Financial Sector Liberalisation in Jamaica

Chapter 1
Introduction and Overview

(1) Project Aim
The Jamaican financial sector saw rapid growth in the 1980s. By the mid-1990s, however, the system collapsed resulting in a massive government bailout to the tune of some J$80 billion. Many argue that the process of financial sector The aim of this liberalisation that commenced in 1985 is largely to be blamed. played in the demise of the Jamaican financial sector.
paper is to examine the process of financial sector liberalisation and the role it
(2) Liberalisation Defined

Liberalisation, in the general sense, means making less strict. From a financial perspective, liberalisation, often used interchangeably with deregulation, is the freeing up of established government rules and a move towards an environment determined more by market forces. Market discipline is substituted for the hand of the government with the aim of creating a more efficient marketplace. Liberalisation is achieved by deregulation and through the process of privatisation; privatisation being the exposure of the public sector production process to free market forces. The emphasis of this project is on the process of deregulation of the Jamaican domestic and Foreign Exchange (FX) market designed to remove market distortions and improve efficiency.
(3) The General Contents of the Paper

To put the paper in proper perspective, liberalisation that commenced in 1985 is contemplated against the historical background of the financial sector going back to the 1960s. Close attention is also paid to economic environment preceding liberalisation and its evolution over the years.
The process of financial sector liberalisation was embarked upon with good intentions in mind but today the debate rages on as to its role in the collapse of the Jamaican financial sector. While there are compelling arguments linking liberalisation to the decline of the financial sector, others argue that other factors, such as the ineptitude of managers and directors were solely responsible or played just as important a role. The purpose of the study is to examine whether the objectives of the Financial Sector Reform Program (FSRP) were achieved, to outline the impact of liberalisation on the system and to look at other factors that could have contributed to its decline. The massive fallout in the financial sector saw the intervention of the Jamaican Government through the Financial Sector Adjustment Company (FINSAC). With the important role played by this organisation, its projected impact on the Jamaican economy and its budgetary resources in the years to come, the paper would not have been complete without an appreciation of Governments bailout plan. Many other countries (developed and developing alike) have undergone the process of the financial liberalisation. examined. To establish some parallel with the Jamaican experience, similar reforms in other regions (mainly Japan) have been
(4) Reasons for the Research

Presently, there is very little literature documenting in a very structured way, the liberalisation process. Further, since the collapse there has been no formal The investigative structure to look into the crisis and the causative factors.
research will not only prove useful in providing a better understanding of financial sector liberalisation in Jamaica and its role in the banking crisis, but also
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in developing appreciation of current trends in the sector and broader macroeconomic environment. The information will prove useful to academics, bank personnel, and even to the regulatory bodies.
(5) Focus on the Banking Sector

Finally, the paper contemplates financial sector liberalisation from a broad perspective and its impact on financial intermediaries and markets. However, for focus and clarity, particular emphasis is placed on the analysis of its effect on the Jamaican banking sector. The emphasis is on its state prior to liberalisation, its subsequent growth, the collapse and the aftermath.
(6) The Organisation of Financial Systems

The essence of financial sector liberalisation is dependent on how financial systems are organised and their structural characteristics. Chapter 2 examines financial systems and it also takes a more detailed look at liberalisation. It closes with a historical perspective of the Jamaican financial system.
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Chapter 2
Financial Systems
(1) Introduction
The paper as outlined in the first chapter examines the collapse of the Jamaican financial system and the role played by liberalisation in its demise. This chapter puts financial systems and the role of its functional units into perspective and describes briefly the regulation process. Oftentimes, financial systems are regulated to the point where they prevent free interplay of market forces. The process of economic liberalisation, which is used to free these forces, is also a focal point of this chapter. commenced in 1985. Liberalisation of the finance sector in Jamaica The latter half of the chapter looks at its historical
development going back to the 1960s and up to 1991. The year 1991 is used as a marker, as the second phase of the liberalisation process (as will be shown) commenced at just around that time.
(2) What is a Financial System

A financial system essentially serves to move funds from those with surplus funds to those with a shortage of funds. In developed countries, such as the United States, the financial system typically comprises lenders (savers), financial markets, financial intermediaries, and borrowers (spenders). This structure is represented in Exhibit 1.
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Financial Systems
Indirect Finance
Financial Intermediaries
FUNDS
FUNDS
FUNDS
Lenders (Savers) 1. Households 2. Business Firms 3. Government 4. Foreigners
FUNDS
Financial Markets
FUNDS
Borrowers (Spenders) 1. Business Firms 2. Government 3. Households 4. Foreigners
Direct Finance
Exhibit 1 Flow of Funds through the Financial System

SOURCE: Frederick S. Mishkin, An Overview of the Financial System, Chapter 3, Money, Banking, and Financial Markets, 1989 (Scott, Foresman and Company, 1989), p. 43.
As shown in Exhibit 1, funds flow from lenders to borrowers either directly or indirectly. In direct finance, funds are borrowed directly from lenders by selling them securities (claims on the borrowers future income or assets). The indirect method involves a middleman or financial intermediary that stands between the lenders (savers) and borrowers (spenders).
(3) Financial Markets and Intermediaries

Financial markets and intermediaries are two of the functional units making up the financial sector. These include Debt and Equity Markets, Primary and Secondary Markets, Exchanges and Over-the-counter Markets, Money and Capital Markets and Depository, Contractual and Investment Institutions. Exhibit 2 below illustrates differing types of units.
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Financial Systems
Types of Financial Markets Debt and Equity Primary and Secondary Exchanges and Over-the-Counter Money and Capital
Types of Financial Intermediaries Depository Institutions (Banks) Commercial Banks Savings & Loan Associations Mutual Savings Banks Credit Unions Contractual Savings Institutions Life Insurance Companies Pension Funds Fire and Casualty Insurance Companies Investment Intermediaries Finance Companies Mutual Funds Money Market and Mutual Funds
Exhibit 2 Financial Markets and Intermediaries

SOURCE: Frederick S. Mishkin, An Overview of the Financial System, Chapter 3, Money, Banking, and Financial Markets, 1989 (Scott, Foresman and Company, 1989), Portion extracted from p. 51.
(4) Regulation of Financial Systems

Financial systems are usually tightly regulated by agencies under specific legislation. In the United States, for example, the financial system is among the most regulated sectors of the economy. Regulation is designed to accomplish the following: Provide information to investors so that they are able to determine how safe potential investments are. Ensure the soundness of the financial system to protect investors and depositors and funds they have invested. Improve control over monetary policy such as in the control of money supply through reserve requirements.
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Financial Systems
Encourage home ownership to develop a more politically involved electorate, more responsible citizens and, ultimately, a more stable society.
(5) The Process of Economic Liberalisation

Economic liberalisation is the act of reducing government-imposed constraints on the behaviour of actors in the economy. It concerns: Programme and sector aid that promotes policy and institutional change designed to free internal and external markets for goods and services; Improving the efficient operation of markets; Correcting market distortions; Restructuring enterprises and institutions in the public sector; and Strengthening public revenue and expenditure planning and management Liberalisation is achieved by privatisation and deregulation. The main features of the liberalization process, opinion formers and policy makers and implementation agencies are shown in Exhibit 3. The highlighted features are the subject of this paper.
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Financial Systems
Features of Liberalisation Liberalise Trade and Promote Exports Deregulate industry and commerce Reform finance sector institutions - removal of ceilings on interest rates and selective credit controls Reduce subsidies Free Prices Restructure and/or sell off state-owned enterprises Reduce the budget deficit, by cutting public expenditure and maximizing tax revenue Reduce the numbers of civil servants Devalue the currency and liberalise foreign exchange dealing
Opinion Formers and Policy Makers Politicians Ministries or Agencies Political Parties
Implementation Agencies Government Departments The Central Bank Commercial and Investment Banks
Non-Government Organizations (NGOs) Representatives of external agencies The Central Bank Government Advisors
Agencies The Stock Exchange Managers in State Enterprises Private Sector Managers
Academic Institutions
The Press
Financial and Regulatory bodies responsible for market supervision Economic development agencies Taxation Authorities Private Consultancy Companies Ministries of Agriculture and Rural Development and NGOs Ministries and other agencies concerned with social safety net provision
Exhibit 3 Features of the Liberalisation Process
Privatization and Deregulation

Privatization involves the exposure of the public sector production process to free market forces. The most commonly understood meaning is the sale of state-owned enterprises, but it can also refer to the contracting out of a service. While, deregulation is the easing of rules under which a firm or an industry operates, allowing expansion within the sector or diversification into other sectors and opening the sector to other entrants. Fewer restrictions on price is another recurring theme.
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Financial Systems
Internal vs. External Liberalisation

The liberalisation process can either be internal or external. With internal liberalisation, reforms are concentrated on freeing local markets while; externally, the process may involve the removal of exchange controls to allow locals freer access to foreign markets and foreign investors, the same freedom with local markets. Financial sector liberalisation in Jamaica basically had two phases. Phase one dealt with the internal markets; while phase two was both internally and externally focused.
(6) The Structure of the Jamaican Financial System

By 1991, it was the financial intermediation aspect of the Jamaican financial system that was well defined with varied financial intermediaries active in the areas of life insurance, commercial and merchant banking, and mortgage financing. There were also credit unions, development banks, and a unit trust. (see Appendix 5 for information on financial intermediaries operating in Jamaica in 1985). These institutions, falling under the jurisdiction of the Ministry of Finance and Planning, had sprung up to facilitate increased financial intermediation despite developments that led to instabilities in the international financial system during the early 1970s. Specifically in 1971, the Bretton Woods system of fixed exchange rate began to unravel. By 1973, the system finally collapsed with the more widely traded currencies allowed to fluctuate in line with market forces. The international financial system was further shaken by the OPEC oil crisis in 1974.
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Financial Systems
While the financial intermediaries were very active in Jamaica in the mid-1980s, financial markets were virtually non-existent. To give an idea, the Jamaica Stock Exchange which offered an opportunity to trade stocks, only operated for two trading days. Further, the simple process of transferring stocks was cumbersome. The process was badly in need of simplification in terms of the length of the process and the steps involved, such as adjusting stock registers and issuing new certificates.
(7) Historical Perspective (1960s to 1991) The Financial System in the 1960s
From even before the 1960s, the Jamaican financial system was already taking shape (See Exhibit 4). The first institutions to emerge were commercial banks followed by companies specialising in mortgage financing. With the 1960s coming to an end, commercial banks, trust companies, building societies, life insurance companies, credit unions were the dominant financial intermediaries in the sector. A Government Savings Bank set up initially to offer a savings option and later to invest in Local Registered Stocks issued by the Government of Jamaica also played an important role during this period.
The Financial System in the 1970s to 1991

By 1991, the sector had undergone further expansion and now included merchant banks. It was also during this period that a unit trust, a mortgage bank and development banks were first introduced in Jamaica. Appendix 5 for a description of these entities). (see
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Financial Systems
1941 Credit Unions
Early 196os The Central Bank, Life Insurance Companies, Trust Companies, and Building Societies.
1970 Unit Trusts
1940
1950
1960
1970
1980
1969 Merchant Banks and Development Banks NB. Commercial Banks were established in 1836
Exhibit 4 Time Line The Establishment of Financial Intermediaries in Jamaica
(8) The Banking Sector

The Jamaican banking sector essentially comprises commercial and merchant banks. In the early days of the banking sector, foreign-owned banks were the norm. Initially, commercial banks dominated with merchant banks making their appearance in 1969. It was soon after this period that the ownership landscape slowly began to evolve from predominantly foreign-based to local-based ownership.
Commercial Banks
Commercial banks were the first financial intermediaries to operate in the Jamaican financial sector and by 1961 the operations were well established. They offered current account facilities, time and savings deposits, and loans and were particularly active in financing agriculture, imports, and hotel development. Commercial banks operated under the Banking Act (revised 1961 and 1992) and were (and still are) supervised by the Bank of Jamaica (BOJ).
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Financial Systems
Merchant Banks
Merchant banks provided medium and long-term financing for the business sector in particular and also played an important role in the development of the money market. The activities of merchant banks were supervised by the BOJ, initially through the Protection of Depositors Act and then later, the Financial Institutions Act (1992). Merchant banks remain under the jurisdiction of the BOJ.
The Central Bank

The BOJ, ultimately answerable to the Ministry of Finance, was established by the Bank of Jamaica Law (1960) and begun its operations in 1961. Simultaneous with the establishment of the BOJ was the introduction of legislation to regulate banking in Jamaica. licence from the Minister of Finance. Additionally, the law stipulated minimum capital requirements and liquid assets to deposit obligations, disclosure of certain information to the public and to the Inspector of Banks (the BOJ) and maintenance of cash reserves at the Central Bank. The new legislation made it mandatory for any entity carrying on the business of banking to secure a
(9) Summary
A clear picture of financial systems and the liberalisation process in general has been provided, along with an insight to the historical background of the Jamaican financial sector. The next chapter will investigate this period further and details its structural characteristics revealing the existence of distortions and inefficiencies that retarded the development of the financial sector.
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CHAPTER 3
Distortions and Inefficiencies in the Financial Sector
(1) Introduction
This chapter discusses distortions and inefficiencies in the financial sector up to 1991. The chapter then outlines the structural characteristics of the Japanese financial system and makes comparisons with those that existed in the Jamaican context. This provides an important insight as Japan is one of the worlds most advanced industrialised nations. Finally, the objectives of the liberalisation process that were introduced to eliminate the distortions and inefficiencies in the Jamaican financial sector are examined.
(2) Structural Characteristics of the Jamaican Financial Sector

The preceding chapter is evidence of the varied financial intermediaries active in the Jamaican financial system up to 1991. Despite this, however, it was seen that activity in financial markets were virtually non-existent and as the following sections will show, the Jamaican financial sector lacked the necessary ingredients to facilitate sustained levels of economic growth. productivity below desired levels. inefficiencies in the market. In general, competition levels were low, resources were allocated inefficiently, and These were as a result of distortions and
(2.1) Over-reliance on Non-market Instruments

There was an over reliance on non-market instruments such as credit ceilings with funds being directed to certain sectors under pre-established ceilings; asset ratios that involved a non-remunerated cash reserve ratio (reserve with the BOJ at zero rate of interest); and a non-cash liquid asset requirement (mandatory investment in specified government instruments) to carry out monetary policy. (Appendix 4 shows the predominance of these tools). This predominance effectively prevented the development of the financial money market, as a
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result of the non-existence of tradable financial instruments. Without these, there were minimum investment opportunities for investors.
In the case of the former (credit ceilings), commercial banks began circumventing credit ceilings by shifting loans and deposits to non-bank affiliates in the interest of maintaining their profitability. constrained by reserve and capital requirements. These institutions were less
(2.2) The Interest Rate Structure

