Aligning Financial Regulatory Architecture with Country Needs:
Lessons from International Experience
June 5-6, 2004
The Oberoi, New Delhi
DEALING WITH REGULATORY ARBITRAGE IN THE FINANCIAL SECTOR
Good morning colleagues. Let me first commend the World Bank on organising this seminar, which has wide reaching relevance and applicability. Indeed, the term “regulatory architecture” aptly describes the undergirding framework necessary for sound financial system development and stability, but which is required to evolve dynamically in tandem with increasingly globalised economies, technology driven/ever faster delivery of an increasing range of financial services and products within more complex corporate structures and mounting associated risks that cross all physical and supervisory boundaries and borders. This subject therefore demands our critical, objective and on-going Supervisory alertness and attention, with financial regulatory structures, methodologies and standards adapted to our individual country needs, based on appropriate flexibility in the context of certain immutable Supervisory principles. It is indeed my privilege to be asked to share with you at this seminar on the topic Dealing with Regulatory Arbitrage in the Financial Sector.
Like so many other international jurisdictions, Jamaica has had to grapple seriously with financial system distress in the late 1990s, within which context regulatory arbitrage played a not insignificant role. I have surmised that this is the basis on which I’m considered qualified to address my supervisory colleagues in India and it is my hope and, indeed, expectation that this exchange of perspectives and experiences will bolster our respective reviews and enhancements of our own financial regulatory architecture.
The perspectives I will share in this presentation will cover our Jamaican experiences with regard to regulatory arbitrage in particular. You will also observe that the discussions on this issue feed directly into the area of Consolidated Supervision, which I will also be sharing on later in this conference. This highlights the inextricable nature of these issues as our various
experiences have underlined the fact that regulatory arbitrage opportunities invariably lead to unhealthy conglomeration as entities seek to exploit seemingly “natural” advantages, hence a major focus of a sound consolidated supervision framework being to minimise regulatory arbitrage.
This presentation will cover:
a) The nature of regulatory arbitrage opportunities in the 1990s
b) The impact of exploitation of regulatory arbitrage opportunities
c) Jamaica’s strategies to address the problem
d) Lessons learned and their possible application to other countries
Jamaica’s pre-reform period may be defined as those years leading up to and during the financial system distress of the 1990s, where a number of financial institutions failed due to a number of factors. In this regard, regulatory arbitrage played a feature role in the conglomeration of the financial system as entities sought to take advantage of less stringent regulatory environments which facilitated their conduct of activities akin to banking, but outside the purview of the Banking Supervisor as well as to exploit other existing taxation and reserve requirements arbitrage opportunities.
The examples of arbitrage efforts evidence a sequential pattern as they highlight the strategies of owner/managers whose focus seemed to be solely to illusively grow their books of business in a highly competitive environment, without due care or intent to ensure requisite prudence and soundness, and slid to each new loophole as an existing one was closed. These owner/managers benefited from the advice of bright attorneys and accountants who, based on the frequent appearances of some names in many entities across the banking sector, seemed to have emerged as “expert advisors” in this destructive field which we called “loophole mining”.
Our experiences are best illustrated by some of the most outstanding examples of regulatory arbitrage that we observed.
a) In the period pre-December 1992 (when deposit-taking laws were strengthened), certain indigenous commercial banks that incurred Supervisory criticism for growing non-performing credit portfolios or excess exposures, simply incorporated an institution under the Protection of Depositors Act (PDA - a very basic and skeletal statute which allowed deposit-taking and banking activities and had virtually no Supervisory enforcement capabilities) and transferred these problem portfolios to that entity. The result was a seemingly clean book of business, reported healthy earnings and profits of the commercial bank and escape of the Supervisor’s ire and heavy provisioning requirements in the commercial bank.
b) In December 1992 the PDA was repealed and the Financial Institutions Act (FIA) introduced which had provisions similar to that of the now upgraded Banking Act. The Supervisor was able to take greater action against these adversely performing merchant banks, which were found to have quickly accumulated a mass of non-performing assets and suffered from inadequate capital, among other things. However, the entities were able to, in fairly short order, clean up their books to meet the Supervisory requirements. At the same time, there was an exponential escalation in the number of building societies registered in Jamaica, with a growing number of the expanding indigenous banking groups also now sporting a building society.
With the failure of a merchant bank in December 1994 and the assumption of temporary management by the authorities, it was found in early 1995 that, in addition to outright misleading records in that instance, the magical “clean-ups” in these merchant banks was due, yet again, to transfer of problem accounts and conduct of prohibited business via the establishment of building societies as well as a previous unknown that legally empowered the conduct of deposit-taking business through its members - Industrial and Provident Societies (I&Ps).
