Finsac Enquiry – OMAR DAVIS ON THE DEFENSIVE

Opposition spokesman Dr Omar Davies answers questions from Michael Hylton during the Finsac enquiry at the Jamaica Pegasus hotel on Tuesday. – Rudolph Brown/Photographer

In his seat at National Heroes Circle, Dr Omar Davies presided over a treasury that increasingly became burdened by debt, some of which is attributed to the $140-billion rescue of the financial sector. In prepared testimony presented to the Justice Boyd Carey-led Commission of Enquiry into the financial meltdown and operations of bailout vehicle, Financial Sector Adjustment Company (FINSAC), Davies on Tuesday blamed bankers. On Wednesday, his successor Audley Shaw who now presides over a treasury that is flirting with bankruptcy, charged that Davies was disingenuous in placing blame on bankers, instead of the high interest rate regime he presided over.

The full text of Davies’ prepared submission is reproduced here.

1. What options were open to the Government to deal with the financial crisis in the mid-1990s?

DAVIES: Two main options:

1. i) Appoint receivers for the failed institution(s) and allow them to dispose of assets and eventually pay depositors a percentage of their savings based on the ratio of the realised value of assets to liabilities; or
2. ii) The intervention could take the form of the establishment of an institution such as FINSAC, which would be the umbrella organisation through which depositors, holders of insurance policies and contributors to pension funds were protected.

The latter intervention obviously came with a clear appreciation that the Government of Jamaica (GOJ) would absorb the difference between the value of the assets of the institutions and their liabilities.

There are variations on each option but, conceptually, those are the two main ones which were available.

2. Which option was elected and the reason, therefore, in preference to the other options?

The second option was selected. It should be recalled that at that point in time, there was no-deposit insurance and, hence, pursuing the first option would, most likely, not only lead to the loss of their life savings by a significant percentage of the population but, also, the collapse of the financial system. In such an event, both domestic and foreign organisations would lose confidence in the system, even with regard to those institutions which had not failed.

Given that trade-off, the decision was made to establish FINSAC.

3. What was the prime purpose for FINSAC and what was it intended to achieve?

The prime objective in establishing FINSAC was to allow for orderly intervention in the failed institutions to prevent a total loss of confidence in the financial system; to preserve the savings, insurance policies and pension funds of the public. Secondly, FINSAC was charged with “healing” the intervened institutions and preparing them for divestment.

Finally, FINSAC was assigned the responsibility to spearhead the revamping of the financial system within the context of a more rigorous legislative framework.

4. How was FINSAC capitalised? From what source did the funds come?

FINSAC was capitalised by a small grant from the Ministry of Finance (Accountant General’s Department). The authorised capital was 200 ordinary shares at $1 each. Issued and fully paid up were 150 ordinary shares at $1 each.

5. Was there a loan to capitalise FINSAC?

See answer to No 4.

6. Was the public debt increase consequent on the establishment of FINSAC and to what extent?

The public debt was increased over time because of the intervention of FINSAC in the various institutions. Specifically in the first instance, ‘FINSAC Bonds’ were issued, guaranteed by the Ministry of Finance. The public debt was increased when these bonds were brought formally in the Ministry of Finance’s stock of public debt. As regards the second part of the question, ‘to what extent’, it is estimated that the cost of the intervention was approximately 40 per cent of GDP.

7. What was the reason for high interest rates between 1995 to 2000?

The interest rate policy between 1995 and 2000 was determined by the Bank of Jamaica, consistent with its mandate stability in the financial system, and in the foreign exchange market. Within the context of a coherent macro-economic programme, the interest rate policy pursued was consistent with the fiscal profile, as reflected in the annual budget.

8. Was there a time factor within which FINSAC was to liquidate the loan for its capitalisation?

As was indicated in the response to question 4 and 5, the amount used to capitalise FINSAC was minuscule.

9. What was the reason for public debt rising from 124% of GDP in 1997 to 144% of GDP at the end of 1999?

I have not checked the validity of the figures presented, although I am aware of the increase in the debt. The major reasons for the increase in the public debt during the period would have been the formal assumption of responsibility by the Ministry of Finance of the FINSAC bonds which had been issued. This step was necessary in order to “heal” the repackaged failed institutions, prior to divesting them.

10.Insofar as financial institutions were concerned, was a distinction made between those that had liquidity problems and those that were insolvent?

Yes, there was always a conceptual distinction made between institutions with liquidity problems and those which were insolvent. However, it was only after FINSAC, through forensic auditors, was able to closely examine the books of the problem institution that the full picture emerged.

11. Were the depositors of the failed institutions paid their capital and interest which was sourced from loans to FINSAC?

In general, the answer is yes. However, with regard to the depositors in the Blaise Financial Institution, they were paid 90 per cent of their savings.

