We should never judge our present circumstances in isolation. There will always be a wider context. Late 2008, the world experienced the most severe recession since the 1933 Great Recession. Our region operates with open economies which are vulnerable to external shocks. The 2008 financial crisis significantly impacted our financial services sector. The global crisis coupled with countries still recovering from natural disasters such as Hurricane Ivan meant that our financial systems’ ability to absorb risk was tested.
8 years later, our regional Central Bank has been left to manage and/or resolve 3 insolvent banks, and 2 of our larger insurers have left many persons without a pension and other similar safety nets. Compounding these problems was the fact that our Governments did not have the fiscal capacity to absorb these shocks, and therefore a number of regional Governments were left having to restructure or default on debt, much of which was lent by commercial banks. The foregoing is a brief history which gives context for the current challenges of our regional financial sector.
One of the most significant obligations of a bank is to keep the funds of its depositors safe. Banks, in effect, borrow from and lend to the public. Therefore, lending decisions must be carefully considered, to make sure that depositors will always have access to their funds. Let’s examine the extreme situation. If a bank takes money from the public and lends it to one individual who is unable to repay the bank, then the bank will not be able to repay the public. The Bank will become insolvent (fail) and our society would have had a significant loss of its financial wealth. To avoid this extreme situation, banks lend to customers of perceived good risk, at a profit. The profit portion is critical as it reflects, in part, the recognition of the risk that some loans will not be repaid. Regulators then require banks to maintain a portion of those profits as capital to protect against rainy days, so that depositors will be protected where banks have unprofitable periods.
Over the last 6 years, all Banks within the ECCU have struggled with high levels of non-payment or slow repayments from the public, similar to our extreme example above. Most of this has been due to the declines in economic growth in our countries. What this has meant is that Banks have had to draw on its capital (rainy day funds) to ensure depositors remained protected over the last 6 years. This has meant that the capital of the industry has been significantly used to address recent crises.
In light of the above, we are now faced with the following questions:
- With the recent reduction in capital within the region due to external shocks, can we withstand further external shocks? Can our banks withstand the fallout from another hurricane or another global recession?
- What are the tools available to our regulators and our bankers to ensure we strengthen our financial system and the adequacy of the capital within the system?
The first question is very difficult to definitively answer, given our mix of indigenous and international banks. However, what is clear is that our banks have not fully recovered from the 2008 crises, and any further shocks will significantly challenge our system.
The second question is one which is actively being addressed by both the Central Bank and the remaining market participants. The simple answer to this question is the need for stronger corporate governance to include quality risk management with improved profitability and capitalisation to ensure our system can withstand further shocks. Our industry has responded to the challenge with improved and improving governance standards. However, the industry remains challenged by:
- Unprecedented levels of non-performing loans, which was as high as 40% of total outstanding loans at its peak. This has led to a significant loss of revenue with increased existing risk.
- Increasing deposits with restricted lending policies to protect depositors. For every personal deposit received there is an obligation to pay interest to depositors, but there are few reasonable lending opportunities to cover this payment obligation.
- Operating costs are increasing at a faster rate than revenues. This increased cost is driven in part by increased global regulation. In any business, this is a very challenging and unsustainable.
Historically, banks have cross-subsidized services. That is, when banks lent money during periods of high interest rates and high returns, services such as chequing accounts, processing of deposits, and casual queries, could all be provided at a nominal or no cost because loans were highly profitable. With the recent financial crisis, lending opportunities of an acceptable risk have been very few. This has meant that banks are fiercely competing for these few lending opportunities. As expected in any functioning market, the laws of demand and supply have been at work and interest rates have significantly been forced down for borrowers of a good risk. Therefore, while lending is still profitable, it is not as profitable as it was before. This dynamic has meant that like all well-run businesses, banks have been forced to re-examine the services provided and the costs attached to each service provided, to ensure these services are now properly priced.
In recent times, we have seen an increase in local and international regulations as the financial world grapples with the issue of money laundering and the financing of terrorism. These threats have necessitated increased supervision by Central Banks and increased laws and regulations by local and international governments. Banks have had to implement additional policies and procedures, install new systems to monitor and control money movements, attract and retain staff for key positions in the banks to spot, detect, and report dirty money; all in an effort to keep the financial system safe. All of this has increased the cost of the Bank’s operations.
The challenge of increasing costs has provided the industry both with challenges and opportunities. What the industry has learned is that customers require faster and more convenient service. Technology allows us to achieve this objective. For this reason, the industry has been increasingly investing in technology to reduce the cost of doing business, with the ultimate aim of reducing the cost to the consumer. The traditional branch network is a contributor to the increasing costs. Therefore, as consumers who seek convenience and move towards the technological channels, they will likely see a reduction in the cost to do business. Those customers who continue to use the traditional channels are likely to incur the higher costs, as banks.
The re-pricing of the financial services within recent times by the industry has been met with skepticism by the public. We, however, believe it’s critical to revisit that critical aspect of a bank’s responsibility: to protect depositors. Borrowers of good risk have been the beneficiary of recent low lending rates, but with lower lending rates and the obligation to pay depositors a minimum savings rate when there are few lending opportunities, this has the potential to weaken banks and place them in a position where they cannot withstand the shocks any further external shocks. In most global financial markets and in most businesses, market forces dictate the pricing for goods and services. In our region, market forces dictate our loan rates, but our deposit rates are dictated by regulation. This is therefore a fixed cost, which has to be covered to ensure the solvency of our system. The restriction placed on banks in managing this cost and risk forces us to manage those areas which we can. We have therefore re-priced our services which were previously provided either at a low or nominal price. However, we are very mindful of the impact on our societies and we have therefore invested in technology to provide cheaper alternatives to our more expensive channels.
Banks play a critical role in any economy and this is why they are regulated. Regulators focus on the safety and soundness of the financial system. A critical part of a sound financial system is having well managed, well capitalised, and profitable banks, which protect the financial wealth of our economies. Therefore each market participant has an obligation to ensure they are well managed to prevent any issues of insolvency. Changes in our sector have come from the need for survival, and to ensure the wealth of our countries remain protected so we prevent the failures of the recent past, as we move forward.
Eastern Caribbean Currency Union Bankers Association