The financial sector of the early to mid-1980s was characterised as financially repressive whereby real interest rates were low and sometimes negative. The inflation rates 1980 to 1991 are shown in Exhibit 5. This is against the background that the savings rate up 1984 was just below 10%, climbed to a high of 20% in 1985 and thereafter, was reduced to 18%. The savings rate was deregulated in 1990. Negative real rates of interest had an adverse effect on mobilisation of savings and investments into the system.
1980 IR(%) 29 1981 5 1982 7 1983 17 1984 31 1985 23 1986 10 1987 8 1988 9 1989 17 1990 30 1991 80
IR Inflation Rate EXHIBIT 5 Deposit and Inflation Rates 1988-1991
SOURCE: Trevor Evans, Carlos Castro and Jennifer Jones,, The Impact of Structural Adjustment Programmes on the public sector in Jamaica, Chapter 3, Structural Adjustment and the Public Sector in Central America and the Caribbean , 1995 (Cries, Managua,, 1995), Portion extracted from p. 113.
The regime involved a statutory savings deposit floor rate that meant commercial banks offered rates that were not truly market-determined. This was compounded by the fact that two (2) commercial banks (Bank of Nova Scotia and National Commercial Bank) controlled 70% of the market share and under
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such a regime, they could maintain their status quo as a result of the security their sheer size projected.
(2.3) Subsidised Credit

Also characteristic of the period up to 1991, was the existence of subsidised credit to the prioritised sectors of the Jamaican economy. The targeted sectors were agriculture, manufacturing and tourism. Additionally, preferential rediscounting facilities were operated by the BOJ to facilitate growth in prioritised sectors. With rediscounting, commercial banks extended loans to particular sectors that were in turn funded by the BOJ. Inherent in these policies was the inefficient allocation of resources, as other sectors had to contend with limited and relatively expensive loan financing. Additionally, with the prioritised sectors guaranteed lower rates, there was little motivation to improve efficiency.
(2.4) Crowding Out the Private Sector

A further financial constraint witnessed during the period under consideration was a robust public sector deficit (figures in Exhibit 6) which resulted in rising inflation. One source of funding to the public sector was a relatively high liquid assets ratio, which ensured the availability of financing through treasury bills; while starving the private sector of much needed funding.
Exhibit 6 Public Sector Deficit as a % of GDP (1981 to 1991)
Year 1981/82 1982/83 1983/84 1984/85 1985/86 1986/87 1987/88 1989/90 1990/91
% 15.9 15.7 19.6 15.1 13.2 5.6 5.4 13.3 8.0
SOURCE: Trevor Evans, Carlos Castro and Jennifer Jones,, The Impact of Structural Adjustment Programmes on the public sector in Jamaica, Chapter 3, Structural Adjustment and the Public Sector in Central America and the Caribbean , 1995 (Cries, Managua,, 1995), Portion extracted from p. 113.
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(2.5) The Propensity to Borrow

A further element of the market distortions was manifested in the private sectors preference for borrowed funds as against equity financing. In fact, equity financing was virtually non-existent, as family owned and closely held enterprises preferred to operate closed shops. This not only meant a higher cost and more volatile funding to businesses, but greatly restricted development in the capital markets.
(2.6) Instability in the Foreign Exchange (FX) Market

Since the late 1970s, the FX regime had been the focus of reforms that sought to increase the extent of FX inflows into the formal system and stabilise the exchange rate. (see Appendix 3B for Developments in FX Market).
The Growing Black Market

The reforms were against the background of a black market in FX trading that slowly rose to prominence at end of in 1979, in spite of a period of relative stability in the exchange rate.
The growing ability of the black market to divert FX from the formal network attested to the non-market-clearing rate offered in the official system. In an attempt to ease the demand for US dollars in the official system and to reduce the dependency on the informal market, Special Retained Accounts were introduced during 1981. Special Retained Accounts allowed approved importers to hold foreign currency accounts in commercial banks. During the same period, no funds licences were issued by The Trade Board to allow payments for imports from balances (typically from export proceeds) sourced by the importer. With these licences, importers did not have to wait on the official system to fulfil their FX requirements. These proved unequal to
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the task of easing pressure for US dollars in the official system and lay the basis for a formalized parallel market.
The Parallel Market

The parallel market was introduced in January 1983. system of a fixed parity rate managed by the BOJ. This succeeded a The parallel market
entailed the co-existence of two rates - an official rate and a parallel rate. The official rate was set by the BOJ and used for all official debt transactions, essential imports and converting export proceeds. All remaining transactions such as business travel attracted a parallel rate of exchange determined by each commercial bank on a daily basis. In May of 1983, a CARICOM rate of exchange (fixed at US$1 to J$2.25) was introduced into the mix to be used in CARICOM transactions. The effectiveness of the parallel system was impeded by the fact that over time the parallel market placed increasing pressure on inflows still subject to an official rate. There also continued to be a wide disparity between the official and parallel rates (see Exhibit 7). Date 10/1/83 31/1/83 26/2/83 41/3/83 29/4/83 18/5/83 08/6/83 30/6/83 29/7/83 30/8/83 Official Rate($J) $1.78 $1.78 $1.78 $1.78 $1.78 $1.78 $1.78 $1.78 $1.78 $1.78 Parallel Rate ($J) $2.45 $2.76 $2.80 $2.75 $2.76 $2.76 $2.71 $2.71 $2.71 $2.96
Exhibit 7 The Parallel Market System Official & Parallel Rates (Jan to Aug 1983)
SOURCE: The Bank of Jamaica The Statistical Digest
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In November of 1983 all three rates (official, parallel and CARICOM) were unified at US$1 to J$3.00 and in March 1984, an auction regime was implemented. The auction system for establishing daily FX rates that was introduced in December 1983 remained in effect until October 1989. The system was successful at first, as there was a period of relative stability between November 1985 and April 1989 when the rate was approximately US$1.00 to J$5.50. However, all this time, pressure was building on external payment arrears that ultimately led to devaluation pressures. Instead of responding, the Government was insistent on its existing auction system. This facilitated the persistence of an unrealistic exchange rate and fed the growth of a FX black market. The growth in the black market was blamed on the publics loss of faith in governments ability to operate a FX market. The government eventually yielded and suspended the Auction system and adjusted the rate to US$1.00 to J$6.50 in November 1989. However, devaluation pressures continued and by 1 February 1990, the rate had depreciated to US$1.00 to J$7.00.
(3) The Exchange Control Act

The instability in the FX market was against the background of the Exchange Control Act introduced in 1954. The Act was a very restrictive piece of legislation (with rigid restrictions on both current and capital accounts) greatly impacting on the free play of market forces, the movement of FX in Jamaica and investment options of potential investors (see Appendices 3A and 3B). The Exchange Control Act was extensive in its reach and had far reaching implications. The Act impeded the development of financial markets in significant ways:
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(3.1) Restriction on Investment Flows

The Act prohibited investment inflows from abroad without prior ministerial approval. Further, the Act prohibited the transfer of securities (shares, stock, bonds, etc.) and coupons (represents dividends or interest on a security) to nonresidents without the permission of the Minister. The bureaucratic nature of this process discouraged many potential interests and the constraint, in itself, promoted inefficiency in the finance sector as there was no motivation for financial intermediaries to lower loan rates.
(3.2) Restrictions on Importers and Exporters

Up to the early 1990s, it provided only for exporters and importers buying and selling foreign currency through the official system (the BOJ and commercial banks). Exporters sold all their FX to the system, while importers were required to make applications to fill their requirements. As was shown, transactions were effected at rates managed by the BOJ and commercial banks acting as agents. As such, the rate obtained in the FX market was not truly determined by demand and supply.
(3.3) Restrictions on Dealing in FX

On 25 October 1991, an amendment to the Exchange Control Act provided for the following: The requirement that only authorised dealers buy, sell, borrow, or lend in FX unless approved by the Minister; and Persons buying, selling, borrowing, or lending FX may only do so through an authorised dealer. This was against the background that only commercial banks (a total of 11) were allowed to deal in FX up to 1 July 1991; as at July 1, 1991, two (2)
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building societies and two (2) merchant banks were added to the list of authorised dealers. This meant that up to 1991, local businesses had little opportunity to borrow in a foreign currency to benefit from a lower rate of interest and this was as a result of restriction on foreign inflows. Additionally, the system maintained the status quo and prevented the freedom of market forces to prevail in both internal and external markets. This impeded the development of the FX market.
(4) Arguments for and Against FX Controls

For all the restrictions imposed by the Exchange Control Act, there was still strong support for its existence. After all, most countries in the developing world at some point operated exchange controls. Proponents of the Act argued that controls prioritised how FX was allocated prevented capital flight and that a devalued currency was not necessarily beneficial. They insisted: 1. 2. 3. The importation of capital equipment, energy and food deserved priority over the acquisition of real estate and equities overseas; Capital flight would lead to a destabilised currency and by fuelling inflation, add to the Governments foreign debt burden; and Depreciation that was likely to accompany the abolition of controls would not lead to an improved visible account as exports and imports were not responsive to the exchange rate; the effects of depreciation on costs would be nullified by higher wages, and such could have contractionary effects. On the other hand, antagonists made a strong case against exchange controls in that they:
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1.
Sustained an overvalued exchange rate as the restrictive nature of the Act meant the existence of a exchange rate that was not truly marketdetermined and which, in essence, prevented the orderly operation and development of the FX market;
2.
Discouraged much needed foreign investment, partly because investors feared that they would not have been able to repatriate capital, and partly because rates of return in the trade sectors were depressed by an overvalued exchange rate; and
3.
Distorted the economy, favouring industries that were not exposed to foreign competition (for example financial services).
(5) Structural Weaknesses Japan and Jamaica Compared

Similar to the situation of distortions and inefficiencies that existed in Jamaica pre-liberalisation, the Japanese financial system (during 1950 to 1973) also had structural deficiencies. These included regulated interest rates, indirect financing, window guidance and administrative guidance, and segmentation and strict demarcation of businesses.
Interest Rate Regulation

In 1947, the Temporary Interest Rate Adjustment law was introduced to control all interest rates to facilitate the provision of low cost funds to select industrial sectors. This was similar to the system of subsidised credit and interest subsidies in Jamaica and resulted in collusion throughout the financial system, as interest rates were slow to react to supply and demand and their low-level resulted in excess demand for loan funds. legislation. The situation was controlled through non-price measures such as informal contacts and
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The policy of interest rate regulation had four (4) major effects on Japans system: High profit margins that were predictable and resulted in a fairly stable hierarchy within the system; Little pressure to reduce expenses and increase efficiency; Large banks being in constant negotiation with regulatory authorities who aimed to influence the flow of loan funds for industrial policy purposes; and Regulators allowing the banking system to define their own disclosure requirements through their trade associations. With the latter, disclosure requirements remained rather flexible as credit assessment was based on criteria rather than credit worthiness. Further, depositors did not approach banks on questionable business practices; while major shareholders were usually the borrowers of funds not interested in rigid disclosure requirements.
Indirect Financing and the Dominance of Bank Loans

The Japanese capital market in the period under review was small and regulated and corporations had no direct access to international finance. This was not unlike the Jamaican situation. The bond market was suppressed as government bonds were not issued on a large scale until 1973 and corporate bonds attracted somewhat-expensive funding because of regulation. Capital increases through stock issues were costly and trading in both stock and bond markets remained low until the 1980s. This was a plus for banking institutions, as there was no competition from loan customers wanting to access the capital markets. This situation effectively insured the maintenance of high interest spreads.
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Window Guidance
The excess demand for funds in the Japanese financial system because of artificially low rates resulted in a situation known as overloan where the total capital and deposit liabilities of banking entities fell short of loan demand. Consequently, banks had to borrow money from the Central Bank to make loans to the corporate sector making it easy to influence credit by a system of rationing. This took place in the process of window guidance, a subset of administrative guidance specifically geared towards the lending behaviour of commercial banks. (Administrative guidance being a quid-pro-quo approach that involves a system based on deals, favours, and reciprocal obligations). One effect of window guidance approach was that the hierarchy of the large banks remained unchanged because the Central Bank allocated credit based on existing market share. This affected the need for strategic management decisions, cost-cutting efforts, and competitive positioning. With window guidance, it was not obvious as to who would be responsible for failure in an environment where financial authorities had such a significant role in directing the lending behaviour of banks.
Segmentation of the Financial Industry

The Japanese banking structure up until 1993 was multi-layered. These included lines to separate commercial from investment banking, lines to separate institutions by functions such as size, location and/or profession of the customer) and lines to separate short-term vs. long-term lending among large banks.
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The existence of these clear lines meant that each bank category had their own laws special laws, detailed restrictions, and administrative guidance. In the supervision of these institutions however, the convoy approach was used. Under this system, the impact on small or weaker institutions was very important in deciding whether or not to implement planned changes. If it would negatively impact the institution, then the change would not be effected. With the well-regulated structure of the Japanese financial system, some banks, similar to the practice in Jamaica, moved business to non-bank entities. For example, when the financial authorities asked banks to reduce real estate loans in 1992, the banks obeyed on paper. In order to get around this situation, Japanese banks simply utilised their nonbank affiliates to continue booking loans. The result was a high concentration of very questionable loans in these entities.
(6) Summary
The structural deficiencies of the Jamaican financial sector were outlined in the foregoing sections and the characteristics of the Japanese system illustrated. Financial sector liberalisation measures, timing, etc are not only impacted by these distortions and inefficiencies, but also by the macro-economic environment. The following chapter examines Jamaicas economic background up to the early 1990s.
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CHAPTER 4
An Overview of the State of the Jamaican Economy
(1) Introduction
Chapter 3 provided important insights into the financial sector up to the early 1990s. This chapter examines the macro-economic environment of Jamaica from the 1960s up to the same point. The International Monetary Funds (IMFs) structural adjustment policies that commenced in 1977 are also discussed. Jamaicas relationship with the IMF actually commenced in 1973, but focus will be placed on the period of significant impact from 1977 to 1992.
The distortions and inefficiencies of the financial sector were against mushrooming economic difficulties. These difficulties commenced with a balance of payments crisis in the 1960s when, despite the buoyancy of the economy (high export earnings from tourism and bauxite), the country experienced a deficit on its current account that was covered from foreign inflows. There were other key developments. In 1972, the Peoples National Party (PNP) led by Michael Manley came to power and introduced a number of moderate social reforms. In 1974, however, it moved in the direction of democratic socialism. With this new ideology, the government tightened controls over the private sector and acquired a number of enterprises. them going. In time, the programmes of the PNP proved costly and the government had to resort to massive internal and external borrowing to keep
Further, in the 1960s, Jamaica was one of the worlds top producers of bauxite. However, a decline in demand for Jamaican bauxite and alumina and a government-imposed levy compounded difficulties being faced by the PNP
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government. As a result of the levy, taxes increased sixfold. Alumina production costs rose by US$30 per ton and made Jamaica, which was one of the worlds lowest-cost producers, into one of the highest.
(2) Economic Growth Declines

The period 1972-80 averaged negative growth in G.D.P. compared to an average in excess of 6% in the 1960s. This coincided with Governments increased share of G.D.P. Other key economic developments were: Unemployment climbing to 27.9% of the labour force; and Inflation in the period 1978-80 rising to 49%. According to Lalta and Freckleton (Caribbean Economic Development- The first Generation), it was during the period (1972-76) that Jamaicas economic crisis became entrenched.
(2.1) Factors Behind Economic Downturn

