FINANCIAL CHRONICLE – A prominent think tank has warned that calls for government intervention in credit enforcement could destabilize Sri Lanka’s financial system. The Advocata Institute emphasized that advocating for artificial interventions in credit markets could lead to policies that undermine growth mechanisms, which are crucial for the country’s economic recovery.
Small and medium enterprises (SMEs) in Sri Lanka have faced repeated external shocks, impacting their ability to service loans. Although the difficulty in loan servicing is attributed to these external events, Advocata cautioned that market interventions could exacerbate the issues they aim to resolve.
The institute noted that Sri Lanka is currently recovering from a significant economic crisis. Ignoring risk could threaten the survival of banks and the stability of the nation’s financial system. The statement titled “Good Intentions, Bad Economics: The Risks of Intervening in Small and Medium Enterprise Lending Decisions” elaborated on this perspective.
Recent media reports have highlighted a narrative suggesting that banks are thriving while SMEs struggle, largely due to the impact of external shocks and current lending frameworks. These reports have prompted calls for independent statutory mechanisms to assess the fairness of credit enforcement cases. While these concerns are morally and ethically understandable, Advocata warned that interventions in credit markets could undermine growth mechanisms, especially during periods requiring economic recovery.
Credit serves as a critical resource for SMEs to fund economic activities based on future expectations. It is essential for investment, working capital, and managing cash flow volatility. Access to credit is vital for stimulating aggregate demand and supporting businesses during recovery phases.
Arguments suggest that SMEs were viable before facing repeated shocks, such as the Easter Sunday attacks, the COVID-19 pandemic, and economic crises that led to currency collapse and interest rate volatility. While these events are beyond their control, Advocata stated that interventions in financial and credit markets could worsen existing problems.
Credit inherently involves risk, with repayment uncertainties and the possibility of default. Lending decisions consider expected cash flows, collateral, sector risk, and macroeconomic conditions. Exogenous economic shocks are also factored into these decisions. Interest rates and asset recovery mechanisms balance risk and return, as higher risks result in higher loan costs. If loans fail, depositors and the financial system are compromised.
Portraying banks as villains could have unintended consequences. Laws regulate financial institutions for the benefit of all. Sri Lanka is emerging from a major economic crisis, and banks must manage risks to ensure their survival and the financial system’s stability. Central Bank Governor Dr. Nandalal Weerasinghe emphasized the importance of the banking system, stating, “The banking system is the custodian of this money. If something happens to the system, the savings of the entire country could be lost.” He made these comments at a seminar in Kandy aimed at educating SMEs on available assistance for business recovery.
Financial Repression Theory, developed by McKinnon (1973) and Shaw (1973), argues that government intervention in financial markets impedes economic growth in developing countries. Policies like interest rate ceilings and interference in market pricing can distort credit allocation. Interventions backed by media narratives risk reducing loanable funds, limiting credit for productive investment, and potentially expanding the informal economy and illegal lending.
Other potential consequences include increased financial exclusion, preventing credible and first-time borrowers from securing loans, thereby reducing investment quantity and quality and stifling economic growth. The media, as a pillar of democracy, should hold institutions accountable but must recognize that credit markets operate on economic incentives rather than morality alone. Framing narratives that villainize one side may be rhetorically effective, but encouraging interventions could lead to further distortions, with vulnerable groups bearing the costs.
Banks and financial institutions absorbing risks should not be discouraged, especially in an economy like Sri Lanka’s that urgently needs investment-led growth. Public discourse should support, not undermine, the delicate balance credit markets require.
