Delroy Hunter | Innovative finance and financing innovation in Jamaica
A friend recently questioned why he was not able to participate in NCB’s US$300-million debt issue secured by international credit card receivables (The Gleaner, August 19, 2022).
After all, he has a long and satisfactory relationship with National Commercial Bank Jamaica, understood the risk involved, and found the reward attractive. Unfortunately, as far as I am aware, NCB funded the entirety of the loan through a United States-based entity.
It is imperative that we understand the fundamental importance of the question asked by my friend. It is, in essence, about the level of Jamaica’s financial development and the sophistication of the financial sector, where the latter is reflected in the capacity of the sector to employ innovative finance in order to finance innovation and generate economic growth.
The fact that NCB was able to immediately monetise its future receivables, rather than having to wait to collect the receivables in the future, meant that it could more effectively fulfil the role envisaged of banks by Joseph Schumpeter; that is, financing the “creative destruction” process, where more innovative firms create new and better products and processes of doing business, at the expense of their less innovative peers.
In responding to my friend, I suggested that, perhaps, NCB perceived that local investors did not possess the financial capacity to absorb what was a large capital raise (which was roughly the equivalent of $45 billion) and did not wish to pursue a less efficacious approach of raising the capital in separate tranches from the domestic and international financial markets. Furthermore, the bank might have assumed that the domestic market and its participants are not sufficiently financially sophisticated to correctly price the deal or demand such an asset.
My strong suspicion is that the answer is all of the above. Although purely speculative – there could be other idiosyncratic reasons – further discussion is warranted because of the implications of my answer.
Without specific knowledge, I surmise that the capacity exists locally. This is because the indicative demand for new stock issues, such as that for TransJamaican Highway Limited ($25 billion), suggests that there is a large and unmet demand for investment opportunities. Furthermore, oversubscription is commonplace, economically large, and sometimes occur immediately after the issue opens to the public.
However, there is no established market in which securities that are backed by the issuer’s receivables are traded; and the demand for this asset by local investors was, perhaps, not known at the time. Moreover, if NCB specifically needed to raise US dollars, then it is less clear whether the local market had the capacity.
It is possible that NCB was dissuaded from raising the capital locally by the concern that, even if the funding capacity and demand existed, the requisite financial sophistication was absent. This is because the transaction was not a ‘plain-vanilla’ debt issue. Instead, the proceeds were in foreign currency, the loan was collateralised by existing and future receivables from foreign credit card users in foreign currency, and the loan had an interest-only payment, with principal repayment deferred for more than three years.
To accurately assess the risk and price the debt required additional considerations relative to pricing plain-vanilla debt with the usual features. In other words, a different level of financial sophistication would have been required. Does this level of sophistication reside in Jamaica’s financial sector?
Jamaica’s financial sector does not score highly on standard measures of financial development, such as that constructed by the International Monetary Fund and which measures “financial depth (size and liquidity), access (ability of individuals and companies to access financial services), and efficiency (ability of institutions to provide financial services at low cost and with sustainable revenues and the level of activity of the capital markets)”.
However, the state of financial development might belie the sector’s financial sophistication when we consider the range of financial services firms, their ability to price and trade more complex financial products (financial innovation), and the financial solutions that can be crafted from the existing menu of products and services.
To be clear, while these concepts are related, they are not the same; that is, it is not necessarily the case that an increase in financial sophistication arises immediately from improved financial development. For instance, an economy with many small commercial banks could lead to an increase in financial access, but these small institutions might not possess the sophistication to offer financial solutions such as asset diversification, risk management, or the pricing of non-standard and innovative loans to finance innovation for high-tech firms.
It is reasonable to argue that the level of sophistication of Jamaica’s financial sector is changing at a reasonably rapid pace, thanks in large part to the actions of a growing number of ambitious, well-educated, and experienced young Turks in the financial sector and, to a lesser extent, the competitive response of the more established order.
At the risk of angering some institutions whose products and services I am less familiar with, it is worth highlighting some that are using innovative finance to finance innovation in the real economy.
The Jamaica Stock Exchange (JSE) must be commended for its role in financial development and innovation. Long before the recent flurry of funding activities geared to small and medium-sized enterprises, the JSE had the wisdom to establish the junior market, which not only provides much-needed equity capital to SMEs, but also increases financial development by providing greater access to the public equity market.
A new player that might have had an interest in NCB’s decision to collateralise its receivables is Quantas, which was recently formed with the stated intention of becoming the predominant player in the trading of receivables in the region. What is more, they intend to securitise the purchased receivables, which means they will package them for resale to investors.
This brings financial innovation to the local market that can simultaneously increase economic and financial development as more firms access formal financing and improve their liquidity by selling their receivables, and investors benefit from the ability to invest in a new financial asset.
Sygnus, too, has been using financial innovation in various aspects of its operations. For instance, they offer profit-participation loans in the funding of real estate development. This means that for a developer that is unable to meet the minimum equity input demanded by commercial banks, Sygnus is willing to fund the development at a larger loan-to-value ratio in exchange for a share in the profits. Similarly, Sygnus, First Rock, SEAF Caribbean and other entities engage in various private equity deals where they, essentially, provide capital to private firms to fund growth in exchange for an equity stake.
Complementing these activities, the Development Bank of Jamaica has been working to establish a suitable venture capital-private equity ecosystem to facilitate the financing of economic growth. Since venture capitalists and private equity firms require their target firms to possess the key characteristic of an ‘economic moat’, or sustainable competitive advantages, to ensure long-term profitability, some target firms are likely to be among the most innovative – in products, pricing or processes.
Interestingly, local financial innovation is not solely the purview of entities that directly fund economic activities. In fact, entities like Sagicor Select Funds, which allow investors to purchase equity in entire economic sectors as though they are buying a single stock, and Astronomical Holdings, which uses debt to procure large blocks of equity (margin trading) in public firms they consider undervalued, have taken innovative steps to drive the demand for public equity, thereby improving the sophistication of the local financial sector.
The information and education that surrounds these aspects of financial innovation can also improve the financial sophistication of local investors, whereby they become more knowledgeable about financial matters.
Room to grow
Notwithstanding these encouraging developments, a claim that NCB, or any entity, may be dissuaded from raising capital or otherwise engaging in the local financial market, because of insufficient financial development and limited financial sophistication, might have some merit.
For instance, the claim could correctly be made that: there is insufficient local capacity to manage currency, interest rate, or market risk; a lack of inflation-indexed or currency-indexed instruments, in a context where these risks have been major obstacles to business and personal financial planning; and a financial framework that does not allow for more complex securities trading, such as short-selling, that is, borrowing and selling securities whose value is expected to decline.
Hence, given the clearly existing room to grow, along with the benefits of stimulating economic growth, it is incumbent on all to encourage financial innovation. State and private- sector entities should be encouraged and be willing to engage the local market by bringing increasingly more sophisticated transactions to market. For instance, a more mature market for the purchase and packaging, or securitisation, of receivables for sale to local investors can play a role in the funding of tertiary education, as well as infrastructure and real estate development.
We can encourage a conducive regulatory environment, but one in which the authorities do not waiver in their commitment to create orderly markets by constant monitoring and reporting, as well as resolute enforcement of rules and regulations. Private-sector players also must ensure that they have the appropriate business architecture to prevent and detect fraud and cybersecurity breaches.
Delroy M. Hunter is a finance email@example.com