A number of factors were cited as being responsible for the economic difficulties. Some of these were external and included: Rising oil prices as a result of two oil shocks in 1973 and 1979; Declining terms of trade, for example, while Jamaica experienced higher rates of inflation than its trading partners, the exchange rate remained fixed making exports more expensive; Increasing debt service payments as a result of the growing public sector debt obligations; and Declining net capital inflows as a result of political violence and repatriation fears. The internal factors identified were:
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Structural imbalances manifested in the dependence on imports, a concentration of exports (bauxite and alumina) and production issues such as obsolete technology which limit the growth of exports; Domestic policies e.g. large money wage increases between 1973-76 and expansionary monetary and fiscal policy fuelled by the bauxite levy that resulted in inflationary pressures.
(3) Enter the International Monetary Fund (IMF) (3.1) The First Phase of IMF Policy Measures
With the deepening of Jamaicas balance of payments woes and a worsening of its FX reserve position, Jamaica had no choice but to enter into a Stand-by Agreement with the I.M.F. in July 1977. The arrangement was, however, terminated when the fiscal performance test was failed in December of that year despite the fairly lenient terms set out by the IMF. In 1978, new policy measures were implemented. The months following this new arrangement defined a new era in Jamaica. There was continued economic downturn with most of the performance standards not met. The country experienced unprecedented levels of political violence, and social instability that resulted in massive human and capital flight. The program was terminated in 1980.
(3.2) A Change in Government

The Edward Seaga Administration came to power in October 1980 and managed to arrange (under very favourable terms and conditions) a 3-year Extended Fund Facility in 1981. This facility and a World Bank structural adjustment loan in 1982 made up the new structural adjustment program. The program was aimed at the liberalisation of the economy and the diversification and expansion of exports.
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However, despite what has been described as favourable arrangements, Jamaica failed the September 1983 I.M.F. performance test and as a result had to implement much more rigid adjustment measures. Another stand-by agreement came into effect in 1984 followed by another in July 1985. On the heels of three subsequent failed tests, it came as no surprise when the program was suspended in September 1985. The relationship with the IMF did not resume until 1987 and continued up to 1995. IMF. The PJ Patterson government has since vowed not to enter into any other arrangements with the
(4) Structural Adjustment in Context

Structural adjustment in Jamaica can be broken down into three (3) important periods. These periods, 1977 to 1980, 1984 to 1986, and 1989 to 1992, were characterised by severe deflationary policies (i.e. policies aimed at reducing general price levels) in the system.
First Deflationary Period: 1977-80

In this first period, the IMF agreements included steep devaluation, wage guidelines, deregulating prices and large tax increases. However, despite massive price increases, a sharp fall in real wages, a decline in real consumption and a shift in distribution of income from wages to operating surpluses, the economic growth remained flat. Specifically, real GDP continued to stagnate, the overall current account deficit widened and fiscal expenditure and fiscal deficit continued to grow. The latter has been blamed for IMFs suspension of the second Standby Agreement at the end of 1979.
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Second Deflationary Period: 1984-86

In 1981, the new JLP government secured funding under very favourable conditions from the IMF. The loan was equal to 430% of Jamaicas IMF quota. The optimistic and unrealistic projections of the IMF led the World Bank to conclude that political considerations were more important. Between 1981 to 1984, the IMF loan was accompanied by other official loans and grants totalling US$2.1b. The growth projections for the 1981 IMF Agreement were not met. The
production of bauxite (Jamaicas principal export), sugar, and bananas were disappointing compared to projections. Government expenditure that was projected to decline from over 40% to 30% of GDP by 1983/84 did not budge. The overall public sector deficit, programmed to decline from over 15% to 10% of GDP, instead increased to over 19%. According to one study, The easy availability of finance delayed the pressure for structural adjustment. In March 1983, it was finally accepted that the targets would not be met and the programme was terminated in September. Following on this failure, the IMF Agreement in 1984 had extremely harsh measures. These included: The lay-off of approximately 20,000 public sector workers in one year A large devaluation, huge tax increases, high interest rates A reduction of bank liquidity Targeted reduction of the fiscal deficit from 19% to 7.5% in one year. These targets were not met and by 1986, Jamaica broke off ties with the IMF.
Third Deflationary Period: 1989-92

The year 1987 saw an upturn in the Jamaican economy. This was attributed to: An improvement in the terms of trade;
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A sharp fall in oil prices; The stabilisation of the exchange rate; and The closing of the fiscal gap Real GDP grew by 5.7% and the trend was expected to continue in the following year. Major economic dislocation caused by Hurricane Gilbert in September 1988 killed these expectations. The overall public sector deficit grew from 5.4% to 13.3% of GDP. This was blamed on low utility revenues as a result of the hurricane damage. Other consequences included a surge of demand for FX and insurance reflows were less than anticipated. As a result in 1989, the country faced a fiscal bind. The IMF Agreement was cancelled in September.
Sector Electricity Services Education Health Agriculture Tourism Water Exhibit 8 $580 million
Estimated Damage (J$)
$388 million damage to schools $75M to repair health & hospitals $1.3 billion $20 and $236 million to airports and hotels respectively $60 million
Damage by Hurricane Gilbert, September, 1988 (Jampress News Release, Sept 26, 1998)
SOURCE: Carl Stone, The Run-Up to Elections, Chapter 5, Politics versus Economics, 1989 (Stephensons Litho Press Limited, 1989), Figures extracted from ps. 98 - 101
After the cancelled agreement, another period of severe stabilisation began. This included a target to reduce the fiscal deficit by 6.5% in one year, high interest rates, a continuation of wage guidelines, new taxes including a payroll education tax, and a removal of subsidies causing basic food prices to increase up to 50%.
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Again, the performance test conducted in March 1990 revealed that some targets had not been met. In particular, the net international reserves fell short by US$7m. In March 1991, with the economy growing by an average of 2.5% over the latter part of 1990 and early 1991, Jamaicas fortunes turned and the performance tests were passed fairly comfortably. In June 1991 a Standby agreement was entered into followed by a 3-Year Extended Fund Facility in December 1992. There was some dispute as to whether or not Jamaica had passed the IMF test of 1992. For the year, inflation was over 40% and the growth rate, a mere 1.5%. Further, during the year, there was steep devaluation with the Jamaican dollar trading as high as US$1 to J$30. Through the intervention of private sector interests by selling additional FX into the system, the rate at year-end was US$1 to J$22.96.
(5) Summary
As outlined then, it was structural adjustment in 1981 that called for the liberalisation of the Jamaican economy. The actual process of financial sector liberalisation commenced in 1985 and is thoroughly examined in the next chapter.
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CHAPTER 5
Liberalizing the Jamaican Financial Sector
During the past decade, there has been a distinct world-wide trend towards financial liberalisation. Both developed and developing countries have seriously considered and extensively adopted various measures to this end. Dr. Samuel Shieh, Delicate Art of Monetary Policy, 1 September 1996.
(1) Introduction
This chapter reexamines the actual process of financial sector liberalisation in Jamaica. The two (2) phases taking place up to 1992 and new banking regulation and other legislation introduced by year end are discussed. Further, liberalisation measures introduced in 1992 to 1995, and deregulation in Japan, and the background to its the ensuing banking crisis complete this chapter.
(2) Structural Adjustment Defined

According to Lalta and Freckleton, Caribbean Economic Development The First Generation, a structural adjustment package refers to a set of programmes and policies designed to diversify a countrys economic base so that it is able to respond effectively to changes in internal and external market conditions. Structural adjustment programmes introduced in Jamaica were as a result of domestic policymakers and the IMF realizing that reversal of economic decline and achievement of viability of balance of payments required structural changes in the economy. One of the ways in which this could be achieved was through the process of economic liberalisation.
(3) The Objectives of Liberalising the Jamaican Finance Sector

Finance sector reform was aimed at eliminating distortions and inefficiencies that impacted negatively on the efficient allocation of resources in the sector. By
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Liberalising the Jamaican Financial Sector
effectively dealing with these elements and making the financial intermediation more efficient, economic growth could take place at a much faster pace.
(3.1) Liberalisation Objectives The First Phase

The first phase of financial reform in the Jamaican context (commencing in 1985) was primarily focused on: The separation of monetary and fiscal policies; The elimination of market distortions in the financial market in allowing for the free interplay of market forces in determining interest rates and allocating financial resources; and Promoting the development of more efficient financial intermediation.
The Separation of Monetary and Fiscal Policy

The entanglement of monetary and fiscal policy affected the BOJs ability to manage money and credit in line with the structural adjustment programmes of the IMF. This was as a result of the existence of asset ratios credit ceilings, sectoral credit allocations, and interest subsidies previously alluded to. These management tools distorted credit allocation and the interest rate structure by pushing up rates on loans to the private sector in order to compensate low rates to the public sector. The situation was compounded by the fact that the means to these funds the liquid assets ratio presented a captive market to the public sector and in doing so retarded the development of the capital markets and imposed a quantitative credit restraint to the private sector. By separating the two, government could have greater clarity in its management of the economy. In particular, with greater emphasis on monetary policy, open market operations by the Central Bank would become the mainstay in the management of liquidity in the system. Under
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open market operations, credit allocation would not biased by giving priority to certain sectors and the interest rate.
Freeing-up the Interest Rate Structure

Liberalisation of the interest rate structure was an important aspect of the reform program. This would pull in more savings from abroad and significantly boost foreign investment and ultimately contribute to economic growth. The main emphasis was on removing the floor rate on savings deposits and allowing commercial banks to set their own rates.
Making Financial Intermediation More Efficient

The predominance of non-financial instruments in the Jamaican financial sector, namely credit ceilings and asset ratios was discussed. It was noted that with credit ceilings, some banks were circumventing the restrictions by shifting a part of their portfolios to non-bank affiliates. This made for inefficient financial intermediation as the practice ran counter to governments policy and intentions. While government would have been seeking to limit credit expansion, commercial banks were surreptitiously doing the opposite. Financial reform to ensure the proper evaluation, monitoring, and supervision of financial intermediaries would, in essence, eliminate these distortions.
(3.2) Objectives of the Second Phase The FX Market

The main objectives of the second phase of liberalisation were to facilitate a more orderly FX market and promote its development. greater stability in the exchange rate. A more orderly operation would lead to magnified flows of FX into the formal system and
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(4) The First Phase of the Liberalisation Process

Focus on Monetary Policy The gradual reduction of the liquid assets ratio of the commercial and merchant banks commencing 1986 was a part of the first phase of the liberalisation process. This reduction continued until 1990.
COMMERCIAL BANKS 1985 01/05/86 26/03/87 27/01/88 24/02/88 24/03/88 01/07/89 01/04/90 01/05/90 01/11/90 01/07/92 15/06/95 LIQUID ASSETS RATIO (%) 48 44 35 30 25 20 20 25 27.5 32.5 50 47 MERCHANT BANKS: 1985 01/05/86 26/03/87 27/01/88 24/02/88 23/03/88 01/07/89 01/04/90 01/05/90 01/11/90 01/12/90 01/01/91 01/10/91 01/05/92 01/07/92 01/10/92 01/01/93 01/04/93 01/07/93 01/09/93 01/08/95 01/11/95 LIQUID ASSETS RATIO (%) 25 20 18 13 9 5 4.5 7.5 7.5 8 8.5 9 9.5 11 12 13 14 15 16 17 20 25
Exhibit 9 Liquid Assets Ratios for Commercial and Merchant Banks 91985 to 1995)
SOURCE: Bank of Jamaica The Statistical Digest
As is evident in Exhibit 9, however, reduction of the liquid assets reserve ratio was not sustained and was, over time, brought back to pre-reform levels. In addition to a reduction in liquid assets ratio, the non-cash portion was phased out over time. In 1984, the cash reserve ratio stood at 5% and by 1985 it had increased to 20%.
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The Use of Treasury Bills and other Instruments

Between 1985 and 1991, treasury bills became increasingly significant as a financing instrument with the elimination of the non-cash portion of the reserve requirements. deficit. Also, in 1991, Reverse Repurchase agreements were introduced to provide the BOJ with more control over the money supply. Simultaneous with the introduction of these instruments was an initiative by the BOJ to create a secondary market in Government of Jamaica/BOJ Securities. Treasury bills were used to finance the public sector
Liberalising the Interest Rate Structure

The introduction of a more market-determined interest rate took the form of: The BOJs introduction of a market-determined interest rate on Certificates of Deposit in November 1985; The linking of the savings deposit rate to the average weighted term-deposit rate of the commercial banks (the floor on the savings deposit rate was removed in October 1990).
Improving Efficiency of Financial Intermediaries

In order to promote more efficient financial intermediation, the BOJ embarked on a comprehensive review of the Bank of Jamaica Act, the Banking Act and the Protection of Depositors Act. This was aimed at initiating reforms where necessary. In 1992, the revised versions of these Acts were passed into law.
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(5) Banking Reform

Legislation introduced to ensure the sector was able to cope and continue to foster and support the development of the Jamaican economy. (see Appendix 2)
Overdraft Facilities
Up to the early 1990s, many companies borrowed by way of overdraft. This was a very expensive form of funding. Here it was contemplated that heavily indebted, under-capitalised companies be encouraged to service debt more regularly by converting overdrafts to fixed term loans. This form of cash flow lending placed serious pressures on the cash flow of companies.
Interest on Non-Performing Loans

Where interest on non-performing loans was concerned, the amendments required reversal of interest accruals from income where payments were three months in arrears. This significantly impacted the profitability of banks.
Limitation on Lending to Connected Parties

Limitation on lending to Connected Parties also hit bank profits hard. Whereas before the banking sector made loans without regard to connectivity, this legislation that took a very broad view of the definition of connected party, added a new dimension and significantly curtailed lending activity. In addition, the power of the Minister of Finance was further enhanced allowing the Minister to take action where there was evidence of a threat of unsafe or unsound banking practices. This included cease and desist orders, temporary management of a licensee, suspension of licence, as well as, the revocation of a licence or the liquidation of a licensee in instances of unsound practices.
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To further enhance the capacity of the BOJ to effectively monitor and supervise the financial system, the Department of Supervision of Banks and Financial Institutions was upgraded and strengthened with the primary objective of promoting the stability of the financial system.
(6) Regulation of the Securities Industry

In 1992 also, the Securities Act was introduced. Through the Securities Commission, this was designed to regulate the stock exchange, trading in Government debt instruments, the developing mutual fund market and formalising a system to monitor the growing stock of IOUs. Changing securities legislation in liberalised markets was not unique to Jamaica. For example, in Thailand, where the process of liberalisation began in the early 1990s, the Central Bank (the Bank of Thailand) introduced the Securities and Exchange Act to facilitate the development of the capital market.
(7) The Second Phase - FX Liberalisation The Introduction of A and B Accounts

