As a follow up to the recently concluded 5-part retrospective series on the 1990's financial sector crisis, the Financial Gleaner now presents the first of a two part 2-part follow-up, examining some present implications of the crisis, and addressing some issues that arose in the series.
THE STATE OF THE
BANKING SECTOR
"The soundness of the banking system has continued to improve, and prudential indicators are generally well above international minimum standards. The regulatory and supervisory framework has been further strengthened through legislative amendments. Commercial banks remain quite profitable due to high interest rate spreads and the stable exchange rate."
- IMF Staff report for the 2002 Article IV consultation, July 2002
AS A result of new legislation, consolidation, the efforts of those within the sector, and the new powers enjoyed by the supervisory arm of the Bank of Jamaica, the nation's formal banking sector is in perhaps the best shape it has ever enjoyed, and is in no major danger of any crisis emanating from within itself. It's only Achilles heel, which it shares with everyone else, is the possibility of any economic shock or downturn that would adversely affect the country as a whole.
NEW LEGISLATION
The flood of post-crisis legislation belatedly enacted by the government has helped to ensure that many of the factors that triggered and perpetuated the crisis should not happen again. A few examples of the changes are:
DEPOSIT-TAKING INSTITUTIONS
The Minister of Finance still has final approval by law, but he is supposed to act on the advice of the central bank in this matter. Further, the central bank's requirements for persons being "fit and proper" to own or run a deposit-taking institution have been comprehensively upgraded.
There is still a weakness in this provision, however. While it would now be illegal for the Minister to grant a banking licence to any entity whose principals have been found by the central bank to be not 'fit and proper', the law currently still does not prohibit the Minister from approving the appointment of someone in an existing institution even if that person has been found unfit by the central bank. This situation, with its obvious implications for the possibility of political or personal corruption, is a loophole that falls behind international trends, and is in need of being plugged.
CONSOLIDATED SUPERVISION
During the crisis, groups of companies were a major problem. This because of the practice of some banks moving money and evidence around in related companies outside of the BoJ's jurisdiction, thwarting the central bank's monitoring efforts. Now, the central bank can demand information from any related company, even if that company is not directly under the supervision of the BoJ, and in fact, in limited cases, the central bank can now even require supervised institutions to terminate commercial operations with certain companies outside its immediate group, if such relations pose a risk to the health of the institution. The BoJ can also impose control measures to minimise risk within the group.
CONNECTED PARTY
LENDING AND INVESTING
Offering unsecured loans to connected companies when those companies ran aground, plus giving away unsecured personal loans to their own principals, were among the sins committed by bankers during the crisis. Unsecured loans to connected parties are now illegal, and stringent restrictions have been placed on secured loans to connected parties. In the case of investing the bank's funds in connected or other entities, a bank is now barred from investing more than 10 per cent of its capital base in any one entity, or 50 per cent in any group of entities.
CONTAGION RISK
To further force banks to concentrate on core business and minimise the possible risk of contagion from connected companies, the latest legislation has insisted that deposit-taking institutions engaged in off-balance sheet activities (like managing or investing funds on behalf of its clients) either wind down these operations or transfer them to a separate company under guidelines stipulated by the central bank.
APPROVING AUDITORS
To preclude any reoccurrence of 'creative accounting' by connected auditors, the central bank now has the power to appoint an auditor to undertake a special audit if it sees fit. Proposals are reportedly on the table to take these powers further, and to give the central bank the authority to approve or disqualify auditors from auditing deposit-taking institutions.
ASSUMING TEMPORARY MANAGEMENT
The Bank of Jamaica can now assume temporary management of an institution if it deems it necessary. During the crisis, it only had the power to advise the Minister to intervene, and in most cases it took years for the Minister to act on this advice.
SUPERVISION AT LAST
During the crisis, investment houses and insurance companies were not being properly supervised, although they should have been supervised through the Ministry of Finance, and the Financial Services Commission (FSC) has been created in an attempt to plug this hole in the system.
FIT AND PROPER CRITERIA
Like the BoJ, the FSC has the power to impose 'fit and proper' criteria on prospective owners and managers of institutions under its supervisory portfolio.
LIQUIDITY
For Insurance entities, at least 40 per cent of the insurers capital is required to remain in liquid assets, and after that 40 per cent, another 15 per cent of minimum capital may be invested in preference shares, after required due diligence.
REAL ESTATE INVESTMENTS
Because of the problems caused by the 1990's level of over-investment in real estate, the upgraded Insurance Act now stipulates that a company may invest no more than 30 per cent of its assets in real estate, including up to 20 per cent in real estate generating enough income to pay any mortgage loan on the property. The act also stipulates that a company can invest no more in real estate than 10 per cent of assets or 50 per cent of excess over minimum required capital, whichever is less.
THE BANK OF JAMAICA
AS A SUPERVISOR
The global standard for bank supervision lies within the list of Basel Core Principles for Effective Banking Supervision, a blueprint for effective bank supervision formulated in 1997 by the Basel Committee on Banking Supervision. The committee was established in 1974, and its leadership is comprised of the central bank governors of the G-10 group of developed nations.
In 2001, the Financial Gleaner understands that the Bank of Jamaica requested an assessment on its compliance with the Basel Core Principles, and that the IMF carried out the assessment.
