Removing temptation

Mar 22, 2009 Features / Columnists, Ravi Dev

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Not surprisingly, now that the ever-widening financial gyre has established that it respects no boundaries, everyone is demanding that a quick fix be found and stability returned pronto. Even though “liberalised” by the International Monetary Fund/World Bank, many thought that our lassitude for once might redound to our benefit and spare us the bitterest medicine. But alas, it was not to be – CLICO and Hand-in-Hand Trust changed all that. Obviously, we’re not so “undeveloped” after all. A review of the new regulatory order would appear to be in order.

After all, even the pioneers, practitioners and purveyors of the “light touch” regulation – the US and Britain – have (however reluctantly and regretfully) accepted that governmental oversight and regulation are necessary for a sustainable financial system. Joseph Ackermann, Chief Executive of Deutsche Bank, announced “I no longer believe in the market’s self-healing power”.

Deregulation has reached its limits. But the fact that the developed countries with all their resources could not prevent a meltdown should suggest that there may be some deep systemic contradictions at work here.
One that we have stressed is that the purpose of the financial system is to facilitate activities in the real economy by intermediating funds and reducing risks. So when the financial system starts generating more “profits” than the real economy something has to be seriously amiss.

Secondly, bubbles and crashes have been with us since we allow financial speculation, fuelled by greed. Banks, which by definition borrow short and lend long, cannot be permitted to get deeply involved in that speculative frenzy. This will only contaminate the real economy and destroy the trust and confidence needed to sustain financial intermediation. Damage to the real economy then has to be the central goal of regulation, not the generation of more profits by the financial sector – and the effort will have to be continuing and enduring. And thirdly that the lesson of the last great depression was that banks need a regulatory firewall from the riskier financial “innovations”.

But first we will have to distinguish between regulation and supervision because there has been some confusion in some commentaries on these terms. While regulation refers to the rules that govern the conduct of the intermediaries, supervision is the monitoring practice that one or more public authorities implement in order to ensure compliance with the regulatory framework.

We will begin with suggestions for tightening our regulatory framework and pick up on the supervisory aspects later. We can’t do worse than start with the CLICO collapse. While there has been some debate about the cause of the latter circumstance, there is no doubt that the Governor of the Bank of T&T’s identification of CLICO’s business model has great merit. CLICO pursued “An aggressive high interest rate resource mobilization strategy to finance equally high risk investments, much of which are in illiquid assets and also a very high leveraging of the Group’s assets, which constrains the potential amount of cash that could be raised from the asset sales.”

CLICO was able to execute this strategy because of the new regulatory dispensation that allowed the construction of “financial conglomerates” that went beyond even the “universal banks” in the developed north. These structures offered a bewildering array of financial “products” that were originally created by non-bank financial institutions that were allowed to accept deposits in all but name”. CLICO, for instance, called them “executive flexible premium annuities”. The regular banks, stuck in the traditional “originate and hold” model of accumulating assets, soon decided that if they could not beat the competition they might as well join them and invented the “originate and transfer” model on the assertion that it would better spread risk. Well maybe it could have but it quickly became a cynical ploy for creating “profits” synthetically and speculatively.

CLICO constructed the CL Financial group by adding a commercial bank (Republic Bank), an investment bank (CLICO Investment Bank – CIB), Caribbean Money Market Brokers etc. to its core insurance business and was certainly not willing to just play the traditional intermediation and risk-reduction financial role. The accumulated financial wherewithal was deployed to launch into massive investments in energy, real estate and manufacturing and distribution – in the real but illiquid economy.

CLICO became a one-man venture capital cum hedge fund grafted onto a venerable and trusted insurance company. As pointed out by the T&T Bank Governor, there are intrinsic contradictions in such a business model, especially with high leverage in addition to the dangers of, “Excessive related-party transactions which carry significant contagion risks”. Such a strategy may have worked while the good times rolled but was always doomed if highly unlikely “Black Swan” risks surfaced – as they did.

The question is, “How was this allowed?” CLICO got around whatever regulatory rules remained in place under the new dispensation by playing the “regulatory arbitrage” game. Each component of the conglomerate operates under regulatory rules so money is shuffled around as in a “three card” hustle to the weakest control point.

In Guyana, insurance companies are supervised by the Commissioner of Insurance (COI), while banks (both commercial and investment/merchant) come under the BoG – each operating under different regulatory regimes. As one broker recently noted (unfortunately, after the horse had bolted) our insurance regulations are very weak; he might have noted “and also very limp-wristed”. Imagine CLICO (Guyana) as an insurance company was allowed to violate the rule on the level of permissible foreign transfers for almost two years by the COI without even a reprimand.

It has been claimed that CLICO’s regular commercial bank, Republic Bank, has not been affected by the “contagion” of its siblings. Even these more tightly regulated banks have been able to play fast and loose by manipulating the new Basel II rules that allow them to use subjective criteria for valuating their assets or by creating “off balance” sheet assets to hide high-risk dabblings. Performance yardsticks such as VaR become suspect. Their assets should be scrutinised even more stringently.

We are proposing that the concept of the “financial conglomerate” be henceforth eliminated. Commercial Banks must return to the “narrow” function of soliciting deposits and making loans and so receive “safety nets” from the state such as the discount window of the BoG. They should not be allowed to affiliate with investment banks or insurance companies or trusts etc. as has become the rage in Guyana.

Since greed cannot be regulated away, at least bankers ought not to be led into temptation. The latter financial institutions that do not opt for a commercial bank status would have to ensure that the duration of their liabilities is on average at least as long as the duration of their assets.
(To be continued)

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