BOJ should be more proactive in banking supervision
Published:Friday | April 15, 2011 | 12:00 AM
With the recent news of the disastrous state of the CCMB loan portfolio, I believe it might be instructive for a discussion on the matter of risk management. The fact is there are several financial institutions out there that, whilst not in exactly the same position as CCMB, have been the unfortunate beneficiaries of increasing levels of delinquencies, some of which have resulted in total write-offs.
Analysis of the balance sheets of several banks and other financial institutions reveals that there has been a deteriorating trend in the ratio of non-performing loans to total loans for at least the last three years. Better-run institutions have been able to keep such ratios under four per cent (with the best being under three per cent) and others have struggled to stay below 15 per cent. These facts, however, should be understood in the context of there having been the greatest recession this economy (and the world) has experienced in several decades. Delinquency levels have risen across many countries of the world, and hence it should not come as a surprise that levels have also increased here in Jamaica.
Notwithstanding the great recession (commonly known as the credit crunch), could it be that there are significant frailties in the governance and risk-management frameworks at many of our financial institutions, coupled with equal weaknesses in the supervisory system? I am of the view that the answer to this question is a resounding yes.
RISK RATING
The popular regulatory global standard, commonly known as Basel II, encourages financial institutions to produce a risk rating for each borrower/loan facility that it has in place. Hence, lending institutions are encouraged to employ the use of credit rating/scoring models to aid in the assessment of risk. Such models should also be validated periodically to ensure that they are predictive of delinquency/default and thus still applicable.
Increasingly, it has been best practice internationally to use a credit-rating model to determine the interest rate that should be charged on a loan. If employed in this manner, the interest rate that is charged becomes known as a risk-adjusted rate, with the idea being the better the rating then the lower the interest rate, and vice-versa.
I am unclear as to whether any such models where employed at CCMB as part of (1) determining whether to lend or (2) determining the interest rate to be charged.
As part of its supervisory review process, the Bank of Jamaica (BOJ) should have been in a position to know whether any one of its licensees (including CCMB) are employing the use of risk-rating models and the efficacy of these models. Such reviews would be conducted at least annually.
Risk-rating models should be applied in the re-rating of borrowers at least on an annual basis. If this was being employed at CCMB, for example, the BOJ could have then made an assessment as to the adequacy of ratings on the basis of its own observations of the performance of the various sectors (again this is predicated on the BOJ being proactive and acting on requested information).
CONCENTRATION RISK
It is clear to those with experience of the lending market that financial institutions typically lend to a small number of sectors, the most common being tourism, distribution, retail (that is, personal) and construction. The fact is there are not an awful lot of viable sectors to choose from, and this leads me to conclude that several financial institutions will have fairly high levels of concentration to specific sectors in their loan portfolios. The risk of this type of scenario should be fairly clear to the reader. It is why from a young age many are taught not to 'put all your eggs into one basket' for fear that if we fall then we could lose all.
Best practice lending requires one of three things to happen when faced with concentration risks: (1) don't lend if such risks would result in an exposure above established policy guideline limits, (2) lend only if the new exposure adds some level of diversification to the larger portfolio for which the sector in question is a part, or (3) lend only if adequate compensation for taking on the risk can be obtained. Typically, with the latter approach, a higher interest rate would be charged on the loan. In less developed economies, such as our own, there is a reluctance to choose option three as it is viewed as making a lending institution potentially less competitive.
Much of the lending conducted by financial institutions requires borrowers to put up some form of collateral. In the case of construction lending it is typically the land and/or property being constructed that acts as the collateral. It should be stressed, however, that the purpose of the collateral is not to primarily ensure that a loan is paid off, but to act as a back up in the eventuality that borrowers default on paying over cash flows generated from the financing venture. Given that we know that the construction industry has been in decline for a few years it should come as no surprise that it might not be so easy to liquidate these types of assets without potentially significant write-downs on their value.
Clearly, if CCMB had a crystal ball, then perhaps they would not have chosen to underwrite certain loans, given the resulting level of concentration and potential losses that this would cause. The fact that such loans were granted is likely due to the outcome of deliberations of return versus perceived risk between risk management and underwriting professionals. My question would be, what attention was being paid to the portfolio effect and were the general best practice choices (above) applied?
As it relates to the BOJ, it seems clear to me that the bank had been aware of the deteriorating nature of the various sectors and, in particular, the construction sector. Moreover, the BOJ is provided with frequent reports (for example, every month) regarding the amounts of lending that institutions undertake across the various sectors. Based on this information, I believe the BOJ should have been much more proactive in identifying potential concentration risk and suggesting ways of managing this risk.
If the BOJ played a more proactive role in banking supervision, then perhaps they would have given serious thought to, and sought to, establish limits for the ratio of non-performing loans to total loans in a portfolio (as well as on a sector by sector basis). These limits could have been established as flexible in the sense that they act as a trigger for the BOJ to initiate conversation with institutions if they are breached. If a regulator is not convinced by the arguments presented at the discussion, they would then be able to exercise supervisory powers in some prescribed manner to deter increased lending in the relevant sector.
Typically in non-recessionary (for example, boom) times, loan provisions are relatively low as compared to times of economic recession. These two points of the economic cycle are also associated with rising and falling asset prices. The term procyclicality refers to the process whereby more (increases to what would otherwise be set aside in a boom economy) provisions are set aside by financial institutions in boom times so as to provide additional coverage for loan losses in a downturn of the economy.
I believe a supervisory approach, which provided specific guidance to lenders of the need to increase provisions in boom conditions, would have gone a long way towards smoothing out the impact of subsequent loan losses which, in turn, would have had the effect of reducing the volatility of earnings, which tends to have a positive impact on share prices.
MORE BAD NEWS AHEAD
I am convinced that we will be reading sometime soon about other institutions with large loan losses/delinquencies, and some with even greater levels than CCMB.
As discussed above, I believe a more proactive but handshaking approach is required by both our two financial regulators to ensure that their licensees understand the implications of various types of risks, and those risks can be quickly and easily identified by regulators and lenders alike via enhanced disclosure procedures.
Further to the above, I believe the importance of good corporate governance is required to be instilled at the CEO/board level which is often the place where much of the "bad decision making" in lending takes place. Note that this fact is often ignored or missed by many, but its implication for risk management is potentially quite serious. Simply put, bad decisions at the board level often times result in risk managers getting the blame when defaults occur (even when they were not the ones that approved or recommended the loan). This abrogation of accountability is symptomatic in institutions where good corporate governance and risk management do not take equal footing with other value drivers.
Dr Howard Haughton is the managing director of Holistic Risk Solutions Limited, a risk and financial management consulting company.