FX Liberalisation in July 1990 saw the removal of relevant sections of the Exchange Control Act that restricted the operations of foreign currency accounts by residents and non-residents. This meant commercial banks could, from then onwards, accept foreign deposits accounts designated A and B in keeping with certain guidelines. (see Appendix 2). This was an aspect of the process of external liberalisation where foreigners had freer access to Jamaicas financial markets (in particular the money markets). A accounts were denominated in foreign currency, while B accounts were converted to a domestic currency equivalent, but attracted a local currency interest rate apparently with exchange rate risk in mind.
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The Inter-Bank FX Trading System

The Inter-Bank Trading System was introduced in September 1990 and involved the merger of the official and forward markets. This new system which was operated by commercial banks on behalf of the BOJ, was designed to stimulate the FX competitive market free of government influence. In essence, each commercial bank was authorized to set its own rate and act as clearing house for FX transactions. Two exchange rates prevailed. The spot market related to all transactions completed in two working days, while the forward market related to transactions taking in excess of five working days. Commercial banks were free to dispose of all their purchases except a specified amount (25%) that went to the Central Bank. With the Inter-Bank Trading System, exporters sold their FX to commercial banks at negotiated rates. This was particularly beneficial to traditional Despite all these exporting industries (bauxite, agriculture and tourism).
changes, however, restrictions still existed, as bidders on FX required proof of purchase or order and approval from the BOJ or a commercial bank. With FX liberalisation in train, the slide in the value of the Jamaican dollar continued. In fact, the Jamaica Bankers Association (JBA) introduced new operating rules on 1 June 1991, which were designed to slow the depreciation in the exchange rate and encourage a more efficient FX market. Within these new rules, commercial banks set their own rates within a predetermined range on a daily basis.
Final Removal of the Exchange Control Act

Prior to 25 September 1991, some of the remaining aspects of exchange controls were:
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The requirement that non-residents gain exchange control approval before purchasing real estate; Limits on current account transactions such as vacation travel and business travel; BOJs claim to FX proceeds from identified exports; The need to gain ministerial approval for investment inflows. Restriction of FX trading to Authorised Dealers - chiefly commercial banks1. After 25 September 1991, the decision was taken to remove the remaining aspects of exchange controls. This essentially meant foreign and domestic currencies became interchangeable as the accepted medium of exchange. The removal also had significant implications for Jamaicas current account (trade in currently produced goods and services) and capital account (difference between domestic outflows and foreign inflows on asset purchases).
The Process of External Liberalisation

The introduction of A and B accounts described earlier allowed nonresidents to access the Jamaican financial markets with greater freedom; while the removal of the restrictions of foreign inflows opened up foreign markets to Jamaicans. For the first time, Jamaican entities could borrow on the international market with relative ease as long as certain criteria (specific to the lending institution) were met.
(8) Further Liberalisation Measures (1992 to 1995) Repealing the Exchange Control Act
In April 1992, it was announced that the Exchange Control Act was to be abolished once and for all. This was important, as even though the provisions
See Appendix 3A 40
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of the Act were removed, Government still had right to impose restrictions at any time as the law was still on the books. The removal of the Act meant that once and for all there was no restriction on movement of FX in Jamaica. In August 1992, the Exchange Control Act was repealed (see Appendices 3B).
Continued Development of the Financial Markets

In 1993, the BOJ continued with its initiative to develop the financial markets. Special emphasis was being placed on the secondary market for GOJ/BOJ instruments. This included increasing the range of instruments that could be used in Repurchase agreements (REPOS) and the removal of the limit (2 per month) to the number of REPOS that could be granted to each financial institution per month. In a REPO arrangement, the BOJ contracts to inject liquidity into the system via holders of securities. Reverse REPOS where holders of securities contract to purchase instruments from the BOJ and resell them to the BOJ at some point in the future also became popular. The BOJ was committed to the strengthening of a secondary market for securities for the following reasons: Better transmission of monetary policy measures through the economy and thus improvement in the effectiveness of monetary policy; Easier portfolio adjustment by financial institutions thus reducing reliance on the central bank to adjust their liquidity position; An opportunity for further institution building in the financial sector;
The development of a genuine market-based pricing.
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Foreign Currency Instruments

Another major development in the financial markets was the diversification to include transactions in foreign currency instruments. In September 1993, the Government of Jamaica placed on the market a US$20M bearer bond issue. This bond issue was a means of obtaining foreign currency financing, while simultaneously introducing a new financial instrument to the local money market.
The Introduction of Primary Dealers

Following on the introduction of reverse repurchase agreements by BOJ (mentioned in Chapter 4), it sought to further develop the financial markets by establishing a group of primary dealers in April 1994 to provide underwriting support for all new Government of Jamaica securities and to provide secondary market liquidity. This move was an important step as the BOJ sought to lengthen the maturity of securities issued in the market. Candidates for primary dealer status had to demonstrate strong characteristics of being market makers. Seven (7) dealers were initially chosen.
New Authorised FX Dealers and The Introduction of Cambios

Further liberalisation of the FX market was designed to improve the volume of FX flowing through the official system. This involved the introduction of new authorised FX dealers and Cambios/Bureau de Change system in 1994. The introduction of a network of Cambios/Bureau de Change in the rural and tourist areas was particularly important. This expansion would unify the exchange rate, increase the volume of FX flowing into the official system, provide the basis for dealing with tourist harassment and illegal FX trading, and increase efficiency in the market.
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Cambios No. of Cambio applications No. of applications approved Cambios in operation Cambios not in operation No. of application pending Application rejected 76 13 1 63 153 139
Bureaux de Change No. of Bureaux applications No. of applications approved No. of applications pending 92 3 95
Exhibit 10 The Status of Applications and Approvals of Cambios and Bureaux de Change
SOURCE: Bank of Jamaica Annual Report 1994
PURCHASES FROM CAMBIOS/BUREAUX de CHANGE BY BANK OF JAMAICA (US$M) 1994
Apr 1.05
May 1.75
June 5.21
July 26.84
Aug. 35.20
Sept. 34.40
Oct. 19.35
Nov. 2.96
Dec. 28.03
Total 179.79
Exhibit 11 Purchases from Cambios/Bureaux de Change

The introduction of Cambios/Bureau de Change was significant in that by the end of the first year, they already controlled 14.6% of the official flows into the FX market. The other 85.4 %, of course, being controlled by authorised dealers. The increased competition, in time, negatively affected the profitability of these dealers.
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(9) Deregulation of the Japanese Financial System

After the first oil shock, some of the basic structural features of the Japanese financial system began to unravel. First, the recession of the 1970s led to the government to a large-scale issue of deficit-financing bonds. This resulted in the development of the bond market, as the government had to lower the restrictions on dealings in bonds to make them more marketable. The recession also led to corporations investing their funds in securities firms repurchase agreements. regulation law. With the option offered by these securities firms, banks began losing their corporate customers and as such started to lobby for a interest-free instrument themselves. This developed into a confrontation between banks and securities firms. This was similar to the situation in Jamaica, where unregulated financial institutions were able to offer repurchase agreements at much higher yields to investors and the funding was not subject to reserve requirements. The deregulation of the Japanese financial system brought about changes to the features of indirect finance and bank dominance was also affected. The revision of the Foreign Trade Law in 1980 and a relaxation of restrictions on financial transactions in international financial markets led to an increase in bond issues by Japanese firms in Europe. This was a part of Japans process of external liberalisation. The process resulted in a movement of corporations away from financing through banks and towards direct means of financing. Again, unregulated institutions in Jamaica through IOUs offered a similar option to corporations. These agreements had not been included in the interest rate
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Japans economic background

The period from 1963 to 1973 when deregulation started was a high growth period for Japan with growth rates average about 10%. During this period, its trade balance averaged out at zero. Japans growth in this period was not fuelled by external borrowing but from an internal drive supported by the diligence and a collective sense of direction toward prosperity for her people. In the years following, 1974 to 1982, the world was bothered by the oil crises and Japans growth rate was reduced to 5% with its trade balance still averaging out at zero. Over the period 1983 to 1990, a huge trade surplus was built up by Japan but growth rates remained between 3 and 5%. Over this third period, Japans strength was such that even with the erosion of its wealth as a result of ballooning surpluses, a relatively strong growth rate was maintained. This erosion, however, in due time took its toll.
Economic Instability in the Early 1980s to 1995

While the process of deregulation was in progress from the early 1970s, developments a decade later asked serious questions of the process. In the early eighties, the United States was emerging from a period of very high inflation and was positioned to grow economically. economy as experienced today: The borrow and spend policy of the Reagan administration which expanded the American trade deficit enormously and thus introduced the era of worldwide capital flow; and The emergence of Japan as the major lender of the world who supplied the capital desired by the United States of America.
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Two important
factors appeared on the world economic scene that ushered in the global
As a consequence of the introduction of these factors America imported, borrowed, and spent into prosperity; while the dollar was kept strong by very high real interest rates due to the relentless appetite of the American Government to access the financial market to borrow funds. This strong US dollar stifled the manufacturing sector and resulted in a complete turnaround by the Reagan administration.
The Plaza Accord

At a meeting between America and other industrialized nations, now known as the Plaza Accord, an enormous devaluation of the dollar against the yen was engineered. This resulted in a sharp fall in the value of the dollar from around 250 yen per dollar, to around 125 yen per dollar by the beginning of 1988.
Japans Reaction
After the Plaza accord, Japan was urged to stimulate domestic consumption. As the Japanese economy grew domestically, Japan moved to have savings spent internally, which resulted in less capital outflow and less trade surplus for Japan. The consumption boom was not able to keep pace with the monetary expansion due to the everlasting meddling of Japanese authority over the markets and also due to the existence of various trade barriers to retard the free flow of imports.
The Economic Bubble

The excess cash resources flowed into equities and real estate causing prices to climb to dizzying heights; thus, the infamous Japanese economic bubble was formed. Concerned about the consequences this enormous bubble and the reckless lending of Japanese banks induced by the bubble mentality, the
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Japanese authorities took corrective measures in 1990 that resulted Japanese economy falling abruptly. With this fall, capital flowed out of Japan like it did previously and the trade surplus expanded in line with this development. The authorities were to find that they were late in acting as in 1995, the bubble economy came home to roost.
(10) Summary
The foregoing sections outlined the liberalisation process in Jamaica and also looked at the experience in Japan. Jamaica as was seen, embarked on a radical process designed to free both internal and external markets. The result was radical change in the Jamaican financial sector, which culminated in its eventual ruin. The following chapter details the persistence of macro-economic instability and the changed financial system.
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CHAPTER 6
The Economic Environment and the Financial Sector (1992 to 1995)
(1) Introduction
Chapter 6 examines the economic environment and developments in the financial sector from 1992 to 1995. The bad debt crisis experienced in Korea and Japan are discussed with particular emphasis placed on the Japanese experience. The chapter provides important insights into the looming crisis in the Jamaican finance sector.
(2) Post-Liberalisation Trends (1992 -1995) (2.1) The Persistence of Macro-economic Instability
By 1995, the formal liberalisation process had essentially run its course. However, the programmes that were designed to improve the allocation of resources and to spur economic growth were being blamed for the economic ills being faced by the country. In particular, interest rate policy was erratic with the overall level of rates in the system remaining at very high levels; treasury bill rates climbed to as high as just under 40% and to compound the situation, inflationary pressures remained high, thus ensuring the persistence of financially repressive conditions. For example, inflation rates, while declining from just over 40% in 1992, averaged in the high twenties over the period, resulting at times in a negative real rate of interest to investors. FX inflows were redirected from the official to the informal market and the liberalisation of the FX market did little to stabilise the rate of exchange. This was manifested in the drastic movement in the exchange rate from US$1 to J$23.01 at the end of 1992 to US$1 to J$35.54 at the end of 1995. The high interest rate
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The Economic Environment and the Financial Sector 1992 to 1995
regime was largely a result of Governments attempts to halt the precipitous decline of the Jamaican dollar. Over the period 1992 to 1995, Growth in GDP remained flat (averaging just over 1%). The debt service ratio remained at the high levels reached in 1992 declining to 118.5 % of GDP in 1995. A positive development, however, was despite continuing concerns with the balance of payments position, the net foreign reserves position grew to just over US$400m from a negative position of over US$250m in 1992. Macro-economic instability affected financial institutions and other market players alike. While the volatile conditions were sometimes a recipe for making huge profits, it prevented long-term planning and the high interest rate regime, in particular, eroded the profitability and ultimately the capital base of many borrowing institutions.
(2.2) Developments in the Jamaican Financial Sector Overall Growth

As the FSRP began to take hold in the mid-1980s, the Jamaican financial sector began to grow at great pace. In 1986, the sector recorded its highest rate of growth at 20.6% (See Exhibit 12 below):
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Year 1987 1988 1989 1990 1991 1992 1993 1994 1995
Growth (%) 9.3 16.9 20.6 10.5 19.4 8.0 -6.6 49.9 -2.2
Contribution (%) 6.8 7.8 8.8 9.3 11.0 11.7 10.7 15.9 15.5
Exhibit 12 Rate of Growth and Percentage Contribution of Financial Sector to GDP at constant 1986 Prices
The Commercial and Merchant Banking Sectors

Commercial and merchant banks experienced the greatest expansion within the sector. From a total number of 18 with total assets of JA$8.9b at the beginning of the mid-1980s, the sectors expanded to a total of 41 with assets in excess of J$64b by the early 1990s. picture.
COMMERCIAL BANKS 1994 RAG (%)* RDG (%)* 54 50 1993 32 38 1992 70 88 1991 60 47 1990 13 19 1989 22 10 1994 36 4 1993 2 11 MERCHANT BANKS 1992 73 98 1991 30 9 1990 22 12 1989 33 23
The percentages below paint the
RAG Rate of Asset Growth RDG Rate of Deposit Growth
Exhibit 13 Rate of Asset & Deposit Growth for Banking Sector

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Commencing in 1992/92, merchant banks grew because of the low capital base requirements2, the lack of supervision from the regulatory bodies, and the rapid expansion of unsecured credit (IOUs) to commercial entities and to a lesser extent, individuals, commencing in 1991/1992. In addition to the advantages cited, the liquid reserve requirement was lower for merchant banks than it was for commercial banks.
Financial Institutions Diversify

