The Banking Sector
Why Government’s Involvement?
Jamaica’s current financial sector problems are not unique when viewed against the history of many other countries that have gone through the same financial sector crisis.
Amid the controversy of who or what caused the financial sector failure, was a debate about whether or not the Government should have intervened in the failed institutions.
While detractors declare that the country cannot afford Government's actions, the Government has been steadfast in asserting that the country could not afford a hands off approach, as the social and economic cost would have been unsustainable.
Should the Government intervene?
It has been said that the question of whether or not a government should intervene depends on the extent of the problem and the size of the financial sector. Here in Jamaica, the financial sector is such an important part of the economy and the troubled banks' share of deposits so significant, that to risk the collapse of the sector was untenable.
Beyond this, commercial banks, as the main intermediaries in the financial sector, have a significant role to play in the real sector. Already contracting, the virtual collapse of the financial sector would have had significant negative impact on the real sector. The overwhelmingly clear example of other countries which have faced this dilemma is that the risk to their economies of the collapse of the banking sector has not been considered acceptable.
Can the Government afford the costs of intervention?
Most countries that have intervened to save their financial sectors have concluded that while the costs have turned out to be much higher than anticipated, the rehabilitation has been worth the cost. Jamaica is no different but that is the macro picture.
For the depositor the issues are a lot closer to home. In 1995 when Century National Bank was closed, for the first time in their lives many Jamaicans suddenly could not access their funds. For the first time questions were raised about the security of money in all banks. By 1996 & 1997 rumors of insolvency and the memory of the plight of Century depositors triggered runs on two banks. Confidence in the banking sector was at an all-time low and many considered wholesale panic a real possibility.
On February 7, 1997, the Prime Minister announced in Parliament that government would guarantee depositors funds in licensed deposit-taking institutions, pension funds managed by authorised institutions and policyholders funds in insurance companies.
The result of that commitment is that the man in the street stepped back from the edge of panic even with new revelations of banks in crises. At the end of the interventions over 2,000,000 depositors, over 500,000 policyholders funds had been secured in failed banks and insurance companies.
FINSAC
Towards the end of 1996, Government decided to adopt a cohesive approach to resolving the problems in the financial sector and by January 1997, the Financial Sector Adjustment Company, FINSAC Limited, was established. Similar in mission to the Resolution Trust Company which was set up by the US Government to deal with the savings and loan crises in 1989, FINSAC was expected to have a life span of 5-7 years.
FINSAC’s Objectives
· To restore liquidity and solvency to distressed institutions
· To strengthen the financial management of institutions
· To improve the efficiency of the sector in mobilising and allocating financial resources i.e. to effectively marshall savings for on-lending to the productive sector.
· To create an attractive environment for investors to recapitalise financial institutions.
The Crisis
The first sign of problems in the financial sector came in 1994 when the Blaise Trust & Merchant Bank was put under the temporary management of the Minister of Finance & Planning after investigations uncovered substantial irregularities in the management of the institution. Its affiliated companies, Consolidated Holdings and Blaise Building Society were also in severe financial crisis, and all were hopelessly insolvent. The Minister’s intervention came as a surprise to many, as most investors were oblivious to the risk of institutional failure in the financial sector.
Many were prepared to view this intervention as a one-time occurrence, until 1995 Century National Bank ran into problems and even after support to the tune of $4 billion did not recover. The bank was subsequently put under temporary management in 1996, and eventually closed.
During 1996, a group of CEO's of life insurance companies approached the government for help with what they described as liquidity problems. Preliminary analysis showed that what was positioned as a liquidity problem based on a mismatch of the maturities of assets and liabilities, was in fact a problem of insolvency of varying degrees.
Even more significantly, it became clear that the difficulties affecting the insurance sector had contaminated the banking sector given their connection under the group umbrella, through e.g., inter-company lending, as one cash-rich company advanced funds to another in the group which was short of cash.
