Zooming in on the '90s meltdown

Neville Swaby, Guest Columnist

This is the first of a three-part series on Jamaica's financial sector meltdown of the 1990s.

All regulatory standards require that regulators encourage sound corporate governance within the supervised entities and, wherever legally permissible, the regulators are required to regulate corporate governance requirements. There is growing awareness that good corporate governance practices are important both to the firm and the economy as a whole. The respective roles and responsibilities of the board, management, auditors and actuaries (insurance) in the risk-management process are of critical interests.

The Jamaican financial sector experienced significant difficulties during the years 1993-1997, mainly as a result of the Government's tight monetary policy, weak governance, poor central bank regulations, supervision and deficiencies in the management of the failed indigenous banks. Lack of confidence in the commercial banking sector produced runs on a number of smaller commercial banks. Some of the commercial banks were not adequately capitalised, because the regulatory authority took a proactive attitude toward supervision and the regulatory forbearance weakened the troubled commercial banks further.

Liberalisation of the financial sector encountered a great deal of criticism. One line of criticism emphasised the less-stringent-than-desirable financial legislative framework, as well as the weaknesses in the management of the financial institutions. The critics argued that the financial sector expanded too rapidly, providing a proliferation of services, which in many instances were outside the institutional core function. Emphasising the ineffective supervisory role of the central bank, inadequate legislative and regulatory standards, the critics argued that the legislative and regulatory standards should have been strengthened prior to or in tandem with the various reforms.

The fundamental causes of the Jamaican banking crisis were: (a) financial sector governance; (b) government macroeconomic policies; (c) bank regulation and supervision; (d) the domestic entrepreneurs; and (e) management of financial institutions. From 1993, the commercial banks began to suffer the consequences of high liquid asset reserves and excessively high interest-rate structures. The cash-reserve ratio (CRR) ranged from 22 per cent to 25 per cent, and liquid reserve ratio (LRR) ranged from 47 per cent to 50 per cent. The lending rates of commercial banks were excessively high, ranging from 61.3 per cent per annum in 1993 to a low in 1997 of 44.22 per cent per annum.

Figure 1 (See figures on page F7): The performance of the banking institutions was driven by high levels of inflation during 1990-95 and a credit boom in which many loans and investments were made with no proper risk assessment or appropriately valued collateral. The poor portfolio management and risk assessment bolstered profit making and disguised high levels of inefficiencies in the banking system. The environment facilitated profit-making through the transfer of funds between different types of institutions within a financial group.

Figure 2: From 1993, the commercial banks began to suffer the consequences of high central bank overdraft penalty rates. Under such adverse banking conditions, it is unlikely that any commercial bank would be able to assume interest rates of 120 per cent for overdraft facility by such magnitude.

Figure 3: There were large margins within deposit and lending rates. Deposit rates ranged from 20.79 per cent per annum to 39.8 per cent per annum, based on the amount of deposit, as well as the maturity period. Lending rates ranged from 44.22 per cent per annum to as much as 61.32 per cent. The interest rate spread for commercial banks was 21.52 per cent in 1994 and then increased even further to 28.29 per cent the following year.

Figure 4: The varying rates of interest offered on local deposit instruments, as well as fluctuations in the foreign-exchange market, influenced the deposit structure of the banking system during the period 1993-97. A widening difference in the interest rates on time and savings deposits induced portfolio adjustments, thereby luring depositors to the more attractive savings deposits.

Figure 5: The inadequate capital base and high level of non-performing loans in the commercial banks, in addition to government macroeconomic policies, poor management, inadequate central bank supervision, poor governance by boards of directors and shareholders, led to liquidity and solvency problems in a number of the indigenous financial institutions. The overall health of the financial sector continued to struggle as a result of the Government's fiscal, debt, and monetary policies. The existing policy direction of increasing borrowing to reduce debt and fiscal deficits and to support high interest rates continued to lead to further consolidation, mergers, and bankruptcy of the sector and the economy.

Figure 6: The asset portfolio of banks became heavily skewed towards government debt instruments and towards substantial support for other financial institutions, as opposed to productive loans and consumer-oriented credit.

