Monitoring And Regulating Banks, Merchant Bank & Building Societies INTRODUCTION In keeping with the overall theme of this seminar, the protection of your money, I wish to discuss with you this morning certain provisions which are contained in the law regulating the establishment and operation of deposit taking financial institutions, which are designed to give a greater degree of protection to depositors in these institutions. The institutions concerned are those regulated and supervised by the Bank of Jamaica and the Minister of Finance and Planning, being commercial banks, licensed deposit taking institutions which are commonly referred to as merchant banks and building societies. The discussion will focus on provisions which were introduced into the law in October 1997 mainly in respect of commercial banks and merchant banks, and to a lesser extent building societies, as well as some Regulations which were brought into effect in 1995 in respect of building societies. These provisions were introduced into the law to bolster the supervisory and regulatory powers of the Minister of Finance and the BOJ to deal with problems in the financial sector which emerged in around the mid 1990’s. As a general comment, you will notice that a number of the provisions do not equally apply to building societies. This is because the law governing building societies is in the process of being comprehensively revised and when this exercise is completed it will contain a great many of the provisions now applicable to banks and merchant banks. In many instances, despite the absence of provisions in the law, the BOJ through prudential supervision, sees to it that appropriate action is taken by building societies, similar to that required by banks and merchant banks, to ensure the safety and soundness of building societies. We will now examine the various provisions.
CAPITAL ADEQUACY All supervised financial institutions are required by law to maintain a level of capital to ensure the safety of their operations. One of the principal purposes of a financial institution’s capital is to absorb any losses which the institution may incur, so that depositors funds are not put at risk. Up to October 1997, the amount of capital which banks and merchant banks were required to maintain was set in relation to the level of deposits which they took. It has now been recognized that the real risk to an institution lay in its total assets, being loans made and investments undertaken, so that the assets must now be given a rating to reflect the level of capital needed to support different types of lending and investment activities. In accordance with this approach, the law has now been amended to provide for the adequacy of a financial institution’s capital to be determined relative to the risk it incurs in its business. By virtue of the amendment, the Bank of Jamaica (BOJ) will now be able to prescribe different kinds of risk weightings to different kinds of lending and investment activities so as to ensure that adequate levels of capital are maintained by financial institutions in proportion of the risks associated with their business activities. Prior to 1995, there was no statutory requirement for building societies to maintain capital. In 1995 Regulations were made prescribing a minimum capital requirement for them and allowing for the adequacy capital to be determined a basis similar to that now used for banks and merchant banks.
LICENSING One of the requirements to be satisfied by persons who are directors, managers and shareholders of companies seeking licenses to operate financial institutions, is that such persons be "fit and proper". Originally, the criteria for establishing fitness and property were based on the relevant persons not having been previously convicted of an offence involving dishonesty or not being undischarged bankrupts, or not having an employment record which gives the BOJ reasonable cause to believe that such persons previously carried out acts involving impropriety in the handling of banking business. These criteria were quite narrow and restrictive and did not take account of factors such as the individual’s history of competence, probity, soundness of judgment and diligence in doing business. The law governing banks, merchant banks and building societies has now been amended to empower the Bank of Jamaica to take account of this wider set of criteria in establishing the suitability of persons as managers directors and substantial shareholders of companies wishing to be granted a licence to operate a financial institution.
RESTRICTIONS ON THE GRANTING OF CREDIT FACILITIES One of the major causes of the failure of financial institutions in Jamaica has been the over-extension of credit to connected persons. These include managers, directors and shareholders of financial institutions, their relatives and business associates and companies with whom either the financial institutions or the connected individuals are associated. There have always been restrictions in the law on the amount of credit which banks and merchant banks may grant to persons connected with them, and on the levels of investment which these institutions may undertake them, and on the levels of investment which these institutions may undertake in other enterprises. However, in practice, because the transactions were not at arm’s length, these restrictions were often abused. Quite often, loans were made to connected persons in excess of the established limits, without proper assessment of credit risk, without sufficient security or, in some cases, without any security whatever. Given the high level of risk to a financial institution associated with connected party lending, the law governing banks and merchant banks has now been amended to achieve the following:
a. to absolutely prohibit the granting of insecured loans to connected persons; b. to reduce from 100% to 505 the total amount of its capital which a financial institution may c. d. e. f. g.
