Demystifying the financial crash

Darron Thomas, GUEST COLUMNIST

The early 1990s was characterised by exchange-rate and deposit-rate liberalisation in Jamaica. The economy moved from an essentially fixed exchange-rate regime in the 1980s, up to and including 1989, to a flexible system. In 1992, the Financial Institutions Act (FIA) and the independent determination of interest rates on savings/deposits by financial institutions were implemented. Prior to this, FIA institutions were governed by the Protection of Depositors Act (PDA).

In the aftermath of these events, there was a proliferation in the number of financial institutions. See Table 1. (This article is an excerpt from a research paper available at http://tinyurl.com/jafincrisis)

Exchange-rate liberalisation was not innocuous and sowed the seeds for what became the crisis. The Bank of Jamaica's policy of having FIA institutions surrender up to 50 per cent of their foreign-exchange receipts triggered devastating growth in the local money supply. This led to massive inflation, and in 1991 resulted in -45 per cent real interest rate based on annualised data (see Graphs 1-4 for the impact of this situation). This provided the impetus for portfolio misalignment.

Some commentators contend that commercial banks (CBs) were forced out of their core business of borrowing and lending, and into investments in real/fixed assets. This was to compete against FIA institutions and building societies which had lower reserve requirements. However, investments in real assets, whose prices rose with inflation, meant that banks were profitable but illiquid. One of the reasons, then, for the equalisation of reserve requirements was to eliminate the disparity across the bank types and to ensure that banks indulged in mainly their core business.

Note that in 1991 the average lending rate was about 35 per cent, while the inflation rate was approximately 80 per cent. As such, the real interest rate was approximately -45 per cent; a very low rate. Actually, it runs counter to the high interest-rate argument. This low real interest rate led to investments in real fixed assets.

Graph 4 shows for the overall economy. The high interest rate policy was then implemented as a knee-jerk reaction to the portfolio misalignment which resulted from the negative real interest rate situation.

The banking sector of Jamaica, at the start of the 1990s, was dominated by a few large CBs. Even with the significant change in the number of institutions through to 2004 this remained true. Actually, many of the failed institutions, CBs, or otherwise reappeared as CBs either after a merger or a resale by the Government. One example of this is RBTT, which bought Union Bank - a government conglomerate of five distressed banks. Clearly, the massive failures, along with mergers, increased industry concentration, through a reduction in the number of banks.

The central bank realised the implications of rapid money supply growth early on, and by 1992 implemented measures to rein in the growth in money supply and the inflation rate. Unfortunately, the stage on which the crisis was to unfold was already set. The behaviour of CBs seemingly set off a trend, and BSs and FIA institutions were also, directly or indirectly, deeply invested in real assets. CBs, because of their sheer size, were, however, more insulated from the adverse consequences of their own behaviour than FIAs and BSs (see Tables 1 and 3). The trough of the crisis occurred in 1997 (see Table 3) when the Government had to intervene some 21 times. Eight of these interventions were takeovers of merchant banks, five were BSs, three were CBs, and the remainder insurance companies.

Darron Thomas is an economics lecturer. You may send feedback to columns@gleanerjm.com and darron.thomas@gmail.com.

Source: Economic and Social Survey of Jamaica (various years).