From even before the early 1990s, Jamaican financial institutions embarked on a path well known to their counterparts in other countries. They began to move away from their core businesses. Popular areas of departure were agriculture and real estate development (hotels and residential homes). The National Commercial Bank, for example, invested heavily in agriculture such as the growing and exporting of papayas to the North American market. This was in part based on government initiative to have companies, especially those over which it had some control, become involved in projects that could contribute to national development. Additionally, the concept of financial supermarkets became
commonplace as entities such as the Eagle Group expanded rapidly into insurance and commercial banking. Eagle, which commenced operations as a merchant bank, also owned a unit trust, a stock brokerage and a building society. This form of structure, while helping with efficiency and allowing rapid expansion, was to prove deadly in time to come. Diversification in a competitive environment brought about by liberalisation is sometimes necessary for survival. In the South Korean example, diversification
Merchant Banks JA$5M, Commercial Banks JA$40M up to 1992: JA$25M and JA$80M respectively, after 1992
2
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was permitted by Revised Banking Acts but along more stringent lines than those seen in Jamaica. For example, banks, inter alia, were allowed to: Underwrite corporate bonds for private placement; To lead manage underwriting of public and government bonds; Handle some long-term financial business such as housing loans; and to Issue debentures that were only previously issued by long-tern financial institutions.
Profitability Declines
The years 1993 and 1994 saw banks making supernormal profits, to the extent that in 1994, a surtax (discussed below) was levied by the Minister of Finance, Dr. Omar Davies. To give a better appreciation of the level of profitability, profits made in the first half of 1994 were almost equal to that made in all of 1993 which was a record year. In essence, banks were operating very high interest spreads that were not being passed on to savers. While this was true, the gains made by commercial banks from FX trading in the newly liberalized market were also enormous. Additionally, as the secondary market for trading in government securities grew, merchant banks began trading heavily in derivatives. Countries such as Thailand and South Korea like Jamaica, both experienced increased trading in derivatives albeit in more sophisticated forms. In the Jamaican context, this essentially entailed issuing repurchase agreements against underlying government securities. This form of new activity added to the bottom line, but, in time, became a dangerous practice as some players sometimes issued multiple agreements against the same set of securities with the market not being rigid in having underlying securities delivered for safe keeping. As a result, settlement risk became a big problem in the banking industry.
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Commercial Banks YEAR %* 1995 43 1994 68 1993 57.4
Merchant Banks 1995 17.4 1994 28.4 1993 16.2
* Return on Average Capital Employed Exhibit 14xhibit 13

Record Levels of Profitability for Commercial Banks and Merchant Banks 1993 1995
SOURCE: Bank of Jamaica Annual Report 1993 - 1995
The record levels of profitability attained in 1993 and 1994 were, however, short lived as shown in Exhibit 14. The reasons advanced for the decline in profitability include:
Increased Competition
This came from newly introduced Cambios/Bureau de Change in 1994 that affected profits made by authorised dealers from FX trading. Also, the growth in unregulated institutions (examined below) did much to steer business that would have gone to either commercial or merchant banks.
The Surtax of 1994

The Surtax levied in November 1994 on the banking sector was against accrued profits. The tax represented a levy of 23% on four months profits (unadjusted for tax purposes paid in two instalments). The actual cash payment into government coffers was a serious drain on the actual cash flow of banking institutions. In addition, as bad debts grew, banks were forced to write-back profits on which they were taxed. In essence then, banking institutions suffered from a levy on profits they ultimately did not make which affected negatively the profitability of these entities.
Other Factors Affecting Profitability

The stock market crash and the growing bad debt portfolio of banks also adversely affected profitability in the banking sector. Both of these are
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described below.
The overall average GDP growth of just over 1%
dampened financial activity.
Funding Trends
The period from 1990 to 1995, as mentioned previously, was characterised by the highest interest rates that the Jamaica had seen and interest rate policies that changed with the wind. This essentially forced the market into shortterm posture so as to minimise exposure. The unavailability of long-term funding put financial institutions at great risk as the short-term funding was not only expensive but posed a serious liquidity threat in the event of a run.
The Paper Chase

During 1992, commercial paper (IOUs), as a means of providing financing to cash-starved institutions, became popular. While commercial banks were active to a certain extent in the commercial paper market, merchant banks and unregulated financial institutions were dominant. Commercial paper as a source of financing was useful in that it provided a break from expensive overdrafts and provided an avenue for so-called blue chip companies to borrow at significantly lower interest rates. With the unregulated nature of the market, just about anybody borrowed through the commercial paper financing vehicle. Between 1994 and 1995, when the commercial paper market was at its peak, the total outstanding balance was estimated at J$4b. For a time, the growth in this new business area contributed substantially to the bottom line of lending institutions.
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However, with the continued harsh economic conditions, issuers of commercial paper found it increasingly difficult to meet payment obligations on largely unsecured debt. Unsuspecting investors who did not realise their direct participation in these instruments were made to feel the brunt of these losses.
The Growth in Off Balance Sheet (OBS) Portfolios

Another development in the banking sector was the growth in off-balance sheet portfolios. OBS banking involves taking positions (typically non-cash) that are not accounted for on the conventional balance sheet. an expansion in this kind of banking as a result of: (i) (ii) Investors who were unwilling to have withholding tax deducted from interest earned on their investments; and Bank of Jamaicas cash reserve requirements that made traditional deposit-taking unviable. Interest on Certificates of Deposit issued by commercial and merchant banks had been subject to withholding tax at a rate of 33 1/3%, individuals and corporates alike. Merchant banks in 1987/88 gained increased popularity and sought to increase the size of their balance sheet by offering alternate products such as debentures to circumvent the withholding tax requirements. The legal argument was that debentures were short-term debt instruments not covered under the Income Tax Act and not addressed in the Protection of Depositors Act; and as such, merchant banks were not obliged to withhold tax. Certificates of Deposit, on the other hand, were dealt with in both pieces of legislation. There was
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Another popular means of circumventing withholding tax requirements was the use of Industrial and Provident Societies. These are a form of legal vehicle of some antiquity, governed from 1972 century legislation and were originally designed to encourage groups of individuals to associate together to engage in business and provide welfare benefits for their members. These entities which were set up by banks and other financial intermediaries were under the law not mandated to withhold tax on interest paid. When legislation eventually brought debentures under the withholding tax net (1992), merchant banks again moved to a new instrument in the form of Cash Management instruments which were pooled investments with the rate of return to the investor unguaranteed. Legal opinion maintained that it was the guarantee on instruments that made them subject to withholding tax. In 1993, the withholding tax for individuals was reduced to 25% to discourage banks from creating instruments and other means to assist investors in evading withholding tax and to improve the taxation net. This was, however, to no avail. Another instrument - a Certificate of Participation where an investors funds would be charged against a specific and identified asset held by the institution - was introduced. In order to avoid scrutiny by the BOJ and onerous cash reserve requirements, these portfolios were moved off balance sheet. This activity, in time, was to be a part of the banking sectors undoing as the regulatory bodies were unable to monitor the quality of assets held in these off-balance sheet portfolios. Further, institutions were at times required to extend guarantees to investors in their off balance sheet portfolio thus compromising their capital base, but were not required to reserve against these contingent liabilities.
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Flawed Credit Processes The credit process was seriously flawed in some institutions. In particular, the perfecting collateral arrangements was taken for granted, staff could borrow amounts way beyond normal staff lending limits against weak security, and loans extended for tenors much longer than funding structures could support. Additionally, the banking sector at times fell prey to the halo effect. It was not unusual for politicians or other prominent members of the community to access loan facilities under questionable terms and conditions.
The Burgeoning Bad Loan Portfolio of Lending Institutions

Lending institutions significantly increased their portfolio size from the early 1990s to the mid-1990s. This growth was facilitated through the financing of real estate purchases and motor vehicle loans. These institutions were also very involved in project financing for the development of real estate (hotels and apartment complexes). With financial sector liberalisation in full swing, but without any significant improvement in the broader economic conditions, companies and individuals found it increasingly difficult to meet outstanding loan payments. The period 1990 to 1995 saw punishing interest rates with record levels being recorded in the years 1992 to 1995. (See Exhibit 15 below): End of Period 1990 1991 1992 1993 1994 1995 Exhibit 15 Loan Rates 1990 to 1995
Average Weighted Deposit Rates 24.50 27.50 23.00 39.80 27.85 26.22
Instalment Credit Rates (%) 29.78 33.09 45.07 49.59 55.04 60.93
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One of the reasons for the high interest rates was the governments monetary policy specifically high reserve requirements that were used as a part of the overall demand containment strategy. The high reserve ratio (which was part cash held with the BOJ at a zero rate of interest) essentially forced banks to lend at very high levels in order to cover costs and ultimately return a decent spread (this effect was previously discussed). Spreads shown in Exhibit 14 were arguably wide. High loan rates eventually turned good customers into delinquent borrowers. To compound the problem, new banking regulation meant that lending institutions were forced to write back income on loans over three months in arrears and reclassify as non-performing. The growing non-performing loan portfolio significantly eroded bank profits and resulted in increased vigilance from the Central Bank, even though it was well known at the time that they were limited in resources. Public jitters began to grow. The chart below illustrates the extent of the non-performing loan portfolio of select commercial banks.
Institution Bank of Nova Scotia Century National Bank Citibank N. A. Citizens Bank CIBC Island Victoria Bank National Commercial Bank Trafalgar Commercial Bank Workers Group TOTAL
Loans (after provision) JA$b 20.00 3.70 2.00 1.20 3.10 1.40 24.80 0.33 1.90 58.43
Non-performing Loans JA$b 1.10 2.30 0 1.70 N/A 0.80 13.50 N/A 4.70 24.10
Provision JA$b 0.90 0.70 0 0.07 0.10 0.03 0.30 0.03 4.70 6.83
EXHIBIT 16 Non-Performing Loans of Select Commercial Banks July 1998
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Like Jamaica, the bad debt problem was also a feature of finance sector liberalisation in South Korea. From 1990 to 1993, bad debts in domestic banks grew continuously. In 1990, bad debts stood at 19,103 million won, and in 1993, 29,551 million won. The figure fell to just under 22,944 million won in 1995 but only because bad debt expenses increased substantially.
(3) Japans Bad Loan Crisis

In Japan too, bad debts were a major problem. In 1995, total bad loans were in the region of 70 trillion yen. The causative factors could be grouped in three categories: Improper bank management and the circumvention of rules (such as exceeding limits on loans to one customer, reckless real estate lending, superhigh interest rates, bicycle loans, non disclosure and false accounting; Relationship Business (referred deposits, referred loans, risk shifting to nonbanks); and Fraud (insider trading, Mafia connections, bribery).
(3.1) Improper Bank Management Exceeding Credit Limits

Activities listed are regulatory breaches. These were as a result of: Regulators not knowing about the violations, because of non-disclosure or sloppy investigation; and secondly and more likely The regulators having knowledge of breaches, but not wishing to enforce rules for fear of having to address the underlying structures of the banking system. In many instances breaches were carried over from former mistakes or old regulation that proved to be problematic in an environment of competition with large banks.
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Reckless Real Estate Lending

The problem of reckless real estate lending was not only a product of the bubble economy but also a product of competition in a system not based on strict disclosure rules and monitoring but on cartellized corporation. In such a system there was tremendous temptation and opportunities for shady deals. Under the regulatory approach of convoy protection, this was not a problem as smaller and weaker banks were always protected. In retrospect, it seems the problem regulatory authorities made was to introduce competition in a system they were not quite prepared to supervise.
Super-high Interest Rates

Super-high interest rates came out of premium rates offered by the failing cooperatives. With deposit and loan rate deregulation and Japans regulatory authorities insisting that large, more viable banks withdraw deposits, forced the cooperatives to compete on price. This resulted in these entities assuming greater risks for the reward of higher returns and what ultimately developed into a huge problem of bicycle loans.
Non-disclosure and False Accounting

The problem of non-disclosure or loose disclosure requirements was alluded to. In the case of false accounting, bad loans are transferred to affiliates, with the sole objective of having it temporarily disappear from the books.
(3.2) Relationship Business

Apart from misleading regulatory bodies and the public by shifting questionable loans to affiliates the problem was exacerbated by banks refusing responsibility for the irrecoverable loans.
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Another problem in the Japanese banking system was referred deposits. These which were normally handled by the larger banks was done to: Enhance business ties with large corporations by introducing them to high interest rate deposits; with interest-deregulation in some parts of the market and regulation in others, even a simple arbitrage scheme resulted in a free lunch for the corporation and a fee for the large bank; and Build relationship banking. This was important to get around banking
regulation. By directing a client to a smaller institution, banks could circumvent the Banking Law regulation that prohibits them from extending disproportionately high loans to one single customer. Referred deposits often were covert guided deposits where the larger bank designated both the recipient of the loan and interest rate. While larger banks sometimes provided support by swapping bank personnel, they were quick to deny involvement when things started to go wrong.
(3.3) Fraud
Here, the main problem was from insider deals where large amounts of deposits were withdrawn just before an institution is closed.
The Unprecedented Growth in Jamaican Financial Institutions

From the early 1990s onwards, there was phenomenal growth in the number of unlicensed, unregulated financial institutions in Jamaica, such as investment banks, investment brokers, and other financial intermediaries. Primarily the ex-employees of regulated institutions staffed the principals of these companies.
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These entities not only grew in number but also in size, as there was increasing concern among the investing public regarding taxation on interest earned. The feeling was that the authorities had unbridled access to the records of institutions under its purview and as such it was the clients of these institutions that would have been more vulnerable. Additionally, these institutions had no minimum capital requirements, were not subject to reserve requirements and could afford to be more aggressive and less risk averse and so were able to offer more investment options and also higher investment yields. They also afforded flexibility in accepting investments for much shorter periods than the market and allowed encashments before maturity. With this boldness, unlicensed institutions such as Dehring, Bunting and Golding (1992) and Jamaica Money Market Brokers (1991) played key roles in developing the market for unsecured debt (IOUs).
The Disorderly FX Market

Reforms in the FX market did not bring about order. FX intake by commercial banks was subject to a 25% surrender to the BOJ. In 1991, this requirement was as high as 50%. The amounts were surrendered either at the weighted average rate of all banks or at the weighted average buying rate of each institution plus a market rate. In many instances, sales to the BOJ were at a loss that meant even higher exchange rates to end-users. This would eventually draw criticism from the market and eventually the BOJ. The decision then was, either to trade and bear the political pressure or stay out of the market altogether. The system forced banks to create schemes to elude the surrender requirements which effectively distorted official reported trading volumes.
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Additionally, FX trading schemes set up by banks only contributed to the growth in the informal market, as informal traders were more open to suggestions outside of the established guidelines. Diverting funds to the informal market only served to compound the problem as some end-users refused to purchase in this market. This only put more pressure on the official system overtime that translated to devaluation pressures.
The Stock Market Crash

In 1992, the Jamaican stock market experienced its best year ever in terms of both market activity and growth in market capitalisation. At the end of the year, the index stood at just over 25,000 points with an increase of 235% over the previous year. In 1993, it appeared that the market was a one way train, with the index climbing to the 33,000 mark. Investors made massive gains and for the most part ignored the real possibility of a major correction. Many doomsday analysts at the time insisted that the market was way overvalued and that trading for the most part was without any real analysts. Before the end of 1993, the inevitable happened; the market crashed and crashed hard. The index recorded a 49% plunge and in the ensuing frenzy, investors lost millions. The stock market crash also brought down unit trust companies and other entities offering equity linked investment opportunities.
(4) Summary
The period 1992-95, therefore, saw new and far-reaching developments in the Jamaican financial system. The chapter pointed to a sector that was going through the process of liberalisation and experiencing structural change change that would eventually bring about its demise. describes the crisis. Chapter 7 following
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Chapter 7
The Collapse of the Financial Sector (1995 1999)
Jamaicas financial sector which was primarily domestically owned and controlled, grew substantially in the 1980s before collapsing in the mid-1990s. Paul Chen-Young, With All Good Intentions The Collapse of Jamaicas Domestic Financial Sector, November 1, 1998.
(1) Introduction
The previous chapter examined at length the macro-economic environment and worrying developments in the financial sector over the period 1992 to 1995. Chapter 7 now outlines the first signs of trouble, the actual collapse of the system, and the eventual bailout plan implemented by government.
(2) The First Signs of Trouble