Both building societies and I&Ps operated under statutes that were over 100 years old and had originally been designed to facilitate thrift and savings by their members only, towards specific goals (e.g., owning a home and burial schemes to cover expenses at the death of the saver or his immediate family). The traditional building societies were therefore a long established group of predominantly mutually/membership owned entities, which operated fairly conservatively, while the new wave of building societies were all proprietorships. Importantly also, these entities did not attract the increasingly high reserve requirements as did the commercial and merchant banks, and were therefore able to do less costly and more profitable banking business in the respective frameworks that their deficient laws allowed their uses to be converted to.
On these findings, the Minister of Finance moved immediately to legislative amendments on a two-pronged basis to:
1. Designate building societies as “specified financial institutions” under the Bank of Jamaica Act, thereby giving the Bank of Jamaica supervisory oversight responsibilities and information access authority over these entities while specific regulations were developed to allow for implementation of an appropriate regulatory regime akin to the other banking supervisees. The supervisory exercises that followed quickly cut the nearly forty (40) societies that were registered at that time to less than half that number, as societies which had not yet commenced operations and had no substantive basis to do so under the new licensing regime, were dissolved. The numbers eventually reduced to the four (4) current licensees as mergers took place along-side failures of those building societies attached to the conglomerates that failed in the late 1990s. A split reserve requirements regime was also implemented where once the building societies were operating under their substantive “raison d’etre” and maintained a minimum level of “qualifying assets” relative to their prescribed liabilities, they were only required to maintain token reserve requirements.
2. The deposit-taking provisions of the I&P Act were repealed, institutions identified by the Registrar of Companies as having a deposit-taking provision in their rules were contacted and followed-up to ensure cessation of this activity and the public was cautioned via extensive print and electronic media publications that these entities were not legally empowered to take deposits. (Nonetheless, there later emerged law-suits against a law firm which had apparently continued to operate such an I&P, whose depositors claimed that they were misled).
c) With the plugging of these loopholes, the next moves of these owner/managers were towards the establishment of or alliance with non-banking enterprises which did not fall under the Bank Supervisor but which weak framework allowed them to structure deposit-like liabilities under lax reporting and monitoring requirements and advantageous treatments as to tax and reserve requirements. Insurance companies were principal in this regard, where owner/managers proceeded to quickly build huge portfolios of short-term, interest sensitive, high rate liabilities under deposit-like products, which carried an extremely thin veneer of insurance and used these funds to finance longer-term real estate and other investments (in the expectation that the existing bubbles would have continued to grow). Other entity types included unit trusts and so-called tourism development companies (which attracted the public’s funds to finance investments in hotels and other tourism-based projects). However, the brunt of the arbitraging in this period was effected through insurance companies within these conglomerates that were built up.
The impact of these insurance companies’ failure occurred in the context of already weakened financial indicators in their respective conglomerates, resulting in part from under-reporting of additional problem assets in some instances in addition to the build-up of problem assets in the earlier arbitraging efforts which had not benefited from any real and substantial resolution bar write-offs and provisioning the Supervisor became able to impose. The banking entities in these groups therefore had no wherewithal to avoid the major liquidity strictures and capital erosion that followed, and history tells the painful story of the contagion these arbitrage efforts created for the banking system in the late 1990s.
In particular, the insurance companies exerted tremendous pressures on their affiliated commercial banks to meet their rapidly increasing liquidity needs in the face of rising interest rates and a quickly appearing crisis of confidence in their deposit-like products. This lead to a contagious pull on funds in the banking sector as panicked depositors withdrew their funds in a “flight to safety”. It was later found that in some instances, the failed insurance companies had also drawn heavily on the pension funds they administered thus enlarging the potential to further tremendously undermine confidence in the financial system.
The massive system distress required the intervention of the Government, which was forced to guarantee all deposits, non-connected insurance policies and pension plans, in order to avoid the crisis of confidence that threatened and would have quickly resulted in a huge flight of capital without radical containment action by the Authorities. The cost of these rescue efforts will require the heavy input of generations of Jamaica’s taxpayers, but is certainly well worth the efforts when contemplated against the incalculable costs and the resulting social chaos that outright failure of the system would have caused.
