Oversight missteps a perfect storm for crisis

Neville Swaby, GUEST COLUMNIST

This is the second instalment of a three-part analysis on the financial sector meltdown of the 1990s.

There is much controversy surrounding the main factors behind the problems in the financial sector. The Jamaican crisis shows the full range of causes that have been observed in banking crises in Thailand, Vietnam, South Korea, Indonesia, Venezuela and Mexico. Each banking crisis shows a somewhat different combination of causes, but most of the main ingredients are always there, as they were in Jamaica in different forms:

1. Weak banking system, undercapitalisation of institutions and high levels of non-performing assets.

2. Inadequate macro policies.

3. Corruption and lack of transparency.

4. Bad bank management, and poor strategic planning.

5. Failure of regulatory bodies to insist on compliance with accepted rules.

6. Poor central-bank governance,

7. Excessive related party exposure, inappropriate lending and poor risk management.

8. Inadequate supervision of management by boards of directors and high operating costs, including excessive compensation packages.

The collapse of the savings and loan industry in the United States in the late 1980s and 1991 failure of Pyramid Building Society in Australia are sharp reminders of the need to shape the form of regulation to the nature of the market failure. The causes of the widespread failure of US savings and loans were many, and include fraud, risky lending, insider loans, falling real-estate prices and poor regulation.

In the 1980s, the savings and loan regulatory system was a fragmented and inconsistent combination of state and federal regulators with three basic flaws:

1. Regulatory standards were lax and overly prescriptive. Little attention was paid to capital or solvency, accounting standards were weak and oriented primarily towards achieving tax concessions, and there was virtually no focus on risk management.

2. The prescriptive nature of the regulations include two inherently contradictory requirements: savings and loans were restricted to lend almost exclusively against mortgages, and they were restricted to make long-term, fixed-rate loans.

Savings and loans were able to issue deposits, backed by deposit insurance, without facing any effective supervision to manage the risks they were taking.

weaknesses

The final resolution of the group's problems registered losses of around $1 billion, almost 50 per cent of the group's assets. As with the US savings and loan crisis, the failure of the Farrow Group exposed weaknesses in the Victoria regulatory structure. The failure of the regulators to enforce the regulations was an even greater concern despite clear regulatory violation and repeated warnings from others in the industry.

Deregulation in Thailand's financial system in 1994-95 resulted in large inflows of foreign capital into the country. According to the US Treasury Department national treatment study 471 (1998), Thailand's failure to adequately supervise its banking system in the face of these capital inflows contributed greatly to the 1997 financial crisis.

The unstable banking system that existed in 1997 was the direct result of Indonesia's failure in the midst of deregulation and to adequately supervise and impose prudential restrictions on the activities of Indonesian banks. In the late 1980s, the government undertook a major deregulation of the state-owned controlled banking system in order to encourage greater competition and to expand credit.

In 1977, Taiwan's state-controlled and private-sector banks operated in a liberalised banking environment marked by strict prudential requirements and oversight. Interest rates were not restricted. In tandem with a liberalised environment, Taiwan subjected banks to strict prudential requirements. For example, (i) ownership could not exceed five per cent for each shareholder or 15 per cent per shareholder plus relatives and corporate entities under their control; (ii) banks could not offer unsecured loans to bank executives or to shareholders with more than three per cent ownership; and (iii) banks had to meet capital-adequacy requirements.

The inappropriate sequencing of financial deregulation and liberalisation, and the lack of prudential supervision of the financial system, were important factors contributing to the Asian financial crisis. Walker examines the relationship between the legal regimes and economic performance, in part, by comparing the impact of the crisis on South Korea, Thailand, and Indonesia and positing a direct relationship between the severity of the crisis in each country and the weakness of its regulations and financial systems.

One lesson is clear from the Asia financial crisis: vigorous central banks supervision and regulation are crucial to financial health. In the recent crises, the economies which fared relatively well were those where the regulators were competent and independent of political interference; where they were not, the financial system collapsed.

In the case of Jamaica and Japan, the lack of independence of financial supervision functions within the Ministry of Finance in 1990-1997 was also widely believed to have contributed to financial-sector weaknesses.

inadequacy

Effective governance is also undercut by inadequate enforcement powers given to the banking supervisors. This inadequacy often undermined the credibility and integrity of the banking supervisor in trying to enforce prudential regulations or other regulatory directives with institutions typically found to be non-compliant with the prudential regulations. Some related problems were: weak enforcement, delays or other shortcomings in the judicial system, political interference, lack of decision-making or low staff morale, macroeconomic framework and market infrastructure.

Poorly governed financial institutions are liabilities to the financial system. First, they exert a distorting influence on public-sector rules and institutions; second, they lend to the wrong borrowers and in excessive amounts. Channelling the scarce savings of a society to wasteful borrowers deprives sound companies of credit and thus acts as a drag on economic growth. Excessive lending, meanwhile, can lay the foundation for future crises when an economic shock renders many borrowers unable to repay.

Every one of the major economic crises in East Asia, Argentina, Russia, Indonesia, Thailand Vietnam and Jamaica was accompanied or triggered by a crisis in the financial sector, and the citizens of these countries suffered deep pain in the process. Banks posed a special governance problem that is different from ordinary corporations.

Banks are financial intermediaries whose liabilities are mainly short-term deposits and whose assets are usually short- and long-term loans to businesses and customers. When the value of the bank assets falls short of the value of their liabilities, banks are insolvent. The value of a bank's assets may drop because borrowers become unable or unwilling to service their debt and default risk cannot be entirely eliminated without seriously curtailing the role of banks as financial intermediaries.

Financial regulation has a number of objectives, including safety and soundness, fair disclosure, avoidance of abuses, competitiveness, reserve allocation, and fair treatment. Vigilant, prudential supervision is essential to prevent excessive risk-taking by financial institutions.

Testimony from the enquiry about FINSAC's strategy regarding the NCB 'too-big-to-fail policy', which protected all depositors at banks if a big bank fails, sends several mixed signals. The major problem with this policy is that it may increase big banks' moral hazard incentives to take on excessive risk, and therefore reduce market discipline.

Policymakers in Jamaica now have broad indications of what is to be done to strengthen the financial system after Jamaica's financial crisis. Within this framework, regulators must recognise that supervision and prudential standards need to be improved; that banks need to meet capital requirements and make provision for bad loans to become stricter; hedge against risk; and limit or eliminate lending to connected parties.

Dr Neville Swaby is the acting vice-dean, College of Business and Management, and executive director, UTech/JIM School of Advanced Management. Email feedback to columns@gleanerjm.com and naswaby@hotmail.com.