The official collapse of the Jamaican financial sector started in 1996, but there were signs of trouble from 1994. In December of that year, the Blaise group of three small financial institutions failed. These included a merchant bank- Blaise Trust and Merchant Bank, and a related building society (See Appendix 1 for structure of banking system in 1993 and 1999). The total liabilities of the three institutions were estimated at about US$33m with an asset deficit of approximately US$18m. The failure spurred concerns about the general health of the banking sector. The available balance sheets of major commercial banks at end of June 1995 revealed: Past due loans for six (6) months or over, almost doubling during the twelve (12) months past and represented 8.2% of total loans;
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The Collapse of the Financial Section (1995 to 1999)
Provisioning for loan losses (including capitalised interest), at about 36% of past due loans was below the international norms of 50% for loans in arrears for more than six months; Average capital-to-assets ratio for the system at 6.5%, was below the 8% ratio of the international convention (Basle risk-weighted ratio); In July 1996 the worst fears became reality: Century National, one of Jamaicas largest commercial banks triggered the formal collapse of the financial sector. A report released at the time revealed that the bank had J$3b excess liabilities over assets. The closure made the climate extremely fragile resulting in a series of runs on other banks such as Citizens Commercial Bank, Eagle Commercial and Merchant Banks, and the Workers Bank. By February 1997, it was Eagles turn to close its doors. With a gaping hole left in its balance sheet and being unable to support the huge overdraft offered by the BOJ to support the runs, the Eagle Group became insolvent. In March 1997, a significant stake in the entire network was sold to the Jamaican Government for $1. By the end of 1997, the Government increased its stake in two other commercial banks namely Jamaicas largest National Commercial Bank, and by the end of 1998 had assumed control of a total of eleven merchant and six commercial banks. By 1999, of the over thirty merchant banks in operation, a total of 14 merchant had failed. The collapse of the financial system in the Jamaican situation followed the trend experienced in much more developed economies.
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(3) The Banking Crisis in Japan

Japan, for example, having gone through the process of deregulation of the first oil shock, experienced serious crisis in its financial sector in 1995. 14 of the top 21 banks were expected to post pre-tax losses. Japanese financial institutions (in all) effectively went bankrupt. Against problems arising out of Japans bubble economy and a severe bad loan crisis, Up to 1996, 13
(4) Foreign Banks - Seemingly Insulated

While the Jamaican financial sector fell apart, institutions such as Citibank, Bank of Nova Scotia, and C.I.B.C. Jamaica Limited seemed impervious to the crisis. These foreign-owned banks (following on the experience of their parent companies) stuck to the traditional conservative lending path and maintained a significantly higher percentage of their funding portfolio in government securities.
(5) Bailing Out the Sector

In order to restore confidence to the Jamaican financial sector and to avoid the impact on the broader economic situation, the government introduced the Financial Sector Adjustment Company (FINSAC). Intervention commenced in 1997. For the banking sector, the essence of the bailout plan was the blanket guarantee for all deposits.
(5.1) Role of FINSAC

Broadly, the role of FINSAC includes restructuring of the financial sector, asset disposal, raising capital, paying-off loans, and working out non-performing debt portfolios. The collapse in the financial sector spread across almost all financial intermediaries and as such, the sphere of FINSACs operations extends not only to banks but also to insurance companies, credit unions, building societies, etceteras. Its intervention in the banking sector is shown in Exhibit 17.
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INSTITUTIONS
# OF ACCOUNTS
Billy Craig Merchant Bank Buck Mer. Bank Partner Mer. Bank Caldon Mer. Bank Carib. Trust & Mer. Bank Fidelity Mer. Bank Horizon Mer. Bank Horizon Building Society Island Life Mer. Bank Intercontinental Mer. Bank Island Victoria Finance & Inv. Citizens Comm. Bank NCB NCB Workers Bank Workers Bank TOTAL
840 277 50 149 56 850 403 100 121,566 949,649 73,919 211,692 6,418 1,365,969
AMOUNTS ASSUMED BY FINSAC JA$b 0.40 0.04 0.02 0.13 0.02 0.09 41.38 1.00 0.11 0.10 0.31 5.00 39.20 2.87 90.67
AMOUNTS ASSUMED BY FINSAC US$b
0.29 7.20 7.49
Exhibit 17 FINSACs INTERVENTIONS IN THE BANKING SECTOR (1999 FIGURES) Through FINSAC, the Government will provide guidance and technical assistance to the financial sector. It may mobilise and deploy external technical and managerial support for restructuring intervened institutions.
(6) Japans Approach

In Japan, in order to return stability to banks and protect depositors, in excess of 30 trillion yen was committed to the financial sector. Additionally, other policy measures are been contemplated or have been introduced. For example, the banking crisis resulted in different banks claiming the security for loans. An administration agency is been contemplated to sort out competing claims for security on loans. Also, the Bridge Bank concept where the government is prepared to bail out an institution under certain conditions if approached for help, is being
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contemplated.
These conditions include the requirement that all senior staff
resign and replaced by government officials from Japans Ministry of Finance. The assurance given to viable loan clients is that they will still be able to secure funding requirements from the government-run Bridge Bank. Already, problems are envisaged with this approach: 1. Banks will not approach the Bridge Bank as long as they feel that there is some hope of resuscitating themselves and staff will be reluctant to resign unless there is absolutely no choice, making it likely that only failed banks will benefit from this initiative. 2. 3. Corporates will be reluctant to report funding secured from the Bridge Bank for fear that it will hurt their credit ratings. The proposed funding for the Bridge Bank is set at 1.3 trillion yen which when combined with 2.5 trillion yen already set aside for bail outs, totals 3.8 trillion yen which falls short of the 70 trillion yen required for bad loans. In addition to the above, Japan has also changed the entire direction of its fiscal and budgetary policy over the past couple of years. Since 1998, the government has been very aggressive in cutting taxes and has stopped putting forward contractionary budgets replacing them instead with expansionary budgets. This has been supported by a 17 trillion yen stimulus programme, the largest in Japanese history. Also, it has made extensive arrangements with the United States on the deregulation of key sectors in the economy. (7) Summary The collapse of the Jamaican financial sector described has not only caused instability in the financial sector but to the country on the whole. As the discussion on the bail out plan showed the financial commitment to date is astronomical and the social consequences are just beginning to manifest themselves.
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Chapter 8 addresses one of these very important questions: What exactly were the root causes of the Jamaican financial sector crisis? Naturally many questions are being asked of the regulatory authorities and senior banking personnel.
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CHAPTER 8
The Real Impact of Liberalisation
In recent years, there have been a number of financial crises in both advanced and developing countries. Why did these happen? One reason has been a lack of adequate financial discipline associated with liberalisation at both the national level and the level of financial institutions. With-out strict financial discipline and a solid financial supervisory system, liberalisation is dangerous. Dr Samuel Sheih, Delicate Art of Monetary Policy, September 1996.
(1) Introduction
The previous chapter discussed the banking collapse and the eventual bailout of the sector. The Japan experience was also considered. Following the collapse of the Jamaican financial system the search for answers began. The proceeding sections are focused on whether or not the objectives of liberalisation in terms of removing distortions and inefficiencies were met and on the many arguments advanced to explain the demise of the sector.
(2) Were the Objectives Met? Economic Growth

The I.M.F's structural adjustment policies were geared towards stability and the containment of demand. There was less focus on growth and supply expansion. In particular, the policies of demand management that included deflating the economy and rigidly curtailing liquidity were not key ingredients to spur economic growth. This, therefore, may explain the sluggish growth of the Jamaican economy over the years. Exhibit 18 shows robust growth levels up to 1990 but thereafter, up to 1997, little or no growth at all.
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Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Real GDP Rate of Growth (%) -3.4 1.6 7.8 2.9 6.8 5.5 0.7 1.5 1.5 1.0 0.7 -1.4 -2.1
Exhibit 18 Real GDP Rate of Growth (%) for the period 1985 1997
(3) Critique of Adjustment Policies

The general failure of the adjustment policies (stagnant economic growth, persistent high levels of inflation, etceteras) were previously discussed. With a similar trend observed in many other countries, structural adjustment has come in for broad criticism. Adjustment policies on the whole, are often criticised as having inherent weaknesses. In particular, I.M.F and World Bank policies have been criticised for their failure to take into account economic realities, structural peculiarities, and policy positions of recipient countries. sometimes ignored. In the Jamaican context for instance, the IMF failed to consider or make allowance for: The de-motivating effect of wage guidelines on the labour force; Social and political facts are also
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The impact of demonstrations protesting the rising cost of living on sensitive industries such as tourism which currently constitutes Jamaicas single largest earner of FX (specifically the 1985 gas riots); and The implications of the removal of subsidies and decontrol of prices for the nutritional status and general productivity of a population where the majority currently fall below the poverty line. Another criticism is that the diagnosis and treatment of the I.M.F. ignores external factors impacting on economies in balance of payment crisis, and consequently deals with only a subset of the relevant problems. The authorities consistently downplay the role of eternal shocks, which impact profoundly on small economies such as Jamaica. Again, in the Jamaican situation, such external shocks included the rise in world oil prices (1970s and 1980s), which resulted in large increases in external outflows. Finally, the perception of the IMF and World Bank sometimes impede progress. They are often seen as unrelenting proponents of free-market principles and capitalists ideas set up to extract the surplus wealth of the less fortunate. The breach of trust that is often the consequence, retards efforts to improve production and lower consumption levels.
(4) What of Distortions and Inefficiencies (4.1) The Interest Rate Structure
Attempts to achieve real positive rates of interest (and thereby raise domestic savings levels) were constantly thwarted by rates of inflation, which ran ahead of nominal interest rates. The objective of increasing gross domestic capital formation was precluded by prohibitive rates of interest that rendered the most efficient projects non-viable and encouraged speculation instead.
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Also, while interest rates have been liberalised, the trend observed over the period 1991 to 1996 was a persistence of a divergence between lending and savings rates offered by commercial banks. The trend is illustrated below:
Year 1991 1992 1993 1994 1995 1996
Average Savings Rate (%) 18.52 19.51 18.17 18.75 17.82 17.96
Average Lending Rate (%) 40.12 46.39 61.32 56.14 55.27 55.22
Exhibit 19 Average Lending and Savings Rates offered by Commercial Banks 1991 - 1996
The oligopolistic nature of commercial banking in Jamaica where two banks controlled up to 70% of the market ensured that savings rates remained sticky upwards. (4.2) Interest Subsidies The high interest rate regime has ensured that persistence of interest subsidies through such organisation as the Agricultural Credit Bank and the National Development Bank. While loan rates on the Jamaican dollar were running as high as 60% per annum, certain sectors and projects were able to borrow at 18% per annum through these institutions.
(4.3) The Crowding Out of the Private Sector

The removal of the liquid asset ratio and other liberalisation measures were designed to more efficiently allocate resources to the private sector. However, with the subsequent reinstatement of the ratio and the persistence of high rates
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of interest, the efficient allocation of credit to the private sector has been a challenge. A consistent trend to the private sector was not established until 1989. The figures for Commercial Banks from 1991 to 1996 are shown below: Year 1991 1992 1993 1994 1995 1996 Private Sector (J$b) 11.2 13.3 22.3 29.6 42.5 49.4 Public Sector (J$b) 2.1 8.3 8.3 18.0 15.9 18.7
Exhibit 20
Comparison of Credit Allocation between Public and Private Sectors 1991 to 1996
At a glance, the trend seems heartening; but on closer analysis of available data it reveals that over the period 1990-95, loans to the consumption sector increased by 71% while loans to the productive sector grew by 29 %. Further, some argue that the true story is untold. In particular, they argue that banks and other financial institutions hold huge balances with the government in off balance sheet portfolios. This, they argue continue to mask the true extent of crowding-out in the private sector.
(4.4) The Propensity to Borrow

Just as with pre-liberalisation, the preference for debt to equity continued postliberalisation. This was as a result of the continued underdeveloped state of the capital markets. Additionally, some entities were (and still are) loath to providing the information required by players in the capital markets. interest has been the preference. Even in instances where equity financing has been a realistic option, debt financing at exorbitant rates of
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The extent of capital raised in the local market up to 1995 is depicted in the Exhibit 21: Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Public Offer 0 62.5 8 31 0 0 0 228.96 350 83.87 60 Private Placement 0 0 0 0 0 0 0 449.45 330 210 0 Rights Issue 0 0 0 0 32 10 10 363.87 445.36 150 19.54 Total 0 62.5 8 31 32 10 10 1042.28 1125.36 443.87 79.54
Exhibit 21 Capital Raised in the Jamaican Stock Market Amounts (JA$ Million)
SOURCE: Robert Stennett, Financial Liberalisation, Commercial Banks, Credit Allocation and A case for Direct Credit in Jamaica, Reserves Services Department, Bank of Jamaica, Portion Extracted from Appendix 7.
(4.5) The Disorderly FX Market

The figures below show the flow of FX into the official system over the period 1994 to 1998. The trend is obvious; the flows have improved substantially. Despite this, there are those who would argue that the black market is still alive and well and continue to question the efficacy of the liberalisation process. The instability in the rate of exchange and its precipitous decline have already been demonstrated. YEAR 1994 1995 1996 1997 1998 CAMBIOS 232.2 443.01 1,305.52 1,225.74 1,300.48 AUTHORISED DEALERS 1,228.62 1,210.28 2,013.55 2,306.46 2,304.21
Exhibit 22 Total FX Purchases by Cambios and Authorised Dealers (Equivalent of all currencies in US$m
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(5) Is Liberalisation to be blamed for the Financial Sectors Woes?