invest in all other enterprises; to reduce from 20% to 10% the amount of its capital which a financial institution may invest in any one enterprise; to provide that a financial institution’s overall exposure to all connected persons, in respect of credit facilities granted on a secured basis and investments made, is to be limited to 20% of the financial institution’s capital; to provide that a financial institution’s overall exposure to any one connected person, in respect of credit facilities granted on a secured basis and investments made, is limited to 10% of the institution’s capital; to reduce from 10% to 5% of its capital the total amount of unsecured credit which a financial institution may grant to one person ( not being a connected person); and to reduce from 20% to 10% of its capital the total amount of unsecured credit which a financial institution may grant to any group (not being connected persons)
Furthermore, the financial penalties for breaching these new limits have been significantly increased to reflect the seriousness with which the BOJ and the Minister of Finance regard obedience to these provisions. These restrictions are not yet imposed by statue on building societies, but the BOJ, through its prudential supervision of building societies ensures that sound and prudent credit and investment practices are observed by them.
NON-PERFORMING LOANS Originally, when a burrower from bank or merchant bank became delinquent in making payments of principal and/or interest due on his loan, the lending institution was not required to classify the loan as non-performing before a period of six (6) months had elapsed. At that point the institution was required to create a bad debt reserve in respect of the loan to cushion losses arising from non-payment. During the six (6) month period, lending institution would continue to include the unpaid interest as profits on its books. This practice had the effect of grossly overstating the profits of financial institutions and particularly so, when the incidence of non-performing loans began to rise steadily from about 1995. The law governing banks and merchant bank has now been amended to require those institutions to classify loans as non-performing after being in arrears for three (3) months (instead of six (6) months) and to cease booking interest and create a bad debt reserve as at that time. Furthermore, whereas originally the amount of bad debt reserve to be held was left to the discretion of the institution and its auditors, provision has now been made in the law for the BOJ and the Minister of Finance to prescribe the amount of the reserves which must be maintained. Where building societies are concerned, prior to 1995, there was no specific legal requirement for dealing with bad debts. In 1995 the six (60 month period for ceasing the accrual or interest and creating a reserve was introduced into the law. The law governing building societies is not in line with that relating to banks and merchant banks in actual practice the BOJ, through prudential supervision, imposes a similar three (3) month requirement so as to effectively put building societies on the same footing with banks and merchants banks.
DUTY OF EXTERNAL AUDITORS TO REPORT ON ADVERSE MATERIAL TRANSACTIONS All supervised financial institutions are required to submit to BOJ on a yearly basis, audited financial statements attesting to their financial condition as certified by their auditors. The auditors would be fully familiar with the various transactions and activities undertaken by the institution as disclosed in their accounting and financial records. The BOJ recognises the special position which the external auditors of financial institutions occupy in being able to identify, during the course of their audits, transactions undertaken by the institutions which have the potential to give rise to problems which could put depositors’ moneys at risk. If these transactions are brought to the attention of the BOJ, this early warning would allow for appropriate remedial action to be taken in good time before the problems assume more serious proportions. The law has been amended to require external auditors of banks and merchant banks to report in writing to the BOJ, any significant transactions or conditions which come to the auditors’ attention in the course of the audit which meet one or more of the following criteria:
a. any change in accounting policy or any presentation of, or failure to present, facts or figures b. c. d. e.
which, in the opinion of the auditors, has the effect of misrepresenting the financial position of the financial institution; transaction or conditions giving rise to significant risks or exposures that have the potential to jeopardize the institution’s financial viability; transactions or conditions indicating that the financial institution has critical weakness in internal controls, which render it vulnerable to significant risks or exposures that have the potential to jeopardize the institution’s financial viability; transactions of an irregular nature that have a significant material impact on the institution’s financial position; transactions or conditions which contravene the financial institution’s governing statutes, particularly the provisions relating to capital adequacy or liquidity requirements.
It is recognised by the BOJ that the primary responsibility to take corrective action tests with the management of the institution. Accordingly, provisions have been included in the law requiring that, in addition to advising the BOJ of the problems discovered to the audit, the auditors must also make reports of the problems discovered to the chief executive officer. Failure to the auditor to comply with this requirement is an offence punished by fine or imprisonment. Where building societies are concerned, while there is no corresponding provisions in their governing law for auditors to report significant transactions, there is provision for BOJ to summon the auditor of a building society for the purpose of enquiring into the operations of that building society. this provision is available to the BOJ to obtain information from a building society’s auditor regarding significant transactions which could be harmful.
