The debate on parate execution has been going on for months in Sri Lanka, with the Small and Medium Enterprises (SME) sector opposed to banks using parate rights to recover loans, while the Government, the Central Bank of Sri Lanka (CBSL), and the banking sector believe that abolishing parate rights will impact the sustainability of the banking sector.
The debate started back in November last year after the Supreme Court delivered a landmark judgment stating that properties mortgaged to a bank not only by an actual borrower but also by a third party for the loan granted to the actual borrower could be sold at an auction to recover the unpaid loan and interest thereon under the parate law.
Since the debate on parate execution has now reached its peak, The Sunday Morning looked into this law and its real impact on the SME sector and banks.
What is parate execution?
Parate execution is a Roman-Dutch law concept that grants a Licensed Commercial Bank (LCB) the power to sell a mortgaged property that had been secured to the bank as collateral whereas ‘parate’ is a Dutch term which means immediate.
Speaking to The Sunday Morning, a legal head of a private bank who wished to remain anonymous said that the parate law had been enacted to support the SME industries in Sri Lanka as it was seen as a method to enable the SME sector to borrow money easily by making recovery easy for banks, which were earlier reluctant to provide loans due to recovery issues.
According to the banker, before the parate execution law was brought in, banks would have to go to courts to get a mortgage bond action when a facility defaulted and it would take 8-10 years to get a mortgage executed, as a result of which banks were not willing to lend money.
Initially, parate rights were available to State banks such as the Bank of Ceylon, People’s Bank, State Mortgage and Investment Bank, and National Savings Bank, but through the Recovery of Loans by Banks (Special Provisions) Act No. 4 of 1990, the rights were extended to other private banks.
How do banks use parate rights to recover loans?
Explaining how banks use parate rights, the banker said that banks had a mechanism for loan recoveries and collections where loans in arrears up to 30 days were categorised as Stage 1 loans, loans in arrears up to 60 days were categorised as Stage 2 loans, and loans in arrears up to 90 days and above were considered Stage 3 loans. Generally, parate execution is applied by banks for loans with 3-6 months of arrears.
“When loans hit 90 days of non-performance, the banks are required to provide for it; the impairment kicks in, reducing the bank’s profitability,” the banker said.
Further, most banks send a letter of demand to the borrowers when a loan hits 90 days of non-performance, after which, according to the banker, most borrowers settle the loan. “If it doesn’t happen, then the banks pass a resolution under the Parate Act,” the banker said.
This is where the banks submit a paper to the director board on the outstanding loan, the amount, the outstanding period, and the actions taken so far which have failed. The bank then recommends that the board take action under the Parate Act and sell the security provided for the loan via a public auction.
Thereafter, the banker said that a notice of that resolution by the director board was sent to the respective borrower and, if it was a third-party mortgage, to the mortgagor. Then the banks generally wait for 1-2 weeks as, according to the banker, a fair number of borrowers negotiate and get into restructuring and rescheduling of the facility at this stage.
After a resolution notice is sent to the borrower, if the borrower does not respond, then the bank publishes the notice of resolution in all three languages in national newspapers and the Government gazette as per the requirement of the law.
Thereafter, if the borrower does not respond according to parate law, the banks have to inform an auctioneer, fix a date for the auction, and publish the date of the auction in a Government gazette. “This takes about 6-9 months and then the property can be sold,” the banker said.
Further, the banker said that parate law specifically stated that the banks could not own the property but could acquire the property at the public auction if there were no buyers. At the public auction, the banks have the right to set a floor price, which is called an upset price; the law does not define how this price has to be set and the banker said it was generally set at the market value of the property or the amount due, whichever was higher.
The banker said that the Banking Act required banks to take the valuation of properties given to the banks as security once in every three years at a minimum and even yearly based on the value and the size of the loan. This valuation is used to provide for a value of the property at the public auction.
“Generally there are no bidders at the public auction and therefore the banks buy the property at a nominal price and thereafter sell the property as the law does not allow the banks to keep the property longer than required,” the banker said.
Banks are required by law to provide the excess amount after the recovery of the facility through the sale of the property to the borrower, but the banker said that in most cases the value of the property was less than the loan amount, as by the time of sale of the property, the loan would already have been in arrears for 1-2 years and, given the lack of buyers for these properties, they were sold at bargain prices.
Generally, it takes about 2-3 years for banks to recover the loans through parate execution, from the point of letter of demand to the sale of the property.
Banks not willing to negotiate debt with SMEs
Speaking to The Sunday Morning, Micro, Small, and Medium Enterprises (MSME) Chamber of Sri Lanka Executive Committee member Selvarajah Thumilan said that banks were not willing to negotiate with borrowers to restructure or reschedule loans and allow loans to reach the Non-Performing Loan (NPL) level to use parate rights to recover the loan, which was more beneficial to them.
He said that the banks had executed the parate law on 1,140 cases in 2023 as opposed to the 557 cases stated by Central Bank Governor Dr. Nandalal Weerasinghe.
In December, Dr. Weerasinghe said that banks had recovered Rs. 38 billion in due loans up until November 2023 through parate execution on 557 individuals, which only amounts to 2.7% of Stage 3 impaired loans and 0.4% of the total loans provided.
Moreover, Thumilan said that the turnover of many companies had dropped in the last few years not merely due to local conditions but also global conditions.