The inefficiencies in the banking system were reflected in large operating expenses, in particular, compensation packages paid to executives, and growth in non-performing loans. The expansion in non-performing loans was partly caused by the inability of the insurance companies' associates to service their debt obligations with the commercial banks. These institutions experienced liquidity problems, as the mismatch of short-term, 'deposit-like' liabilities with traditional long-term investments could not be sustained when clients demanded their funds. The first financial group to experience substantial solvency problems was the Blaise group in 1994. By 1995, similar problems surfaced in the Century National Group. The takeover of the management of Century National Bank (CNB) by a government subsidiary was followed by a run on deposits at two other commercial banks.

troubled institutions

In order to address the mounting problems within the banking sector, the Financial Sector Adjustment Company (FINSAC) Limited was established January 1997 by the Government to deal with the troubled institutions. FINSAC is similar to the Resolution Trust Corporation set up by the US government to deal with the 1989 savings and loan crises. By the end of 1997, the Government of Jamaica assumed management control of a number of failed financial institutions, including CNB, Eagle Commercial Bank, Workers Savings & Loan Bank, Island Victoria Bank and Jamaica Citizen Bank.

The Jamaican financial crisis of the 1996 provided numerous lessons and raised important questions, placing several critical issues on the policy agenda. These interrelated issues include: financial-sector governance, the mindset of domestic entrepreneurs, management of the financial institutions, macroeconomic policy, and deficiencies in the regulatory environment.

A country's financial system, including banks, is important for financial development and prosperity.

Financial-sector governance is important for several clear and obvious reasons. One critical reason is to avoid financial crises - the failures of large numbers of financial institutions, or the sudden and sharp collapse of prices of financial instruments traded on capital markets. Financial institutions must function effectively, because they operate the payments system and store much of the wealth in any society. Poor governance is typically associated with corruption, which not only corrodes the trust individuals have in the private and public institutions, but also acts as a significant deterrent to foreign direct investment.

Good governance practices established and applied in normal times should help significantly in times of crisis. Exceptional circumstances, however, require exceptional measures, and an appropriate institutional set-up to take such measures and implement them. The key conditions in good governance are appropriate accountability arrangements for those in charge of measures and a high degree of transparency of the restructuring strategy to ensure that all parties involved in times of systemic crisis are well informed about the authorities' intentions.

The financial system of a market economy is the 'central nervous system' through which the market mechanism that operates. The infrastructure of the financial system must be supported by a comprehensive legal and regulatory framework that provides for a stable medium of exchange, creditworthy financial institutions, fair and honest capital markets, and efficient payments, clearance, and settlement systems.

Government regulation and supervision, which form part of the rule of law, must support an environment in which counterparties can effectively assess the risks of the transactions. The burden of managing risk in the financial system should not lie with private institutions alone. A central bank law is required that establishes a politically independent but accountable central bank that is mandated with the responsibility to maintain stability and to act as the lender of last resort.

LEgal framework necessary

Laws and regulations are required that create a comprehensive legal framework for financial institutions. These laws should address the powers of such institutions, the minimum safety and soundness standards that they must meet, and their regulation and supervision on a consolidated basis. Such laws must allow supervisors to set prudential rules and regulations to control risks, including those covering capital adequacy, loan loss reserves, asset concentration, liquidity, risk management, and internal controls.

When corporate governance is effective, it provides managers with oversight and holds boards and managers accountable in their management of corporation assets. Effective corporate governance is closely related to efforts to reduce corruption in business dealings and makes it difficult for corrupt practices to develop and take root in a company.

Good regulatory governance in the financial system is increasingly being recognised as a key component to achieve and preserve financial stability. All of the recent systemic crises list weaknesses in the regulatory governance, or poor public-sector governance among the contributing factors to the crisis. Government's failure to adequately regulate and supervise institutions was a contributory factor to the debacle in the 1996-1997 financial-sector crises in Asia and Jamaica. Specifically, there was tardiness in updating prudential regulations and in putting adequate supervisory agencies in place.

The Jamaican financial crisis of 1996-1997 was severe. A downturn in the real-estate and stock markets precipitated illiquidity problems in the overexposed life insurance industry, despite central bank assistance. Panic spread throughout the sector. The Government was initially inclined to follow the standard remedy of closing distressed institutions. However, after months of contemplation to evaluate the extent of the problem, fast-track legislation and other measures were introduced to resuscitate the sector.

In the decision to embark on a programme of liberalisation, the authorities seem to have moved with undue haste, ignoring McKinnon's strictures that restoration of fiscal instability must precede financial liberalisation.

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.