On Wednesday evening, the Financial Services Commission (FSC) at its 10th Anniversary Investor Briefing, held at the Terra Nova Hotel, St Andrew chose as its subject of debate the question, “Does Financial Regulation Prevent Institutional Failure?”

Managing Director of National Commercial Bank (NCB) and Caribbean Business Report’s Business Personality of the Year Patrick Hylton was one of the presenters, choosing to address the subject both in the international and local context.

He said the crash of the global financial markets in 2008 had made the effectiveness of regulation a topical issue and that if there is one issue around which there is consensus, it is the need for reform of financial systems and how hey are regulated. The primary focus of much of this thinking has been around preventing a recurrence of these events leveraging enhanced regulation.

“In Jamaica we had our own financial sector melt down in the mid nineties. There seems to be general agreement, that many of the actions subsequently taken to strengthen and safeguard our financial systems, have worked effectively and may very well have prevented contagion arising from the global crisis of 2008.

“This does not however absolve us from evaluating the global meltdown, the drivers thereof and the subsequent changes to regulatory regimes across the globe, as a means of identifying relevant enhancements for our regulatory and operating frameworks,” said Hylton who is in a unique position to comment on this matter having served as the head of FINSAC and the head of the country’s most successful bank.

He went on to say that while one may argue generally, that financial institutions in tightly regulated jurisdictions fared better, the point can also be made that this did not necessarily spare those jurisdictions, from the contagion effect of failure elsewhere, leading to failure in their markets. This is particularly true for countries which had operating subsidiaries or affiliates of failed or failing institutions. Here Hylton cited examples such as CLICO, Lehman Brothers and the US dollar life lines provided by the Bank of Jamaica to the securities dealers.

Even in fairly well regulated markets a catastrophic fallout in fiscal and real sector economies can serve as a catalyst for institutional distress. Again here Hylton reveals his perspicacity citing the Argentinean experience where capital control were imposed.

“The economic crisis in Argentina which forced the government to impose capital controls and deposit freezes on Argentina’s nationals precipitated a run on Ecuadorian banks, where Argentina nationals held deposits. Following a sovereign downgrade, local Uruguayans began to withdraw deposits from the banks leading to liquidity shortages and the government intervening in several banks.

“There is also the risk of financial institutions being managed and or governed by persons whose interests and behaviours are not aligned with the long term sustainability of the business. Even though an efficient regulatory regime should quickly catch up with and expose such persons significant damage can be done before this happens. The 2001/2002 failures of Enron, WorldCom and audit firm Arthur Anderson can be attributed to downfalls in corporate governance and unethical behaviour.”

The inference one can draw from this is that strong regulation is a necessary but not sufficient condition for preventing institutional failures and financial crisis. In variably, certain exogenous changes come with risk implications that are impossible to predict by regulators. To the extent that some failures and crises are an unavoidable part of the cycle of capitalism, the responsiveness of regulatory regimes and all other relevant actors are critical in facilitating an accelerated recovery, which is just as important as the role of prevention.

“When one examines the evolution of financial systems and the drivers of their sustainable performance it is clear that safeguarding these systems require cooperation between multiple stakeholders. To my mind those stakeholders are:

1. The players and institutions in the industry

2. Regulators

3. Industry associations (e.g. JSDA, JBA)

4. Ratings agencies and independent analysts, auditors/actuaries

5. Government

Hylton examined these closely:

1. Institutions – Each individual institution can choose to take a path that prevents a future crisis and that sustains shareholder value for the long term. Invariably the management and Board of any corporation will be aware of any problems in their institution long before the government, auditors and regulators hence self-policing and corporate governance are critical to the prevention of institutional failure.Part II next week.

2. Regulators – Regulators do have a critical role to play. They are in a real sense the vanguards of the system. Regulators are key to maintaining confidence in the markets, ensuring consumer protections, playing a supervisory and monitoring role, reducing financial fraud and increasing public awareness. In addition to being adept at crafting legislation and regulations they need to adequately supervise and monitor institutions and the financial system.

3. Industry Associations – Associations are a good mechanism to establish codes of conduct and regulate against the code. They are also good for lobbying for appropriate regulations and legislation that improve market efficiency or reduce market threats.

4. Credit Rating Agencies and Independent Analysts – There is general consensus that credit rating agencies underestimated the risks associated with the subprime mortgage market and derivative credit products, which contributed to the 2008 crisis.Conflicts of interest derived from a model where credit ratings agencies are paid by firms issuing debt was a likely contributor to the impaired quality of ratings during this period.

This group must be independent and are critical to alerting investors, companies and regulators alike to potential failure risks. Regulations are required to support the independence of this critical player. Similar principles are to be applied to the role of auditors and actuaries who should both be required as well as protected by legislation in making disclosures of institutional weaknesses and/or malpractices.

5. Government – Government plays a key role in maintaining fiscal responsibility and macroeconomic stability, establishing a legal framework which facilitates efficiency of redress and accountability, and providing legislative support to foster effective supervision and competition.