EXPANDED AUDITS Further use of the work of a financial institution’s external auditors to ensure the safety and soundness of the institution is achieved by the inclusion of a provision in the law regulating banks and merchant banks to empower BOJ to require the auditors of such institutions to report in writing to the BOJ on the extent of the auditor’s procedures in auditing the Balance Sheet and Profit and Loss Account of the institution and its subsidiaries, and also to increase, where necessary, the scope and extent of the audit or perform such other audit procedures as the BOJ may specify and make a report to the BOJ in respect of these findings. Failure by the auditors to comply with any such requirements is an offence under the law is punishable by fine or imprisonment.
MINISTERIAL APPROVAL FOR THE ACQUISITION OF CONTROLLING INTERESTS Under the law governing banks and merchant banks, where an agreement is entered into for the acquisition of a controlling interest in a local bank or a merchant bank by any person, the agreement is subject to the approval of the Minister. The position, before October 1997, was that where an application for approval was made to the Minister, he had to give his decision within 21 days of the receipt of the application, and if the Minister failed to respond within the twenty-one day period, he was deemed to have waived the requirement for approval. In assessing the application,
the Minister was required to satisfy himself that the applicant was a fit and proper person and that the interests of the institution’s depositors would be adversely affected if the applicant obtained a controlling interest in the institution. The period of twenty-one days proved far too short for establishing an applicant’s fitness and property or assessing the effect of the acquisition on an institution’s well being. Furthermore, the provision for automatic approval, in the absence of a decision by the Minister within twenty-one days, was undesirable. The law has now been amended to provide that the time period allowed for the Minister to review and make a decision on such applications is increased to sixty days and further, to remove the provision for automatic approval in the absence of a response from the Minister within the prescribed time. The amendment also introduces into the law, a set of conditions to be taken into account by the Minister in assessing the application, in addition to the fitness and property of the applicant. These conditions are:-
a. the nature and sufficiency of the financial resources of the applicant as a source of continuing financial b. c. d. e.
f.
support for the institution; the soundness and feasibility of the applicant’s plans for the future conduct and development of the institution’s business; the business record and experience of the applicant; whether the institution will be operated by persons who are fit and proper persons; where the applicant or any of the applicant’s affiliates is a deposit-taking financial institution, the size of: a. the institution intended to be acquired by the applicant, and b. any deposit-taking financial institution affiliated wit the applicant to be calculated on such basis as the Minister considers appropriate, and the best interests of the financial system in Jamaica.
TRANSFER OF POWERS OF INTERVENTION FROM THE MINISTER OF FINANCE TO BOJ Prior to October 1997, the power to intervene in problem financial institutions was exercisable by the Minister of Finance who would, of course, act on the recommendation of the BOJ. These powers of intervention consisted mainly of:
a. requiring undertakings to be issued by the Board of Directors of a financial institution to take b. c. d. e. f.
necessary corrective action; issuing directions to a financial institution to take necessary corrective action; issuing Orders to the financial institution to cease and desist from engaging in the particular harmful activity; taking temporary management of the financial institution; applying to the Court for the liquidation of the institution or for its reconstruction, or for a Scheme of Arrangement to be made between the institution and its creditors; suspending or revoking the institution’s licence.
While recognising that the more serious powers of intervention ought to be exercised by the Minister of Finance, on the basis that he is ultimately responsible for the financial sector, it was also recognised that the BOJ should itself be able to exercise powers of intervention at an early stage of problems occurring without the timeconsuming process of advising the Minister and waiting for him to take action.
Accordingly, the powers to require undertakings from financial institution’s Board of Directors, it issue directions to financial institutions and to issue Cease and Desist Orders have now been transferred from the Minister of Finance to the BOJ. This will allow for the speedier exercise of those powers of intervention which will in turn lead to a greater level of protection for depositors.