Liberalisation of the financial sector, that was part of the structural adjustment programmes of 1985 onwards, was to have resulted in sustained levels of economic growth. As the preceding sections show, as the FSRP progressed, the economic crisis deepened and when the financial sector collapsed, it was only natural that the stagnation in the broader macro-economic environment would take the blame.
(5.1) The Macro-economic Factor

The economic environment eroded the financial viability of banking entities. This was the real impact of structural adjustment and the financial sector reform programmes.
(6) The Impact of the FSRP

In assessing the role that FSRP had in the collapse of the financial sector, it is important not to forget that this program was a part of broader IMF adjustment policies. The FSRP did not take place in vacuum but rather was implemented with a comprehensive set of policies designed to improve Jamaicas balance of payments and ultimately spur economic growth. led to instability in the financial sector. The FSRP contributed to this economic decline as a result of factors brought on by monetary management and the newly liberalised FX market. Consequently, it is difficult, if not impossible, to separate structural adjustment, the FSRP, and the collapse of the Jamaican financial sector. As the preceding section shows, however, structural adjustment resulted in economic ruin that ultimately
(6.1) Monetary Policy

The effect of persistent high reserve requirement ratios and its effect on loan rates were discussed. The high loan rates overtime significantly affected the
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viability of borrowers. The resulting bad debt problem was compounded by competition brought on by the growth in the number of financial institutions (regulated and unregulated) that forced some banks to make extremely marginal loans.
(6.2) The Liberalised FX Market

The liberalised FX market also had negative implications for borrowers in that continuous and sometimes precipitous decline in the value of the Jamaican dollar. In particular, importers would dispose of goods bought at a certain exchange rate on credit, only to have profit margins eaten up by an unfavourable move in the exchange rate. This sometimes had the more serious effect of putting clients indebted to banks out of business. The removal of the Exchange Control Act liberalised Jamaicas current and capital accounts. From even before 1990/91, massive capital flight took place leading up to the 1980 elections when there was great political and social unrest. With liberalisation, capital flows have had a marked effect on the FX market in the form of exchange rate instability. With devaluation pressures, and the governments insistence on maintaining a stable exchange rate, high interest rates were used to counter. These killed economic activity that in turn translated to low levels of economic growth.
(7) Other contributing Factors to the Jamaican Financial Sectors Demise

The foregoing has demonstrated the impact of the broader macro-economic situation. The stifling environment that existed up to the mid-1990s was punishing on businesses. The link between the structural adjustment policies, the FSRP and this unforgiving environment is unmistakable. The adjustment policies, of which the FSRP was a part of, did much to retard economic growth and ultimately the financial viability of businesses - financial institutions were not spared.
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Despite the link established between structural adjustment, financial sector reform and the decline in the financial sector, there are those who vehemently argue that other factors were responsible or just as important in the collapse of the financial sector. Those who take this view point to the experience of foreignowned banks such as Bank of Nova Scotia, Citibank, etc. These banks, amidst the fall out, remained financially viable by maintaining sound banking principles. Supporters of this view, argue that other factors were responsible for the collapse in the financial sector.
(7.1) Financial Conglomerates

One argument holds that the intertwining of activities between entities forming financial conglomerates played an important part in the demise of the financial sector. These relationships were particularly deadly, when member companies decided to make their entrance into the hotel industry. In the Eagle Group for instance, expensive short-term funds taken through its merchant banking arm was used extensively to finance real estate development (The Crowne Plaza Hotel) by its insurance arm. The project suffered from massive delays, huge cost overruns as a result of devaluation and eventually became a huge drain on the cash resources of its merchant banking arm. The intertwining of companies also proved costly for the NCB Group of Companies. The National Commercial Bank and Bank of Nova Scotia (no relation to NCB Group) at one time shared 70% of the commercial banking market share. It was hard to think that anything could shake the foundation of NCB. However, its parent company and insurance arm Mutual Life Assurance Society which was in operation for over 100 years had invested extensively in the stock market and real estate.
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When the stock market crashed, these illiquid investments and predominantly short-term funding which was a feature of the finance sector proved, to be a telling combination. National Commercial Bank (the countrys largest commercial bank) was forced to pump billions into Mutual Life Assurance to offset losses. A similar fate befell the LOJ Group of Companies that included a commercial and merchant banking arm Citizens Bank Ltd and Citizens Merchant Bank Ltd. While banks overextended themselves to group members, the drain on cash resources was further compounded as news of problems within a group fuelled runs on the commercial and merchant banking arms in mid-1996 and early 1997.
(7.2) The Actions of Owners/Directors and Managers

The irresponsible actions of directors and managers are also being blamed for the problems experienced in the financial sector. With the rapid growth in the financial sector, supervision by the regulatory authorities could not keep pace. Consequently, managers (who often times did not have the requisite training) had considerable leeway in which to operate. With this lack of accountability, poor management decisions and sometimesoutright mismanagement became common place. In the Workers Savings and Loan Bank for example, a company controlled by its Chairman was able to borrow J$130m secured by the groups shares. Another company owned by another senior executive and apparent right-hand man borrowed J$34m against real estate. such huge sums. The evidence showed that these companies had neither the earning capacity nor the capital base to borrow
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(7.3) The Weak Regulatory Environment

In 1992 legislation was changed and the BOJ boosted its monitoring unit. However, the BOJ miscalculated the adequate number of staff and training that would have been required to carry out its supervisory function effectively and to enforce disclosure requirements. Apart from inadequate supervision, there is also the argument that the regulatory structure leading up to the collapse of the financial sector was insufficient. For example, capital adequacy ratios did not meet with international standards and on-lending to related parties was not sufficiently regulated. With the inadequate number of in-experienced staff and weak regulatory structure, the authorities failed to recognise growing difficulties in the sector and even with recognition of the problems, the regulatory bodies were late in moving to resolve the problems. Merchant banks, for example, were important players in the commercial paper market. As was discussed, these obligations were held off balance sheet and not subject to the scrutiny of the regulatory authorities even though the Securities Act and the Securities Commission were introduced, in part, because of these activities falling outside the general purview of the BOJ. In many instances, merchant banks were forced to absorb huge losses from non-performing unsecured debt that ultimately impaired their capital positions.
(7.4) Profitability and Taxation Levels

The decline in the banking sector is also linked to declining profit levels starting in 1995. This, as was discussed, was linked to increasing levels of competition, the Surtax on banks of 1994 and generally high corporate tax levels (33%) which meant huge outflows of cash resources and the stock market crash of 1993.
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(7.5) Staffing
Staffing is also blamed for the financial sectors demise. With the massive expansion of the banking sector quality staff was thinly spread. Further with the challenges of the economic environment and as the crisis began to unfold, inexperience took centre-stage. This human resource deficiency ultimately played a role in the downfall of the financial sector.
(7.6) The Role of Trade Unions

Trade Unions are also partially blamed for some of the problems in the banking sector. This situation is particularly common in the countrys bigger commercial banks where unions would demand and sometimes settle wage packages increase in excess of the inflation rate.
(7.7) The Role of External Auditing Firms

It is also inexplicable how auditing firms did not provide any warning about the financial crisis looming on the horizon. It is held that with some indication of the unhealthy state of some financial institutions, disaster could have been averted.
(7.8) The Stock Market Crash

The viability of the financial sector was further compromised by the stock market crash. This was as a result of entities during the boom years, taking and persisting with significant positions in the equities market.
(8) Summary of Causative Factors

The unstable economic environment brought on by the structural adjustment programs and the FRSP negatively affected the finance sector but, as was also demonstrated, many other factors had an input. The foregoing sections validate the important role played by these seemingly isolated factors, but accept the
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notion that they were separate to the FSRP would simply be nave. They had an undeniable link with the liberalisation process. Factors such as the role of trade unions and external auditing firms were indeed separate issues to the FSRP. Moreover, logical reasoning would conclude that these could not have been far-reaching enough to cause the scale of the collapse that took place. However, the other factors such as the growth in conglomerates, the actions of owners and other senior officers, the weak regulatory environment, the stock market crash, stagnant profitability, high taxation levels, and deficient staffing can all be linked to the FSRP. There is no doubt that the FSRP sparked the tremendous growth in the financial services sector that ultimately led to the formation of conglomerates discussed in the first part of the chapter. It was the FSRP that sparked the growth in the financial sector leading to the conclusion that Jamaica was simply overbanked. The supporting argument being that the existing commercial activity could not support so many entities and, as such, some shakeout was inevitable. This argument, however, is difficult to support as criteria required to establish over-banked status are not available. With this growth in the financial services sector, the weak regulatory structure and supervision that was woefully lacking, gave many company executives unbridled freedom and room to engage in many questionable business practices. It was as a result of the growth in the financial services sector, spurred by liberalisation that ultimately led to the human resource deficiency problem. The FSRP and structural adjustment policies created the inflationary environment that pushed the stock market to record levels of capitalisation. This along with other aspects of the FSRP impacted positively on reported banking profits. For example, FX market liberalisation resulted in huge profit gains to authorised
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dealers. It was as a result of these record profit levels that led to the imposition of the 1994 surtax on banking profits. Finally, the other factors described in the last three paragraphs each played a role in eroding the financial stability of the finance sector and in the end their combined effect toppled the Jamaican financial sector. The preceding arguments then have established a pattern; a pattern that is unmistakable; a pattern with a common thread in the form of financial sector Liberalisation.
(9) Causes of the Financial Sector Crisis in Japan

Japans bubble economy of the early 1980s that resulted in reckless real estate lending and ultimately to trillions in bad debt takes most of the blame for the crisis in Japans banking sector. The problems posed by the bubble economy were compounded by the structural weaknesses of Japans financial sector discussed previously. (see Exhibit 23) Structural Anachronistic structure of the banking system and slow deregulation Multi-layered banking supervision Behavioural Bubble behaviour/speculation
Sloppy monitoring and imprudent banking Fraud and bribery
Wait-and-see regulation Administrative guidance and lack of investor responsibility Lack of transparency, collusion, and regulatory entanglement Internationalisation and interdependence with world financial markets Interest Rate Deregulation Exhibit 23 Factors Behind Japans Banking Crisis
SOURCE: The 1995 Financial Crisis in Japan, http://www.nmjc.org/jiap/dereg/papers/bbankfa.html
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Administrative guidance and lack of investor responsibility, multi-layered banking supervision, the convoy approach, lack of transparency, collusion and regulatory entanglement, and interest rate deregulation that existed before deregulation and after, all played a very important role in fuelling Japans banking crisis. (9.1) Wait and See regulation Other structural problems included the wait-and-see regulation where regulators would prevent banks from posting after-tax losses by disallowing bad loan write-offs. This designed to maintain stability in the system; however, such practices only added to the already existing problem of bad debts on the books of affiliates.
(9.2) The anachronistic Banking Structure

Also, aspects of the Japanese financial system was thought to be outdated and needed updating. This was seen for example where there was a clear line between commercial and investment banking that led to the increase in popularity of trust companies that just simply added to layering in the financial sector. This structural problem was not helped by the slow process of deregulation.
(9.3) International Dependence

The period of economic instability (early 80s to mid-1990s) previously discussed also demonstrated Japans vulnerability as a result of its Internationalisation and interdependence with world financial markets. Here, events engineered by the US and other nations had a negative effect on Japans booming economy.
(9.4) Deregulation of Interest Rates

Interest rate deregulation slowly lowered the banks profit margins as a result of increased competition. The competition forced smaller banks into unsound
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business practices. For example, because smaller banks in general have higher refinancing costs, they moved to offer higher interest rates when this was allowed in 1990 in order to compete with the larger banks. To recover the cost that such a strategy entailed, the smaller banks also had to make loans with higher risk.
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CHAPTER 9
Project Summary
(1) Review
Chapter 1 provided an introduction and overview to the project while chapter 2 examined financial systems and how and why they are regulated. The process of economic liberalisation was also outlined followed by historical development of the Jamaican financial sector. The third chapter discussed its structural features and the presence of distortions and inefficiencies. Here, the Japanese financial system was compared to the Jamaican situation in the same context. The objectives of financial sector liberalisation in Jamaica were then discussed. The background to the paper was completed in Chapter 4, which provides an overview of the Jamaican economy. was a part. Chapter 5 outlined the actual process of financial reform augmented by the experience and Japan. The succeeding chapter investigated economic and the Jamaican financial sector developments (1992 to 1995) and importantly pointed to the looming crisis. Chapter 7 provided a brief look at the banking collapse and the eventual bailout plan. Finally, Chapter 8 delved into the possible reasons behind the collapse of the Jamaican financial system. (2) Methodology My research on Liberalisation and the Financial Sector primarily made use of secondary sources of data such as reports presented at workshops, case studies, and other relevant literature (from business magazines and newspaper articles) Particular emphasis was placed on the IMFs structural agreement programmes of which financial reform in Jamaica
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Project Summary
on the subject matter. valuable information.
The Internet also proved to be a useful repository of
(3) What does the Future hold?

The paper investigated financial sector liberalisation and its role in the demise of the financial sector. As was established, liberalisation played a significant role but its impact cannot be isolated. It would be more appropriate to advance that a combination of factors caused the demise of the financial sector as was advanced in the summary of chapter 8. It was established in main that: The stagnant macro-economic environment (low growth rates, the growing fiscal deficit, sliding Jamaican dollar, etceteras) shaped by the IMFs structural adjustment programmes negatively affected the financial viability of businesses (the loan clients of banks) making it difficult for them to meet loan obligations that ultimately, compromised stability in the financial sector. Discussed in Chapters 4 and 8 The existence of high reserve ratios translated into high lending rates to the private sector exacerbated by the already harsh economic conditions which, ultimately, affected their ability to meet debt obligations, resulting in unprecedented growth in bad loans Discussed in Chapters 6 and 8 The liberalisation process resulting in growth in the banking sector and much increased competition ultimately compromised quality staffing and contributed to the booking of marginal loans that weakened the strength of established financial institutions.
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Project Summary
Discussed in Chapters 6 and 8 The growth and business practices of financial conglomerates, where, for instance, the insurance arm compromised the viability of their group by carrying huge investments in long term assets (equities and real estate), while funding themselves predominantly with high-cost short term funding. The existence of a weak regulatory environment, both in terms of legislation and personnel, that allowed banking principles to carry out questionable transactions and persist with faulty credit processes with the problems being compounded by the pace at which they reacted to the banking crisis. Weak disclosure requirements that allowed banks to operate huge unregulated off balance sheet portfolios with a high degree of unsecured debt. Depressed profitability levels in the financial sector precipitated by the stock market crash, the surtax of 1994, and the relatively high level of corporate taxes. Diversification as in the case of the National Commercial Bank where huge investments were made in agriculture in the interest of nation building. Discussed in Chapter 6 Financial sector liberalisation failing to remove structural deficiencies of the system so that investment inflows and savings were not stimulated, credit continued to be allocated inefficiently through interest subsidies, crowding out of the private sector persisted and the propensity to debt remained a fact of life. Discussed in Chapter 8 Competition not only from licensed financial institutions but also from unregulated players not subject to reserve requirements and other regulatory constraints and more willing to accept risk and offer flexibility to customers.
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Project Summary
(4) Solving the Problems of the Financial Sector