For example, he said if an apparel manufacturer which earlier earned $ 10 million through the sale of apparel products had seen a drop in revenue to $ 5 million, he would not be able to pay a bank facility instalment obtained against earlier revenue. “The loan should also be rescheduled to 50% to match the new cash flow, but if the banks don’t agree, then the facility automatically goes to NPL,” he said.
He said that banks intentionally sent facilities to NPL level rather than restructuring or rescheduling so that they could recover the loan through parate rights.
Thumilan said that the amendments the MSME Chamber was proposing to the parate law included appointing an independent valuer to value the property which would be auctioned by the bank. He noted that malpractices had been observed during this valuation, where banks undervalued properties and sold them at a public auction at a lower price than the actual market value.
“If the loan is less than the auctioned amount, the banks have to refund the rest of the money, but to avoid that banks are having the property undervalued,” he said.
Anti-parate activists and SME sector
Speaking at a webinar organised by the International Chamber of Commerce Sri Lanka (ICCSL) on 17 February, CBSL Governor Dr. Weerasinghe said that there had to be a clear distinction between anti-parate activists and the SME sector, adding that the CBSL and the Government were taking a lot of measures to support SMEs to face this difficult time.
He said that suspending parate rights could not help SME recovery but would support anti-parate activists, adding that anti-parate activists had already borrowed from the banks out of the money of depositors but found themselves unable to service those obligations and intended to default on those obligations.
“We need to support SME recovery; there is no question about it,” he said, adding that the banks were funded up to 80% by depositors’ funds and used these funds to grant credit and that minimising credit risk was of utmost importance to ensure bank sustainability and to protect depositors.
Weerasinghe said that parate law had to be strengthened further to minimise the time taken to recover the asset so that the business could survive: “The business can continue while the borrower who is not viable can transfer that asset to someone who can run the business. We need to protect the enterprise or the business, not the unviable borrower.”
He also said that Sri Lanka should introduce bankruptcy laws to transform businesses that were not viable into viable ones by having a proper legal framework to declare bankruptcy and let the business be run by someone else who was able to run it. He added that the Government was drafting legislation similar to the Indian bankruptcy law, which would further facilitate the transition and continuity of businesses.
Banks not willing to lend if parate rights removed
Speaking at a webinar organised by Capital Alliance Ltd. (CAL) on Wednesday (21), DFCC Bank CEO Thimal Perera said if parate rights were removed, banks’ willingness to lend would drop and banks would be a lot more cautious and conservative in lending, which would not help the economy or the SME sector, which required bank financing to grow.
He said that over the last 2-3 years, banks had been engaging in restructuring and rehabilitation of facilities and customers who had been experiencing stress due to the economic downfall, adding that the banks had looked at everything from interest rate reduction, tenor extension, interest waivers, and write-offs to turn them into performing facilities and match cash flows to loan repayments.
He said that parate rights were important because banks lent depositors funds and parate rights provided a safeguard for depositors. He added that the banks took comfort in the presence of parate rights, as they could be deployed by banks to recover money when dealing with willful defaulters. Perera said that having parate rights also safeguarded bank capital adequacy and profitability levels, apart from depositor funds.
“This is not something we like to do or want to do; it’s not that banks want to own hotels and houses and put people out on the road. We are in the business of finance, not real estate. It is something that we use to bring defaulters to the table and to put some pressure, particularly on willful defaulters,” he added.
Also speaking at the webinar, Standard Chartered Bank CEO Bingumal Thewarathanthri said that parate law had been executed on some 600 cases in 2023, recovering Rs. 38 billion worth of loans, which was about 0.4% of the total asset book.
“If you are trying to protect that group (0.4%), you are punishing the entire asset base,” Thewarathanthri said, adding that the removal of parate law would lead to an increase in loan pricing because the bank’s risk-weighted asset models would change.
He stressed that there would also be a larger implication to the whole growth agenda, because the financial sector was currently struggling to kick-start the lending engine.
Proposal by MSME Chamber to replace parate rights
The MSME Chamber is urging the Government to suspend parate execution until a ‘bad bank’ is set up using the Public-Private Partnership (PPP) model (Government to own around 30% with the balance owned by participating banks and international agencies like the International Finance Corporation) to mop up and restructure bad debts, leaving 2.5% for the banks to manage.
Proposals the MSME Chamber intends to present to President Ranil Wickremesinghe for the amendment of the parate law include allowing all lenders to accept facility restructure based on existing cash flows on a concessionary interest rate and financial discipline to be established not based on CRIB reports but in line with cash flows and revival plans.
Another proposal is to grant lenders interest-free loans for accrued interest and for accrued interest to be re-calculated based on the original cost of borrowing and on the market rates, whichever is lower. Since this is a revival initiative, similar to what the CBSL did for local debtors with a haircut on interest rates, all lenders are to follow the same policy as there will be no loss of capital.
Furthermore, parate is to be considered with a defined clause of nature of the default and if parate is executed on the property and acquired due to there being no bidders, the bank must pay the stamp duty to the Government at the present market value of the property and the stamp duty cost must not be passed to the borrower.
Govt. to temporarily suspend parate rights while safeguarding banks
Speaking in Parliament on Wednesday, State Minister of Finance Ranjith Siyambalapitiya said that even though parate rights had been brought in to protect the banking sector, due to the current circumstances, a proposal would be presented to Cabinet this week on temporarily suspending parate execution whilst protecting the banking sector.