Finsac commission of enquiry

Chapter Two on 'Banking and life insurance industries' of the submission of former chairman of the Eagle Group of Companies, Dr Paul Chen-Young, to the FINSAC enquiry.

The phrase 'bailout of the banking sector' has been frequently used to describe the Government's intervention. This is misleading.

There was no widespread bailout of owners of financial institutions.

Only shareholders in certain entities like National Commercial Bank and Life of Jamaica did not lose their investments.

Investors in other financial institutions received no compensation whatsoever and, in some cases, have been subjected to lawsuits.

It must be emphasised that it was the public, with deposits and commercial paper in the troubled financial institutions, that became the main beneficiaries of the intervention in the banking and life insurance industries.

In the 1990s, there were four major life insurance companies in Jamaica: Mutual Life; Life of Jamaica; Island Life; and Crown Eagle, which collectively accounted for about 90 per cent of the business.

These were eventually taken over by FINSAC. These were all 100 per cent owned by Jamaican entities with Jamaican management. They all prospered until the late 1990s when they ran into trouble and sought financial assistance from the Government.

The leadership of these institutions epitomised successful Jamaican entrepreneurship in an industry that was the main source of long-term savings through insurance premium income and the establishment of pension funds.

The long-term savings generated were a steady source of funding for Government securities and investment in the stock market.

The leadership pioneered commercial real estate development and can take credit for the development of New Kingston and the redevelopment of downtown Kingston.

In the tourism sector, life insurance companies were the source of capital that built and refurbished hotels in partnership with highly successful Jamaican hotel chains like Sandals and the Issa group.

Without the life insurance companies, government divestment of hotels would have been a failure. It was the active involvement of the life insurance companies that must be created with the hotel infrastructure, which now exists.

Operating in a volatile economic climate, where high interest rates, high inflation and regular devaluation were being experienced, management of the life insurance companies has the difficult decision on how and where to invest.

They made major investments in commercial buildings and hotels, which caused serious funding problems as their main source of long-term funding - premium income - declined significantly and they were then forced to compete heavily for short-term, high-cost commercial paper to support their investment.

In The Entrepreneurial Journey in Jamaica: When Policies Derail (revised edition 2005, pages 61-62), I said: "The difficulties that faced the life insurance companies were manifested by:

1. The surrendering of life insurance policies from 800 in 1992 to 6,400 in 1996;

2. The fall in gross premium income from J$8 billion in 1995 to J$6 billion in 1997; and

3. The massive growth in short-term liabilities (mainly commercial paper) from J$1 billion in 1991 to J$24 billion in 1997."

The 1997 report of the Office of Superintendent of Insurance states: "Premium income has trended downward over the last four years ... . The downward could have been influenced partly by the state of the economy where consumers were no longer investing in life insurance policies."

The most serious consequence of this development in the life insurance industry - a by-product of the harsh economic climate - was that it pushed directors and management to turn to high-cost commercial paper in order to complete projects that were undertaken with the presumption of relatively cheap long-term financing from premium income and protection from devaluation.

In some cases, new projects were undertaken to seek some type of asset-value protection from sustained devaluation and high inflation rates.

Serious mismatch

The heavy reliance on high-cost, short-term commercial paper created a serious mismatch of assets and liabilities and long-term investments made could not generate sufficient return to service these debts.

This was the crux of the problem, not management failures nor unsatisfactory information technology in the industry.

As the financial crisis became evident, in 1996 the leadership of the life insurance companies met in an attempt to address the problem.

Pricewaterhouse was commissioned to undertake a study as to the amount of funding needed for the life companies to stay afloat. Richard Downer, of the firm, came up with an estimate of J$20 billion and a team comprising Dennis Lalor, Dr Marshall Hall and me was appointed to take our case to the minister of finance.

The team met with former Finance Minister Dr Omar Davies, who promised to consider providing assistance and requested that each company submit financial projections to allow his team to be a useless exercise as all of the life companies were eventually taken over by FINSAC and sold to overseas interests.

This action by FINSAC wiped out the dynamic years of entrepreneurship that was exhibited by Jamaicans in this vital industry, which was Jamaicanised under then Minister of Finance Edward Seaga in the 1960s.

The entire entrepreneurial leadership of what was then some of the most admired companies in Jamaica was summarily cast aside as the Government used its financial muscle to take over the life companies.

The 1980s and 1990s saw a significant increase in the number of banking entities as Jamaican entrepreneurs entered the banking sector, especially merchant banking, where capital requirements were minimal.

At its peak, the banking sector comprised 11 commercial banks, of which only three were foreign-owned; 30 merchant and investment banks; 15 building societies; and three unit trusts.

Between 1980 and 1997, the assets of commercial banks grew from J$2 billion to J$157 billion, while those of merchant banks rose from J$130 million to J$18 billion.

By 1998, after FINSAC intervention, nearly all of the domestically owned commercial banks and merchant banks were either closed or sold to overseas interests.