The Jamaican financial sector has undergone many changes since Century National Bank collapsed in 1996. The banking sector has contracted significantly and more solid principles are being employed. Supervisory authorities finally have the manpower, along with improved legislation (Revised FIA, Banking Act, Securities Act) to carry out their duties. Additionally, the BOJ has introduced new banking regulation especially with regards to stricter capital requirements (Basle Guidelines). Deposit Insurance (despite the J$200,000 or US$5,000 insurable limit) has also been implemented and disclosure requirements designed to protect investors are at their highest. Despite all this, however, the Jamaican financial sector is still ailing and is in need of meaningful, long-lasting solutions. The discussion of the country being over-banked was previously discussed. If this arguments held, the fallout that has taken place was part of the solution to solving Jamaicas banking crisis and that more contraction would be welcome. The 'over-banked' concept is, however, difficult to prove as the numbers are just not available. Additionally, removing distortions and inefficiencies discussed in Chapters 3 and 8 will always be a challenge as a result of: (a) The Interest Rate Structure The wide gap between lending and savings rates were discussed. This will be difficult to resolve based on the dominance of the National Commercial Bank and Bank of Nova Scotia. Legislation stipulating a
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Project Summary
maximum spread is a possibility but this would be against free-market principles. (b) Interest Subsidies Under the existing interest rate regime and with the problem discussed above, removing interest subsidies would plunge the businesses sector into further crisis. (c) Crowding Out With the government present debt problems and FINSACs obligations not yet taken into consideration, the persistence of the crowding out phenomenon will remain. This was also discussed. (d) The Propensity to Borrow Regulation in the form of the Securities Act is now in place to oversee development of the market for equity financing. However, until stability and investor confidence is returned to the system, the propensity to borrow will remain. (e) The FX Market While there have been improved flows into the system as demonstrated in Chapter 8, the Jamaican dollar continues to devalue and can only be addressed by solutions of the macro-economic level broadly discussed. Hence, in solving the problems of the Jamaican financial sector and returning the institutions to a path of sustained growth, there are five (5) realistic considerations related to restoring investor confidence, resolving structural issues, and establishing an environment based on co-operation. These include:
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Project Summary
(4.1) Restoring Investor Confidence (4.1.1) Economic Considerations

In order to put confidence back into investors, and improve savings and capital inflows, the economic ills of the country must be addressed and stability must be maintained. There are frightening issues such as the debt problem where the debt service takes up over 60% of the budget (over 90% without projected overseas borrowing), marginal or negative growth rates, and the continued devaluation of the Jamaican dollar. The current environment of over-reliance on monetary management to restrain demand with interest rates being used to support the exchange rate has to be re-examined. The requirements needed are fiscal and monetary policies to support a growth oriented strategy. Without these, financial sector initiatives in isolation will be futile and the efforts of FINSAC will come to nought.
(4.1.2) FINSACs Obligations

FINSACs debt obligations now exceed JA$100b and expanding, and to compound the problem, asset values have been written back making the institution insolvent. The restoration of confidence will also depend on how the government addresses the FINSAC issue. Importantly, these debt obligations are not yet factored into budget considerations. It is imperative that these figures be accounted for once and for all and that the government presents a well thought-out plan to deal effectively with these obligations. A plan detailing revenue projections, projected borrowings, debt service plans, and the ultimate impact on interest rates. These will help to bring some clarity to the thought process of investors and ultimately, return confidence to the system.
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Project Summary
Additionally, with the huge real estate holding and bad debt portfolio held by FINSAC, the process of selling off or working out these assets must be transparent and be done in a timely fashion. In particular, real estate holdings have been the subject of much debate because of recent disposals that were done at values way below market rate. confidence of investors. Such a process will also help the
(4.1.3) Resuscitating Insurance Companies

Life Insurance Companies, battered in the recent crisis, play an important role in governing long-term funding which is important to the stability in the financial sector. Currently, governments plan involves selling these institutions to wellestablished companies in Trinidad and Barbados. The delicate handling of these disposals, while having them concluded in the shortest amount of time, will also help to return stability to the sector.
(4.1.4) FINSAC Must Ensure Meaningful Restructuring

In some instances, FINSACs intervention has not brought about the desired restructuring that would return the institutions to viability. In the case of National Commercial Bank (NCB) where FINSAC intervened to the tune of $20b, profitability levels have been marginal and the huge machinery of office buildings, real estate holdings, and staffing still remain. Again, meaningful and transparent restructuring would help return confidence to the sector.
(4.2) Resolving Structural Issues (4.2.1) Defining the Role of Financial Institutions
Merchant Banks were initially set up to act as intermediaries in sourcing long-term funds. The importance of stable funding noted above. As was seen in Chapter 6 though, these entities while being creative and dynamic in their product offerings, were focused more on short-term money market transactions. Some consideration must be given to having the institutions return to this important role
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Project Summary
or creating legislation to introduce a new vehicle to carry out this very important role. (4.3) A Co-operative Environment
(4.3.1) The Role of the Private Sector

The highly questionable business practices of bank managers and directors were documented in Chapter 6. As the crisis unfolded, the relationship between In private sector players and the regulatory authorities became strained. particular, the private sector was accused of being dishonest. Resuscitating the financial sector will mean closing this credibility gap, through meetings, dialogue, etc., which have already started. support from each group, policy initiatives are bound to fail. Without the mutual
(5) Conclusion
The process of financial liberalisation in the Jamaican situation was examined in detail against the background of the historical development of the sector and the macro-economic environment. The policy measures were, by and large, successfully implemented but their real impact was less than desirable. Liberalisation and the structural adjustment programmes of the IMF did little to foster sustained levels of economic growth, and distortions and inefficiencies in the financial system persisted. The paper established that liberalisation played a significant role in the demise of the financial sector, coupled with the input on other factors. Without a solid economic foundation and rigid supervision, the financial sector simply spiralled out of control and eventually met its fate. The authorities had good intentions and sought to introduce legislation to regulate banking structure and conduct rules, but lacked the infrastructure to implement, reinforce, and penalise. The
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Project Summary
resulting bailout is set to cost government and ultimately Jamaicans, billions of dollars. With the fallout in the sector, it was shown above that the regulatory authorities are at a heightened sense of awareness with much improved legislation and trained personnel. Despite these, however, an unsettling disquiet remains. The trouble is, the economy is now even more fragile and liberalisation forces that have taken so much of the blame for the demise of banks are still at work. Finally, the study Interestingly reveals that sound banking principles could withstand the sometimes destructive impact of liberalisation, structural adjustment and economic stagnation. This was seen in the case of foreign-
owned entities that have remained viable throughout the turmoil.
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BIBLIOGRAPHY
Alex, (17 July 1998), Bad Debt Clouds Future, The Financial Gleaner, Weekly Newspaper Publication, Kingston, Jamaica Anonymous, The Statistical Digest, Monthly Bank of Jamaica Publication, Kingston, Jamaica Anonymous, (March 1983), A Proposal for a Study to Assess the Operation of the Foreign Exchange Market in Jamaica, Fidelity Economic and Financial Marketing Services Limited, Kingston, Jamaica Anonymous, Bank of Jamaicas Annual Report, Jamaica (1984 to 1997), Kingston,
Anonymous, (July 1990), Liberalisation of the Foreign Exchange Mechanism, Bank of Jamaicas Economic Bulletin, Volume 5 Anonymous, (March 1991), Exchange Control Liberalisation in Jamaica, London Economics Anonymous, (7 April 1992), Exchange Control Act To Go, The Daily Gleaner, Newspaper Publication, Kingston, Jamaica Anonymous, (2 February 1994), PJ Patterson Outlines Fine Tuning Process, The Daily Gleaner, Newspaper Publication, Kingston, Jamaica Anonymous, (28 July 1995), Structure of the Financial System, The Financial Gleaner, Weekly Newspaper Publication, Kingston, Jamaica Anonymous, (July/August 1996), The Demise of the Jamaicas Banking Sector, Knutsford Business Magazine, Kingston, Jamaica, Volume 1, Number 2 Anonymous, (March 1996), Korean Foreign Exchange and Capital Markets, http://www.kol.co.kr/~kdbmst/focus/fx_lib.html, KDB Economic & Industrial Focus (Economic Research Magazine published by Korean Development Bank) Anonymous, (1999), The Effects of Financial Liberalisation on Korean Banks, http://www.kil.colkr/~kdbmst/focus/f96061.html Anonymous, (1999), Economic Liberalisation Governance, Http://www.britishcouncil.org/governance/ecfin/liberal.htm, The British Council Anonymous, Financial Sector Issues - The World Bank, Country Economic Memorandum
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Bibliography
Armstrong, Martin A., (6 July 1998), Why Japans Bridge Bank will Fail http://www.pei-japan.co.jp/gest_pages/BRIDGE.html, Princeton Economic Institute Baumol, William J. & Alex S. Binder, (1988), Economic Principles and Policy, Harcourt Brace Jovanovich, U.S.A., 4th Edition Brown, Headly & Company Limited, (1992/93), The Jamaican Economy in a Changing World: The Way Forward 1993/94 and Beyond, Stephensons Litho Press Ltd, Kingston, Jamaica Buck, Basil, (5 January 1999), FINSAC Omars Waterloo, The Daily Observer, Newspaper Publication, Kingston, Jamaica Chen-Young, Paul, (1 November 1998), With All Good Intentions The Collapse of Jamaicas Domestic Financial Sector, Policy Papers on the Americas, Volume IX, Study 12 Evans, Trevor, Carlos Castro & Jennifer Jones, (1995), Structural Adjustment and the Public Sector in Central America and the Caribbean, CRIES, Managua, Nicaragua Findlay, Ronald & Stanish Law Wellisz, (1993), Political Economy of Poverty, Equity, and Growth: Five Small Open Economies, Oxford University Press for the World Bank Forest, Raymond, (31 July 1998), Financial Sector Supervision Becoming Easier, The Financial Gleaner, Weekly Newspaper Publication, Kingston, Jamaica Gardner, Professor E.P.M, (1997), Bank Financial Management Unit 1: Introduction, Environment and Bank Financial Analysis, Institute for Financial Management Grassl, Professor Wolfgang, (22 July 1998), Unions Blocking Path to Recovery, The Daily Gleaner, Newspaper Publication, Kingston, Jamaica Hempel, George, Donald G. Simonson, Alan B. Coleman, (1994), Bank Management: Text & Cases, John Wiley & Sons, Inc., U.S.A., 4th Edition Jerram, Richard, Michael Hodges, Louis Turner and Richard Kurz, (1997-98), Liberalisation and the State, http://www-douzzer.ai.mit.edu:8080/conspiracy /PEGB/ chap02.htm, Political Environment for Global Business Course Guide, London School of Economics and Political Science
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Bibliography
Lalta, Stanley & Marie Freckleton, (1993), Caribbean Economic Development The First Generation, Ian Randle Publishers Lue Lim, Gail, (1991), Jamaicas Financial System - Its Historical Development, Bank of Jamaica, Kingston, Jamaica Madura, Jeff, (1998), International Financial Management, South Western College Publishing, 5th Edition McNight, Franklyn, (12 November 1991), Banks Feeling the Heat over JA$ Slide, The Daily Gleaner, Newspaper Publication, Kingston, Jamaica Mishkin, Frederic S., (1989), Money, Banking & Financial Markets, Scott, Foresman & Company, U.S.A., 2nd Edition Panton, David (Foreword by Rex Nettleford), (1993), Jamaicas Michael Manley: The Great Transformation (1972 to 92), Kingston Publishers Limited, Kingston, Jamaica Prystay, Cris, (Nov 1996), Rocky Road to Liberalisation, http://web3.asia1.com.sg/timesnet/data/ab/docs/ab1141.html Schaede, Ulrike, (February 1996), The 1995 Financial Crisis in Japan, http://www.nmjc.org/jiap/dereg/papers/bbankfa.html, University of California, San Diego Shieh, Samuel, (1 September 1996), Delicate Art of Monetary Policy, http://web3.asia1.com.sg/timesnet/data/ab/docs/ab1095.html Smith, Vindelyn, (December 1991), Monetary Development within the Context of Liberalisation (the case of Jamaica), Research and Programming Division, Bank of Jamaica, Kingston, Jamaica Stennett, Robert, Financial Liberalisation, Commercial Banks Credit Allocation and a Case for Directed Credit in Jamaica, Research Services Department, Bank of Jamaica, Kingston, Jamaica Stone, Carl, (1989), Politics vs. Economics The 1989 Elections in Jamaica, Heinemann Publishers (Caribbean Ltd), Kingston, Jamaica Wint, Carl, (1 April 1999), Debt Eats into Budget, The Daily Gleaner, Daily Newspaper Publication, Kingston, Jamaica
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Financial Sector Liberalisation in Jamaica

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Financial Sector Liberalisation in Jamaica

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Chapter 1

Introduction and Overview

(2) Liberalisation Defined

(3) The General Contents of the Paper

Introduction and Overview

(4) Reasons for the Research

Introduction and Overview

(5) Focus on the Banking Sector

(6) The Organisation of Financial Systems

(2) What is a Financial System

Lenders (Savers) 1. Households 2. Business Firms 3. Government 4. Foreigners

Borrowers (Spenders) 1. Business Firms 2. Government 3. Households 4. Foreigners

Exhibit 1 Flow of Funds through the Financial System

(3) Financial Markets and Intermediaries

Exhibit 2 Financial Markets and Intermediaries

(4) Regulation of Financial Systems

(5) The Process of Economic Liberalisation

Exhibit 3 Features of the Liberalisation Process

Privatization and Deregulation

Internal vs. External Liberalisation

(6) The Structure of the Jamaican Financial System

The Financial System in the 1970s to 1991

1941 Credit Unions

1970 Unit Trusts

Exhibit 4 Time Line The Establishment of Financial Intermediaries in Jamaica

(8) The Banking Sector

The Central Bank

(2) Structural Characteristics of the Jamaican Financial Sector

(2.1) Over-reliance on Non-market Instruments

Distortions and Inefficiencies in the Financial Sector

(2.2) The Interest Rate Structure

IR Inflation Rate EXHIBIT 5 Deposit and Inflation Rates 1988-1991

Distortions and Inefficiencies in the Financial Sector

(2.3) Subsidised Credit

(2.4) Crowding Out the Private Sector

Exhibit 6 Public Sector Deficit as a % of GDP (1981 to 1991)

% 15.9 15.7 19.6 15.1 13.2 5.6 5.4 13.3 8.0

Distortions and Inefficiencies in the Financial Sector

(2.5) The Propensity to Borrow

(2.6) Instability in the Foreign Exchange (FX) Market

The Growing Black Market

Distortions and Inefficiencies in the Financial Sector

The Parallel Market

Distortions and Inefficiencies in the Financial Sector

(3) The Exchange Control Act

Distortions and Inefficiencies in the Financial Sector

(3.1) Restriction on Investment Flows

(3.2) Restrictions on Importers and Exporters

(3.3) Restrictions on Dealing in FX

Distortions and Inefficiencies in the Financial Sector

(4) Arguments for and Against FX Controls

Distortions and Inefficiencies in the Financial Sector

(5) Structural Weaknesses Japan and Jamaica Compared

Interest Rate Regulation

Distortions and Inefficiencies in the Financial Sector

Indirect Financing and the Dominance of Bank Loans

Distortions and Inefficiencies in the Financial Sector

Segmentation of the Financial Industry

Distortions and Inefficiencies in the Financial Sector

An Overview of the State of the Jamaican Economy

(2) Economic Growth Declines

(2.1) Factors Behind Economic Downturn

An Overview of the State of the Jamaican Economy

(3.2) A Change in Government

An Overview of the State of the Jamaican Economy

(4) Structural Adjustment in Context