VESTING OF SHARES OF NON-VIABLE INSTITUTIONS As has been indicated before, there are specific powers of intervention which may be undertaken both by the BOJ and the Minister of Finance in respect of problem financial institutions, with the more serious ones being exercisable by the Minister. The traditional powers available to the Minster are subject, however, to a vast number of procedural steps and can be challenged in Court by directors and shareholders of institutions against which action is taken. So that, where the protection of depositors’ interests requires prompt and decisive action to bring about the re-organization of a financial institution, and the managers, directors and shareholders of the institution refuse to co-operate voluntarily, the time and expense necessarily involved in undertaking the traditional powers of intervention will not be I the depositor’s interests. To allow for the taking of prompt and decisive action, provision has been put into the law governing banks, merchant banks and building societies to give the Minister of Finance power, after consultation with the BOJ, to determine that a financial institution has ceased to be viable and to take action leading to the shares of the institution being vested in the Minister, subject to Cabinet approving the Minister’s action. Upon the shares being vested, the Minister technically assumes ownership and control of the institution and is put in a position to enter into a wide range of restructuring transactions in respect of the financial institution to benefit its deposits, including the sale of the shares or the sale of assets. or both. The shareholders and directors of the institution cannot interfere with the Minister’s restructuring powers and their remedy lies in a claim for compensation out of any surplus moneys remaining after a restructuring transaction is undertaken, if indeed there is any surplus. The first instance of the exercise of this power took place in July, 1998 when shares of Workers’ Savings and Loan Bank, Corporate Merchant Bank and capital assurance Building Society, were vested in the Minister. The restructuring of these institutions is now well underway.
SPECIAL AUDITS OF FINANCIAL INSTITUTIONS There have been occasions in the past on which the BOJ has been dissatisfied with the manner in which audits have been carried out by the auditor engaged by a financial institution. One institution in which this situation was found to exist ultimately failed and questions still remain concerning certain dealings which ought to have been identified by its auditors but were either never at all raised or were apparently misrepresented in the audit reports. In order to ensure that audits accurately reflect the condition of the financial institution, provision has been included in the law governing banks and merchant banks empowering the BOJ, in circumstances where it considers it necessary, to appoint an auditor, other that the auditor engaged by the institution, to undertake a special audit of the institution and to make a report to the BOJ of the findings of such audit with particular emphasis on
whether the financial institution’s systems and procedures are adequate for the protection of its depositors and shareholders.
EXAMINATION OF BOOK AND RECORDS OF HOLDING COMPANIES OF FINANCIAL INSTITUTIONS In some cases, the shares of financial institutions are held by other companies (known as holding companies). There is no limitation on the types of businesses in which these holding companies may be engaged. Activities undertaken by these holding companies can severely affect the health and condition of the financial institution, hence it is important that the regulatory authorities be in a position to gain first hand knowledge of what is taking place in the holding company. Prior to October, 1997, holding companies of financial institutions were required to submit their audited financial statements to the BOJ, however, BOJ had no power to actually examine the books of holding companies to establish whether transactions were being undertaken which were detrimental to the subsidiary financial institution. The BOJ has now been given the power to examine the books, records, statements and other relevant documents of holding companies of banks and merchant banks, as well as to require the managers of such holding companies to provide such information in respect of such companies as the BOJ deems relevant.
STANDARDS OF CORPORATE GOVERNANCE The BOJ recognizes that its role as Supervisor of the financial system is not limited to enforcing the specific provisions of the regulatory laws, but extends to putting in place systems and procedures to ensure that financial institutions generally behave in an appropriate manner, both for the protection of individual depositors and the soundness of the financial system in general. Accordingly, after extensive discussions with the financial institutions, it has established standards of Self-Governance for financial institutions are run according to the well established principles of safety and soundness. These standards relate to the following areas of the institutions operations:
i. ii. iii. iv. v. vi. vii. viii.
Capital Management Credit Risk Management Liquidity Management Securities Portfolio Management Interest Rate Risk Management Foreign Exchange Risk Management Internal Controls Real Estate Appraisal Management
While these standards are not yet to be found in the law, degree of conformity with them is taken into account in the BOJ’s assessment of whether or not an institution is being properly run. A system of self assessment has been devised to allow institutions to take ongoing stock of their conformity with the standards.
CONCLUSION The provisions outlined constitute the steps which have been taken so far to bring about greater level of protection to depositors’ funds. There is a Task Force on financial legislation which has been established by the Minister of Finance which is maintaining an ongoing review of the law to ensure that other areas of concern are dealt with. Experience has taught that effective supervision and monitoring of financial institutions requires that the law keeps in step with developments both locally and internationally so as to allow the supervisory and regulatory authorities to recognize and effectively deal with problem situations both for the protection of individual depositor and the financial systems in general. Randolph G. Dandy Senior Legal Counsel Bank of Jamaica 22 July 1999