When the 'run' on banksprecipitated the crisis in 1996-97, the Government created FINSAC in late 1996.

Shortly thereafter, it became the largest holding company in Jamaica, owning some 158 companies; nearly all of the domestic-controlled banks, accounting for about 60 per cent of total assets; and nearly all of the life insurance companies, representing at least 90 per cent of total assets.

Certain specific factors that caused the demise of the banking industry can be cited.

First, domestic banks took a fundamentally different approach to risk taking and nation building.

Most of the domesticically controlled banks took a more aggressive lending approach and even direct investments. They saw themselves as playing a leading role in the development effort.

This is not to defend such practices as they ultimately led to the collapse of the sector. It is a statement of fact that proved to have been a costly strategic mistake.

Second, changes in the banking law required that loans with non-current interest be classified.

The impact of this change had an adverse effect on the profitability of banks, as illustrated by the fact that National Commercial Bank had to classify J$13.5 billion of its loans as non-performing, amounting to nearly four times its capital base.

Even though necessary, this new regulation had a devastating effect on the viability of banking entities and enough time was not given them to absorb and restructure their operations, including seeking additional capital and joint-venture partners.

Third, regulation under the new banking regulations sterilised 50 per cent of commercial bank deposits, where 25 per cent had to be placed in a non-interest bearing account at the Bank of Jamaica and another 25 per cent had to be used to purchase government paper.

Fourth, many customers could not afford to service loans during the period of high interest rates averaging over 50 per cent along with annual devaluation.

This led to higher bad-loan provisions, which adversely affected profitability and the viability of banking institutions.

Fifth, following the liberalisation of foreign exchange in 1990, the high interest-rate policy encouraged massive flows of foreign exchange, most of which came from Jamaicans, to take advantage of annual returns of around 50 per cent on Jamaica Government Treasury bills - far in excess of the four per cent on United States Treasury bills.

This huge differential served as a virtual guarantee to cover any potential losses against devaluation and was a heavy price to pay for foreign exchange, which was partially used to protect the Jamaican dollar.

This led to a rapid build-up in foreign-exchange accounts in the banking system and ways had to be found to invest these funds. Hence, banks started making foreign-exchange loans and investments in tourism, which later created problems.

Sixth, an overlooked, but important factor was the criticism of financial conglomerates (like Eagle) by then governor of the Bank Of Jamaica, Jacques Bussières. As I wrote in With All Good Intentions: The Collapse of Jamaica's Domestic Financial Sector:

"Mr Bussières made no secret of his opposition to financial conglomerates, criticising them on radio talk shows and in public speeches. His philosophy was that the most appropriate model for Jamaica was to ensure separate ownership of financial entities such as insurance companies and banks, creating what he termed a 'Chinese wall' between them. By taking such a position publicly, he unwittingly helped to undermine the domestic financial sector which had begun to suffer a creeping lack of confidence."

Seventh, during the high interest-rate regime in the 1990s, the domestic-controlled banks were more aggressive in lending and also made direct investments in the real estate sector.

They, in part, followed the banking strategy used by Germany and Japan to develop those economies. The late G. Arthur Brown, as governor of the Bank of Jamaica, implicitly recognised the merits of such a strategy when he allowed the banks to make direct investments up to 20 per cent of their capital. But in a volatile economy, such a strategy proved to have been a serious mistake.

Shunned hotel investments

It is interesting to note that none of the foreign-controlled banks participated to any significant degree in the resuscitation of the tourism sector, including the hotel divestment programme.

There was explicit encouragement by Government for the domestic financial institutions to be actively involved in development projects and the hotel divestment programme.

The local banks took the risk and were abandoned when the crash came.

It was the domestic financial institutions which came together in 1985 and for the first time pioneered the concept of consortium financing (with some 15 entities) to fund the construction of the 235-room Sandals Ocho Rios hotel that became a model for financing other hotel projects.

Eagle Merchant Bank led that consortium and later almost all of the major domestically controlled financial institutions, like Life of Jamaica, Mutual Life, National Commercial Bank, Century Bank, Workers Bank, became major investors in the expansion of the tourism industry.

Indeed, the domestic financial institutions can take credit for major hotel developments in Jamaica.

The domestic banks also led the way in government privatisation. The domestic merchant banks, with Eagle playing a leading role, were at the forefront in the privatisation of the Jamaica Telephone Company, Radio Jamaica, Caribbean Cement Com-pany, and National Commercial Bank.

In retrospect, it can be argued that the foreign-controlled banks did the smart thing in not committing themselves as the domestically controlled banks did in helping to develop Jamaica and were, therefore, able to survive the trauma of the 1990s.

The policies of the domestically controlled financial institutions were fully supported and encouraged by the then Government.

But when the crisis came, it turned its back on these institutions, took them over and sold them to overseas interests.

This has destroyed the possibility of Jamaicans ever having any future effective control over the banking industry - one of the 'commanding heights' of the economy.

business@gleanerjm.com

Continues next week.