Caught in the squeeze: Are the expectations set for financial institutions realistic?

Ralph Thomas, Contributor

Jamaica's financial sector has received both criticism and accolades for the way in which it has played its increasingly critical role in national development and contributed to growth, or lack thereof, in our economy over the years. However, as Jamaica's economic growth flounders and the fortunes of the business sector waxes and wanes, accordingly, it begs the question of the extent to which our financial institutions are able and willing to promote and contribute actively to economic development.

It is suggested that some are mere free-riders on our society, opportunistic margin gatherers bent on maximising shareholder value and uncaring of the plight of our people. I do not subscribe to this belief but, if it is the case, only then would elevated moral suasion such as tongue-lashing by the political directorate and stiffer regulations and penalties be appropriately applied to bring banks in line.

This debate is a profound one, as it is possible that the expectations that we have set for our financial institutions are indeed unrealistic. There are large gaps in the spectrum of financial services to promote development and growth that we expect commercial banks to fill. Our expectations are sometimes inconsistent with their prescribed role and activity and primary obligation to their shareholders, which must be balance with responsibility to depositors. There are regulatory requirements, prudential standards, cost factors, performance requirements and best practices that constrain banks from being all things to all persons and that force them to be disciplined in managing risks and managing profits and profitability. Should we wish it to be any other way?

While not the subject of this article, we must, at some other point, critically examine the role that public sector or development-financial institutions are designed to play. Much of the gap between expectations and outcomes is caused by the failure of our development-finance institutions to fulfil their expected role as engines of national development and growth, filling the gaps left by privately owned institutions. Managers of these institutions should be held accountable for these results and the institutions themselves should be reshaped to make them more relevant.

role of commercial banks

In examining the evidence, therefore, we must be clear on what role we expect commercial banks and other private-sector financial institutions to play and create harmonised incentives and sanctions, much like a carrot and a stick, that ensure that banks continue to play a pivotal role in achieving the goals of the national Vision 2030 plan, which is the bipartisan framework for our development.

As we examine the banking sector, it is important to make a distinction between different categories of banks and near-banks, namely commercial banks, savings-and-loan institutions such as building societies and credit unions. All play a critical economic role as financial intermediaries through which money flows from those with excess funds (savers), to those with a need for funds (borrowers). But this does not happen passively, as considerable effort and cost must be expended to gather these funds from many depositors and redeploy the funds to borrowers, with a margin that makes the entire business profitable.

This financial intermediation role played by banks is an essential element of the management of monetary policy by the central bank and enables it to regulate economic activity by influencing the money supply through management of interest rates. Consequently, managing the level of interest rates remains one of the key challenges of our time. The BOJ is also culpable in the high levels of interest rates, as these have been one of the few tools they have been able to use effectively to manage foreign-exchange rates.

Businesses are caught in the squeeze play between the commercial banks and the BOJ who are like two large elephants in the room, sitting where they please and crushing the hopes and aspirations of the business sector, small and large. Better coordination of interest-rate and credit policy is required to ensure that the needs of the business sector and consumers for lower rates and access to credit are met so that we can grow the economy.No one should begrudge the commercial-banking sector a fair return on their invested capital. However, very strong arguments can be made that their lending rates are indeed excessive and needlessly so. The costs that banks use to justify high spreads over their costs-of-funds really reflect an amazing level of structural inefficiency that banks are unprepared to address. It is easier to pass on the cost of administrative inefficiency to the customers, through higher fees on all services and higher lending rates, than to reorganise and refocus the banks to deliver services efficiently. In contrast, because of better regulation and competition in the United States (US) financial markets, banks are forced to achieve higher levels of efficiency and operate profitably at lower interest-rates spreads than those enjoyed by banks in Jamaica. Can you imagine mortgage rates of three per cent to five per cent and lending rates to consumers and small businesses below 10 per cent? Can you imagine the impact on our economy if these interest-rate levels were in place here? Businesses would flourish, consumers could spend more and GDP would grow dramatically.

As a banker who worked on Wall Street as a senior executive for two decades in all areas of commercial banking and managed a significant retail-banking franchise prior to my return to Jamaica, I believe I can speak with some authority on issues confronting the banking sector and the relative level of inefficiency to which they have grown accustomed, while still making significant profits. If a 10-per cent reduction in bank overheads could be achieved while holding rates and charges to customers at previous levels, billions of dollars could be freed up and left in the hands of customers to invest in their businesses and promote economic growth.

Unfortunately, the banks have chosen to engage in continued profit-taking at the expense of their customers, many of whom are already financially stressed because of the downturn, further contributing to a decelerating economy.

In the area of consumer lending, interest rates on lines of credit and credit cards to some highly rated customers are in the neighbourhood of 49 per cent, which is clearly unreasonable. Such extensions of credit are sometimes used to finance small businesses, as it is sometimes difficult to separate the small business owner's finances from that of the business. In the US, the threshold for usury, which is the maximum amount a bank can charge a borrower, is 25 per cent and violations of this law are often accompanied by severe sanctions. Enforcement of similar laws with low thresholds are necessary in Jamaica to protect consumers, as well as better consumer advocacy, and consumer protection regulations, since the banks appear unwilling or unable to self-regulate in this area.

serious introspection

Bankers are encouraged to engage in serious introspection and seek to achieve structural shifts in their operational costs by changing their business models appropriately, and accompanied by more effective risk and treasury management, as this can lead to more sustainable profits in the long run and better customer retention and customer satisfaction. Consumers too, must be more proactive and move their banking relationships to institutions with better rates and service. Commercial banks currently maintain excessively high rates of capital, beyond the prudential standards of 10 per cent established by the BOJ in implementing the Basle II Accord, which recommends capital standards for banks worldwide. Although appearing prudent, overcapitalisation really reduces return on equity, a critical measure of banks' profitability. The banking sector can safely increase its financial leverage by reducing capital levels to a level closer to the BOJ standard, and provide their investors with better performance results, as long as they establish Enterprise Risk Management programmes and utilise the rare skills of professionals who understand how to make a bank perform optimally.

Well-capitalised banks have the opportunity to grow their loan portfolios without adding capital, and growth in lending should be deployed to emerging growth sectors in the economy, particularly small- and medium-size enterprises. Such loan-growth initiatives at this time would require creativity in lending, infusions of equity by private investors, and credit guarantee and insurance programmes, tax and other incentives provided by the public sector. These measures should significantly expand economic activity and generate jobs and economic growth.

It is time for banks to reduce expectations for the excessively high return on invested capital that their owners/investors have enjoyed in recent times, in fairness to the customers and reflective of the present economic constraints.

Simultaneously, financial performance of banks can be improved by tighter management and a more strategic approach to their business, as they have been somewhat tactical in their management responses, shifting and changing emphases to take advantage of short-term opportunities that in the long run are not beneficial to the development of their business. I am, however, highly confident that our bankers will respond to these challenges and deliver a wider array of high-quality services that meet and exceed customer expectations.

Ralph S. Thomas is a senior teaching fellow of the Mona School of Business - UWI (Policy and Strategy and Risk and Treasury Management) and a financial consultant, and was a vice-president of the Bank of New York-Mellon. Feedback may be sent to columns@gleanerjm.com.