In response to the systemic issues in the late 1990s, the Government implemented a number of measures to protect and strengthen the financial system, which included those designed to minimise the opportunities for regulatory arbitrage, as follows:
1. Consolidation and vesting of responsibility for financial system regulation in two agencies:
a) Bank of Jamaica, which was given supervisory responsibility for all deposit-taking institutions. Supervision of building societies (1996) and credit unions (2002) was added to the Bank’s commercial bank and merchant bank supervisees.
b) The Financial Services Commission (FSC), which was created in 2001 and given responsibility for regulation of all non-banking financial institutions, notably insurance companies, securities dealers, collective investment schemes (unit trusts, mutual funds, etc.), and is in process of establishing the regime for regulation of pension funds.
2. Incorporation and commencement of operations of the Jamaica Deposit Insurance Corporation (JDIC) to put in place the Scheme for explicit coverage of the public’s deposits under various criteria and prescribed maxima.
3. A Memorandum of Understanding (MOU) was executed in December 2001,which enabled formation of the Financial Regulatory Council (FRC). This high level financial inter-regulatory group FRC is chaired by the Central Bank’s Governor (also statutory Supervisor of banks) and comprises the heads of the FSC and JDIC as well as the Financial Secretary. The FRC meets regularly to share information and determine on policy and action relating to, inter alia, identifying and addressing any gaps or other potential arbitrage opportunities and work to eliminate same or make them non-viable.
4. Legislative amendments to the deposit-taking statutes in 1997 and further in 2002, strengthened the Supervisory Authority’s powers over the banking system and included powers to exercise consolidated supervision with a view to minimising regulatory arbitrage, specifically:
· Provisions were added to significantly strengthen the “fit and proper” criteria, which allowed the Supervisor to assess all relevant matters including employment history and qualifications/expertise in relation to suitability for the job. Importantly also, these new provisions established an automatic statute bar against persons who were previously involved in the ownership, directorship or senior management of failed institutions to serve in any such capacity within the banking industry, unless specific waiver was so granted by the Minister.
· Powers to require acceptable and veto inappropriate conglomerate structures that include a deposit-taking licensee, including restructuring of a mixed conglomerate to establish a financial sub-group under a financial holding company, comprising all group financial entities. This is to facilitate transparency and comprehensive prudential assessment of all financial risks and exposures within the group.
· Establishing reporting requirements for all group entities wherein the Supervisor may require returns to be made by financial holding companies as well as deposit-taking licensees (on an individual and consolidated basis) and receive audited financials of all companies in the conglomerate each year.
· Enhancement of provisions relating to cross-border inter-regulatory cooperation and information sharing as well as establishment of similar mechanisms for domestic intra-regulatory relationships
· Requirement for the separation of potentially contagious non-banking activities from banking entities so as to better contain and define such potential and take action through the FRC to address same.
5. Restructuring of Supervisory methodologies and approaches to facilitate more coherent assessment of conglomerates long preceded and were important in early recognition of the pending financial system distress. These operational changes enabled the Supervisor to better see what was happening across groups, particularly as regards the reckless practices and risks evolving in the insurance companies and conglomerates described earlier, and made clear the evils of regulatory gaps and overlaps which facilitate regulatory arbitrage. These changes will be more fully described in the presentation on consolidated supervision.
6. Forthcoming measures to be implemented to strengthen the consolidated supervision framework in regard to regulatory arbitrage potential further developing on MOUs to include cross-sector relationships in financial groups. In this regard we are contemplating and have raised with our regional colleagues, the issue of establishing MOUs with non-bank regulators in the region where related to home/host responsibilities impacting financial groups.
However, the imperatives for most developing countries must be focusing on strengthening their regulatory framework and on safety and soundness issues per the far greater adverse impact of undertaking the risks associated with the practice of their more developed counterparts, and the potential for contagion to the deposit taking sector.
4. Finally, as the title of this conference articulates, each jurisdiction must use its experience, good judgement and intimate knowledge of its environment, financial sophistication, risk profile and stage of development to inform its adaptation of international principles and best practice in updating and enhancing its regulatory infrastructure. This may require in some circumstances that, given acknowledged weaknesses in other areas, certain activities or practices that operate internationally be constrained until, for example, supervisory or other required capacity or framework is built to allow wider operations in these regards.
In closing, I will quote a colleague of mine who once likened the desires of Jamaica’s financial system players to freely offer first-world type financial products and services in the context of a developing country’s financial regulatory architecture, with that of allowing a jet propelled vehicle to operate with only an outdated braking system to control it. In other words, the safety and stability of our respective economies and financial systems is dependent on both the strength and structure of our regulatory architecture (read braking systems) being aligned with our country needs.