S.Venkat Raman, CEO & Chief Rating Officer, CariCRIS

 

 

Regulation plays an extremely critical role in developing financial markets, and further, in taking them to a level of sophistication. A financial market regulator’s role, at the core, is to lay down rules of engagement and monitor conformance to the same, to ensure a level playing environment for all participants and create the confidence for all stakeholders that fair practices are followed.

 

 In addition, good regulation should promote good corporate governance practices, as it should seek to set the expectations and demands of all stakeholders, by setting inviolable standards of conduct for the entities regulated- in terms of accounting, disclosure, reporting, governance structures, management practices and stakeholder relations.

 

Regulatory Models: Regulation is a tough job, especially in free market economies, and calls for careful balancing of various issues. It is also important for regulation in emerging markets to be dynamic, in that it needs to evolve over time, and shape itself according to the priorities of the market, the needs of the economy, and the maturity of market participants.  Regulation also should guard against becoming counter-productive - the cost to participants of conformance to regulation in terms of both money and effort should not outweigh the benefits and discourage the growth of the market itself.  Several models of regulation can be observed around the world; but on balance, jos_t market practitioners favour a “light-handed” system, which has comprehensive and exhaustive laws combined with minimal controls and intervention, over a “heavy-handed” system, which has minimal laws, but leaves much to interpretation and consequently frequent and drastic interventions.

 

Regulation of Credit Markets: Credit markets invariably account for the bulk of the financial system in any economy and as a consequence,  regulation of credit markets, i.e., lending and investments by financial institutions, insurance companies, pension funds, trust funds etc, is critical for determining the long term stability of the financial system. Moreover, credit and counterparty risk is the jos_t critical risk in a financial system, with the maximum potential for causing system-wide distress or losses. Accordingly the regulations which determine the credit quality and concentration risk of credit or investments become a key issue.

 

The Caribbean Context: In relatively small economies like in the Caribbean, this issue assumes greater significance, as the concentration of ownership of businesses increases the potential for concentrated exposures and connected lending. Moreover, shared ownership interests in merchant banks, commercial banks and asset management companies, a common feature in the Caribbean, may not provide sufficient scope for arm’s length transactions in investment decisions and does not present a credible degree of independence to an external observer. A scrutiny of regulations surrounding financial institutions in some Caribbean countries shows that regulation of portfolio credit risk deserves far more attention.

 

For instance, with the application of International Financial Reporting Standards, IFRS, valuation of unlisted investments is largely assumption driven (rate of return, perceived risk, profitability expectations and the value of underlying assets). Under conditions where few debt securities listed and there is virtually no secondary market in debt across the Caribbean, valuation can at best be a good guess, particularly with respect to non-sovereign debt. In such a situation, auditors, as a professional group would greatly benefit from the presence of credit ratings for debt securities that could be used to construct a yield curve across risk categories and across tenors.

 

Another area calling for attention is that of liquidity risk management in banks and financial institutions. For instance, some financial institutions in the OECS adopt a maturity bucketing of (a) less than 1 year (b) 1 to 5 years and (c) beyond 5 years, while disclosing their asset-liability mismatches.  In CariCRIS opinion, the second maturity bucket of 1 to 5 years is too broad and might potentially mask liquidity issues that might start surfacing just at the end of the 1 year period. 

 

Ratings & Regulation of Credit Markets: In the banking sector, Basel-I earlier and now Basel-II guidelines set the standard for indirectly regulating the quality of loans or investment exposures of banks. Even though the Basel guidelines relate to capital adequacy, by linking capital requirements to credit ratings, there is an in-built incentive for banks to achieve a reasonably high credit quality in order to optimise the level of capital they hold. In the Caribbean, jos_t economies are a good distance away from having a game plan for implementing Basel-II, although Barbados and Bahamas are reputed to be moving in that direction decisively.

 

For investment institutions, in many countries around the world, both developed and emerging, regulators seek to control credit quality by stipulating credit rating thresholds for investments made by insurance companies, pension funds and trust funds. A sample list of usage of ratings in regulation of investments is provided in the attached tables. A guideline which can be commonly observed in these regulations is the requirement of minimum investment grade rating (Rating of BBB- or equivalent). Another feature included by regulators in many countries, though not detailed in the tables here, is to stipulate that not more than a certain portion of the total investment portfolio can be invested in unrated debt. Similarly, either by way of formal regulations or by market practice, mutual funds (particularly gilt funds and money market funds) often use external credit ratings to determine the profile and characteristic of various investment schemes, and it is common to find schemes marketed as “AAA” Funds or “AA” Funds, which presents a clear picture to the investor about the credit risk associated with the investment choices.

 

 Table 2: Use of Ratings in Regulation in Select Countries- Emerging Markets

 

 

Local Rating Agencies: In the described instances, regulators have the ability of using rating linked investment guidelines, since in many countries local rating agencies provide national scale ratings, apart from ratings available from international agencies such as Standard & Poor’s. However it must also be borne in mind that it was such initiative with regard to rating linked regulations that led to the establishment of local rating agencies in many countries. Malaysia is a case in point where rating linked regulation preceded the establishment of the local rating agency. While lack of sufficient  number of  ratings by international rating agencies could have been a problem in the Caribbean in the past, the establishment of the Caribbean regional rating agency, CariCRIS by several Central Banks and financial institutions from across the region, makes the situation quite different now, as access to ratings for issuers is now locally available. Regulators need to now take advantage of this development and take a leaf from best practices in other emerging markets.

 

In applying ratings, regulators would need to consider the availability of rated securities, particularly when evolving from a scenario where no such regulation exists. The ideal or recommended way of resolving this problem, is to provide a graded transition. For instance the investment institution could be required to meet, say over a three year period a  desired limit of having, say 60% of all investments in investment grade rated securities, (by stipulating 20% in first year , 40% in the second year etc.).

  

Conclusion: Financial Sector regulators in the Caribbean have taken significant strides during the past decade and a half, to strengthen their respective financial systems, particularly in the wake of system failures observed in the region in the past. This is especially the case with the commercial banking sector. . While a few regulators such as the Financial Services Commission, Jamaica have taken some initiatives, across the board, there is substantial scope for strengthening regulations which drive the investments and securities market, particularly those which determine investment by pension funds, debt (mutual) funds, trust funds and insurance companies, being institutions that have serious fiduciary responsibility in terms of handling public funds. Specific areas needing attention include individual exposure quality, concentration risk and liquidity risk. The Caribbean region, as has been proved time and again, is susceptible to external shocks and the risk is heightened by the high indebtedness at the sovereign level in many countries. In this context, it behoves financial system regulators to quickly move, and the easiest way would be to appropriately borrow from tried and tested best practices in other emerging economies, rather than re-invent the wheel. While this would require some serious adjustments on part of the regulated institutions, there is no doubt that such measures would ultimately serve to make our financial systems more robust and resistant to potential systemic crises.

 

Note: This article also appeared in The Magazine of the Caribbean Association of Indigenous Banks - (CAIB 2006)  ____________________________________________________________________________________________________________________ 

Disclaimer: CariCRIS has taken due care and caution in compilation of data for this article. Information has been obtained by CariCRIS from sources which it considers reliable.  However, CariCRIS does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information.  CariCRIS is also not responsible for any errors in transmission and especially states that it has no financial liability whatsoever to the subscribers/users/transmitters/distributors of this article