no relatively small banks or non-banking financial institutions and also there will be expanded foreign presence in banking sector. Are these changes good for the country? This might be the question that we all need to find an answer.

Efficiency of any contemporary economy depends on the efficient functioning of the country’s monetary system. Hence the failure of monetary or financial system will bring down any economy no matter whether it is big or small. This was proved clearly during the Great Recession of 2008. Therefore, ensuring the efficient functioning of the country’s monetary system must be a priority in governance. This is highly important for any country because the modern monetary system is inherently fragile; due to this very reason the professional ethics of CBSL must be at its best.

Modern money, whether it is paper currency or electronic currency, is a fiat currency. Fiat currency is simply defined as any money declared by a government to be legal tender. However, most of the fiat money is produced by the banking system and not by the Central Bank or the government. This is facilitated by a core banking system known as Fractional Reserve Banking system. Though we use the fractional reserve banking system, it enhances the fragility of the monetary system.

Now, you may possibly think that the objective of the proposed changes to the monetary system by CBSL is to increase the stability of a useful but fragile monetary system. Anybody may think that this could be the objective, since Cabraal insists that “Larger financial firms with better capital buffers will be better able to withstand economic shocks.” This is an unproven mythical belief because we saw that the largest bank in assets in the U.S. had to be bailed out in 2008. Similarly, the largest bank in deposits in the U.S. was also bailed out by the government. Therefore, if this is not a reason why the CBSL proposes new structural changes in the banking sector?                                           Read More