Diagnostic reviews of troubled institutions in 1997 unearthed several factors contributing to the sector's turmoil:
· Absence of or failure to comply with proper internal control procedures.
The troubled banks showed a high incidence of fraud and irregularities
indicating weaker controls.
· Poor risk management and inadequate portfolio diversification
This resulted in (1) a high ratio of bad loans and (2) poor portfolio diversification
as evidenced by unacceptably high exposure to single borrowers and/or single
industries. To further compound the situation, where portfolio diversification
occurred, it was into areas where they had no competencies.
· High and increasing levels of non-performing assets
Due to inadequate investment assessment and monitoring there were
increasing levels of non-performing assets. In not matching the maturity of
assets to liabilities banks became vulnerable to movement in asset prices, interest
rates and exchange rates. For example, banks used short-term deposits to
invest in long-term investments like real estate.
· High operating costs.
The troubled institutions were inefficient, requiring large spreads between
lending and deposit rates. Jamaican spreads rose from 1992-1994 levels of
14%-15% to 21% -22% in 1995-97 compared to spreads of 7%-8%
in Barbados, Guyana, and Trinidad and Tobago during 1992-1997.
Owners and operators of local banks have maintained that larger spreads
are needed to compensate for the higher reserve requirements which
averaged about 48% of deposit liabilities compared to half this percentage
in Guyana and Trinidad and 39% in Barbados during 1993-1997.
The larger spreads pushed up interest rates and in some instances, no
doubt compounded customers' indebtedness and inability to pay, thereby
contributing to bad debts. The high spreads continue with a recent World Bank
study of 132 countries ranking Jamaica's interest rate spread of 19.1% in
1998 as the seventh highest in the world.
Poor quality of management and strategic planning
Domestic Banks had negative Return on Assets compared with positive, although slightly declining, ROAs of 2% - 3.5% in the case of foreign banks in Jamaica.
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Failure to exercise due diligence and care.
Financial institutions operated without sound corporate governance practices
and with limited involvement of their Boards of Directors.
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Unusually high appetite for risk.
Most local financial sector entrepreneurs have been cited as being too quick to
risk depositors’ funds, too competitive with each other to exhibit the trappings of
success, hence the 'edifice complex' and too prone to bend prudential norms and
regulations.
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A high incidence of connected party lending
For example, when depositors began to withdraw funds placed in lump sum,
interest-sensitive policies, insurance companies tapped into their affiliated banks
for funds to meet withdrawal demands, thus weakening the banks, when the
insurance companies were unable to repay these loan.
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Breach of fiduciary duty and fraud.
Several files have been turned over to the Director of Public Prosecution
indicating forensic evidence of fraud and breach of fiduciary duty, among other
crimes.
Macro Level Contributory Factors
At the macro level, overview sector studies have shown regulatory weakness among the important contributory factors to the crises.
With the move away from direct controls to a system of rules and supervision in the early nineties, the three main statutes governing the financial sector were amended in 1992. These were the Bank of Jamaica Act, the Banking Act, and Financial Institutions Act
The Bank of Jamaica (BOJ) Act was amended to make monetary policy more effective, regulate the management of foreign exchange and to give statutory recognition to the BOJ's Department of Bank Inspection.
However, while the legislation was timely, institutional strengthening at the supervisory agencies was not yet in place. By 1997 new legislation was put in place to stem the imprudent practices the financial sector crises had unearthed and to provide stiffer penalties for infringements.
Consequently, the situation had already become a crisis, and the deterioration could not be stemmed. The deposit insurance which would have placed a cap on sums recovered and lessened the cost of FINSAC intervention to taxpayers, did not come on stream until 1998, by which time all indigenous banks had failed or were in severe difficulties.
The Banking Act and the Financial Institutions Act provided for stricter licensing of banks, minimum levels of capital, stricter prudential controls, provisioning for loan losses, strengthening of supervision and regulation and mechanisms for identifying and punishing the culpable in troubled institutions. The amendments also enhanced the power of the Minister of Finance to intervene in troubled institutions.
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