According to a standard supervisor assessment form obtained from the Bank of International Settlements (BIS) in Switzerland, where the Basel Secretariat is located, there are 25 core principles, and under the components in each principle, a supervisory authority can get a ranking of 'compliant', 'largely compliant', 'materially compliant', or 'non-compliant'. While the actual results of the BoJ assessment are not available to the public, sources reveal that the local central bank was rated among the better supervisory agencies in the world, and that of the stringent criteria, it was rated 'compliant' in 14, 'largely compliant' in 10, 'materially compliant' in two, and 'non-compliant' in one. Significantly, this assessment occurred while the local central bank was still in the process of proposing more legislation to upgrade its supervisory capabilities. Since some of that legislation came into effect a year after the assessment, it means that the Bank should score higher in any fresh assessment, as the recent legislation should make it compliant in at least two or more additional criteria. However, based on the standard list of criteria, one area where the BoJ could not have been graded "compliant," and which no legislation has been introduced to remedy, is that unlike the central banks of the developed world, the BoJ is not fully independent, and still has limited ability to impose sanctions. The Minister of Finance still has the last word on issues such as approving legislation, fitness and propriety assessments, and revoking licences.
This factor, which Jamaica shares with many developing countries, must be seen as a weakness and a potential risk for the future soundness of the sector, as the crisis of the 1990's made a very clear case for independent supervision of financial institutions.
THE STATE OF THE NON-BANKING SECTOR - IF IT WORKS, FIX IT!
The non-deposit taking sector needs more attention to make it as structurally strong as its formal counterpart. This sector has shown remarkable growth in recent years, but this growth has not been matched by any major upgrading of either the legislation or the supervisory body that is supposed to monitor and regulate it. The sector is still generally healthy, but because it has grown beyond its original framework, that framework now needs to be upgraded in an effort to counter any possible problems before they arise, instead of just waiting for them to happen.
MORE DYNAMIC
This sector is much more dynamic by nature than the formal banking sector, and this inherent dynamism calls for a supervisory framework that is equally dynamic. Securities dealers and investment houses are supposed to be very basic operations, where the deal is simple. A customer hands over a certain amount of money for a dealer to invest. The customer can minimise risk by opting for lower risk instruments, or instruments with a guaranteed rate of return, but riskier options, such as the stock market, are a matter of choice, and all options should be at the customer's risk. The dealer makes money off agreed commissions, assuming the investment pays off.
There are also non-negotiable fees, so the dealer makes money even if the investment fails or returns less than anticipated. In other words, just like at a casino gambling table (to which much of investment activity is very similar), the dealer should never lose. Where things get complicated, is where the dealers start to gamble, and put themselves at risk with their own funds, their customers' funds, or worse, borrow external funds to invest.
In a worrying trend, industry insiders reveal that this practice has in recent times become a practice of some dealers in Jamaica, which means that depending on the nature of some of these investments, some dealers may be vulnerable to any unanticipated change in the local or international economic climate, such as shifts in fund ratings, or unexpected movements in interest or exchange rates.
GUARANTEED RATES OF RETURN
This sector has also at times displayed elements of one feature that was one of the reasons for the 1990s crash of the insurance sector: a maturity mismatch of assets and liabilities while boasting limited capital. Some dealers have at times exposed themselves to risk by offering clients guaranteed rates of return on medium and short-term instruments, while most of their managed funds is simultaneously locked into long-term instruments. This is all against a background where securities dealers currently handle over an estimated $256 billion in managed funds, compared to the more than $348 billion in the formal deposit-taking system. With some 33 such brokerage and investment houses in the market, this is a sector average of over 7 billion dollars per investment house.
Much of this activity is being handled as off-balance sheet activity making it difficult for the FSC, or anyone else, to monitor. This also means that many investors have little or no knowledge of exactly what is happening to their money. It is the view of some industry observers that registration and disclosure requirements similar to those imposed on its supervised entities by the American Securities Exchange Commission (SEC) should be introduced in Jamaica and quickly.
The minimum capital requirement for these companies is a mere $5 million dollars in "free assets"(which the act defines as "net asset worth held in the form of cash and readily convertible securities"). Several of these companies, however, are on an individual basis, playing with funds to the tune of several billion dollars. At least two of these companies are frequently quoted as having over $30 billion under management.
Some analysts agree that among the new regulations that should be introduced to monitor this sector are much higher capital requirements, as well as a liquidity requirement that forces these companies to hold a certain percentage of liquid assets in relation to their liabilities. Total liabilities, including off-balance sheet managed funds.
When some local investment houses sell "government paper," the customer is not actually buying government paper secured by government. The customer is really buying an instrument backed by the investment house, secured by its own investment in government paper and any other funds at its disposal. But what then happens if the investment house borrows to make that investment in government paper? Do customers know that their investment is not backed by actual capital? Also, how do customers know whether or not their investment in a given instrument was not "over-leveraged" by deliberate over-subscription? These are not deposit taking institutions, so there is no insurance protection for customers' funds.
One prominent banker has already publicly aired his concerns about this sector, and sources indicate that the management of another prominent commercial bank as well as officials from the central bank have independently documented concerns and recommendations concerning potential weaknesses in this sector that should be addressed before any major problems arise. These concerns have been taken directly to the Minister of Finance, but predictably, no sign of life has been seen from Dr. Davies in response.
