The Contours of a Future Regional Crisis – and the Need to Look Back to the Future

It is all too easy to attribute new causes to future crisis events. The need in advanced economies for effective reforms to address systemic risk and the supervisory challenges arising from this have largely dominated the discussions as to the furtherance of financial stability following the events of the past three years. Yet, the recipe for promoting financial stability is not uniform across all national and regional financial systems. In the case of the national and regional financial sector of the Caribbean, cross-sectoral risk may not be the most urgent weakness and this may not be the most instructive approach for addressing the potential for future financial sector crisis events.  Systemic risk is no doubt an increasingly significant component of the supervisory and institutional design of national and regional regulatory systems in both developing and advanced economies, indeed a natural corollary of globalization on the financial system but it may not be the primary deficiency that is likely to contain the seeds of a latent crisis event in the region. Rather, more useful for the purpose of predicting futures significant disruptions from the financial sector and in designing the most appropriate policy interventions, a more instructive approach may well be to look back to the future. Specifically, this refers to the need to examine the extent to which core issues of development and those that have contributed to earlier financial crises in the region may yet be un-resolved and may contribute to further failure events with implications of a regional nature.

A few points need to be borne in mind in addressing this issue. Historically episodes of financial sector disruptions in this region have predominantly been attributable to fraud – rather than contagion, as has been the case with the recent global financial markets turmoil. Second, the weaknesses in the advanced economies where the last global crisis erupted resulted from financial markets that had moved so far from the traditional models of finance for which regulatory frameworks had been designed , in their level of innovation and in providing “hybrid” and cross-sector forms of instruments that regulatory systems could not effectively appreciate the passage, degree and impact of risks. Such advances promoted arbitrage and were not appropriately governed by traditional supervisory systems for the purposes of safeguarding the stability of the financial system. This is not the case in the region. Financial instrument innovations hardly originate in the markets of the region and models of finance have remained relatively faithful to traditional practices. Such traditional practices augur against a proliferation of exotic products that outpace regulatory tools. Contagion and the related supervisory challenge of adapting supervisory techniques for advanced, cross-border risk transfer while important and a continuing pillar in advancing supervisory capacity, may not be the most compelling challenge at this time for the region. It ought nonetheless to receive attention in advancing supervisory capacity and enabling future development of the financial markets. Third,the financial systems of at least some countries in this regional group continue to be very bank-centric in that they display financial sector landscapes populated predominantly by banks, whether commercial or investment, rather than insurance companies, hedge funds and other NBFI’s. Accordingly, in identifying and assessing the existence and impact of risks to financial stability on national and regional levels it is important to recognize the role and greater weight of the banking sector to the larger economy. This includes appropriate attention to significant consequences of banking failures on the economies, particularly important where few large banking institutions seek to increase their share of or already cover large segments of the regional market. The potential here for future failures from  governance deficiencies – on the overall sector and economy must be considered a high priority here. Governance in this context refers to traditional concepts of corporate governance and to the further notion of governance within the regulatory system.

As George Orwell stated in Animal Farm – “All animals are equal but some are more equal than others.” This certainly applies in the  case of the governance of the financial system. All institutions and weaknesses (supervisory, market, risk) are equal in theory and in the need for regulatory redress, yet some failings are more compelling than others in terms of the potential for significant disruptions to the region and some institutions more important in this concentrated financial sector context including for the purposes of ensuring prudent standards and system wide stability. The degree of urgency with which such weaknesses need to be addressed depend rather on a complex combination of factors that define each system and in practical terms may be conceptualized in terms of the consequences of a failure to address.  Further, the governance challenge must certainly be more equal than other concerns.

In the context of small island developing nations, the governance challenge twinned with widespread corruption and changes in political parties can strongly undermine transparency in the financial and other sectors and mask the true failings that in the case of financial institutions can result in widespread economic distress if these failings – whether of risk, governance, corporate fraud or other causes – are allowed to go undeterred in the hope that disruptions shall be minimal or due to a short-term perspective. Given the historical context, bank-centric systems as well as the traditional approach to financial innovations, there is a strong chance that fraud – rather than inter-institutional systemic risk – shall play a dominant role in facilitating another major crisis event in the region.

For the financial sector, the broader issue of corruption manifests through myriad ways – seemingly lax corporate governance practices, regulatory hesitation to confront or intervene (particularly prior to a financial institution’s failure) for multiple reasons ranging from political pressures to fears of foreign competition and even regulatory xenophobia. The issue of funding from the regulated sector in terms of political contributions only adds to the conflict and challenge. It is arguable that at least in the case of the financial sector, such a tendency can pose significant conflicts of interest where regulators may be deterred from regulatory interventions that may be objectively prudent and in the best public interest. For the purpose of the financial sector the need for a politically and financially independent regulatory authority becomes compelling. It is a question that speaks both to private sector governance and public sector accountability. At an extreme, it bring to the fore the issue of whether public policy making can be subordinated to the private sector demands and what the meaning of this is for the public good.

There is a need to review the governance practices of major financial institutions int he region before contemplating further policy measures. The past history of failures in the region demands this even in the absence of recent global developments. The combination of concentration in terms of few dominant institutions is highly relevant for considering the impact of such deficiencies particularly when contemplating regional expansion. Given the historical context, bank-centric systems as well as the traditional approach to financial innovations, there is a strong chance that fraud rather than inter-institutional systemic risk shall play a dominant role in facilitating another major crisis event in the region. Regulatory capacity – or the exercise of the regulatory function – has been constrained not by such limits – but its weaknesses in effectively supervising the financial sector are reflective of ongoing concerns of broader significance – in particular, weak governance practices (private/public), corruption at multiple levels of the public system and a highly politicised environment.

Financial stability in this regional context may be less a result of an inability to foresee the convergence of events on a cross-sectoral level and the extent to which crisis events can result even in the context of safe, sound financial institutions but more a direct result of the catastrophic impact of the failure of a major bank or NBFI on the region due to regulatory oversight in the performance of traditional micro-prudential supervision. Reliance in purported deviant practices by other financial institutions – whether by the institutions or by the regulators – really serves no appropriate defence in this area. It is an exercise that needs to be fact-driven and based on an independent analysis of the practices of each individual bank. The micro-prudential rule-book does not contain such a waiver..

The weaknesses in the region are more fundamental and damaging in terms of revealing either regulatory failure, ineptitude to supervise a traditional system, passivity in the face of governance failings, or all of the above. Left unattended, these may pose the greatest risks to the financial system and endanger growth in the region. A system that is passive in the face of such failings is unlikely to be a conducive environment for expansion or growth and does not promote the objectives of consumer protection or financial stability.

It is time to consider that the regional challenges are not a reluctance to keep pace with financial market innovations or regulation with the advanced economies globally but rather more basic and potentially damaging failures – negligence, lack of transparency and accountability at many levels of the system. These are governance failings that augur against the public best interest. Such weaknesses serve to offset the benefits associated with traditional financial systems that would otherwise have been a useful feature. The future stability of the region demands attention to these core issues of governance and corruption with specific emphasis on the ways in which they emanate in the financial sector and can disrupt sustainable development and financial stability. Combined with a concentration of supervisory power, there is scope for a regulatory system that serves the interest of few, promotes unjust enrichment and is detrimental to the interests of the consumer. Failure to address such challenges ultimately means that the possibility of this leading to systemic crisis with national and regional implications may well be a question of when, not if.