12. Having repaid the depositors, why were these financial institutions closed down?

The decision was taken to close certain institutions as it would not be prudent to return them to the original investors, not only because of capital inadequacy, but also because of inappropriate management practices which were unearthed.

13. What progress did FINSAC make between 1996 and 2001 to recover funds from the delinquent borrowers and reduce its loans?

I am unable to provide a precise answer to this question, but answers should be available from the records of FINSAC.

14. What was the quantum of the delinquent loans of all the failed institutions at the time of FINSAC’s incorporation?

Same answer as No 13.

15. What was the rate of interest being charged by FINSAC between 1995 and 2002?

Same answer as 13.

16. Were there any guidelines given to FINSAC as to the disposition of assets of delinquent borrowers? If so, what were the guidelines?

The basic guidelines provided to the Board and Management of FINSAC was that equity, trans-parency and courtesy would be maintained in carrying out its activities. For the record, it should also be noted that, at all stages, the Administration sought to appoint to the FINSAC Board and that of the subsidiaries, persons of the highest integrity. In addition, all important actions taken were guided by the Solicitor General’s Department, with the personal involvement of the then Solicitor General himself, the late Dr Kenneth Rattray and his deputy Douglas Leys, the present Solicitor General.

17. Were parameters given to FINSAC within which to negotiate with delinquent borrowers?

Having established FINSAC and appointed a Board of highly reputable persons (first board chaired by Dr Gladstone Bonnick), the only policy guidelines given to FINSAC related to the sale of family residence which had been used to collateralise business loans.

18. Why was it necessary to sell the debts and their securities to Jamaica Re-Development Foundation Inc?

The decision to sell the debts was taken for the following reasons:

1. a) to allow FINSAC to concentrate on other aspects of its mandate such as preparing the restructured entities (example, NCB and Union Bank) for sale;
2. b) to allow FINSAC to provide leadership for revamping the regulatory system governing the financial sector;
3. c) to allow the administration to reach the objective of returning the financial sector to normal, within the context of a regular system which met international-best practices, in as short a timespan as possible; and
4. d) FINSAC staff were coming increasingly under pressure from some debtors, seeking preferential treatment in the settlement of their obligations.
5. What powers did Jamaica Re-Development Foundation have to enforce the collection of bad debts from delinquent borrowers that FINSAC did not leave?

I do not believe there were any.

20. Was exemption given to JRF under the Moneylending Act? If so, what was the purpose for so doing?

I do not recall, but such in-formation would be in the files at the Ministry of Finance.

21. What was the JRF exempted from consequent on the order made under the Act? Is it interest rates or any other exemption?

Same as answer to question 20.

22. Were any of the exemption orders to JRF made retrospectively?

Same as answer to question 20.

23. What was the total amount in monetary terms of the debts sold to JRF?

Same as answer to question 20.

24. What percentage of the total debt was the deposit made by JRF?

Same as answer to question 20.

25. Why were no conditions attached to the exemption order to JRF?

I do not recall. The files at the Ministry of Finance would contain all the relevant correspondence.

26. In what way was it in the public interest to give JRF an exemption under the Act? (Section 14).

Same as the answer to question 25.

27. Were any guidelines given to JRF as to how assets of delinquent borrowers should be disposed of?

No, expect for the request or a moratorium of a certain period to allow those clients who had reached an agreement with FINSAC but had not been able to complete arrangements for financing prior to the transfer.

28. Was any consideration given to the fact that interest rates were reduced by commercial banks, and what was to be done to delinquent borrowers?

After the sale of the bad debt portfolio, the Ministry of Finance had no direct influence over the actions of JRF. However, it was assumed that since JRF was a commercial operation, they would be sensitive to changes in the market.

29. Was it expected that the rate of interest charged by JRF should also be reduced accordingly? If not, why?

See answer to question 28.

30. Was it intended that JRF should be at liberty to charge any rate of interest on delinquent debts, consequent on the exemption order?

See answer to question 28.

31. Was any direction given to JRF as to the rate of interest chargeable, consequent on the reduction of lending interest rates by commercial institutions?

Not by the Ministry of Finance. Please see answer to question 28.

32. What was the reason for packaging the bad debts and advertising for a debt collector to deal with same, when this was the purpose for which FINSAC was established and had been doing so for seven years?

Please see answer to question 18.

33. FINSAC has been in operation for a period of fourteen (14) years and dealing with the enforcement of delinquent loans. What then was the purpose of selling the delinquent loans and securities of a foreign corporation?

Please see answer to question 18. The fact that the firm purchasing the portfolio was a foreign one was irrelevant to the decision. Of note is the fact that a prominent local firm which had, initially, expressed interest in purchasing the bad debt portfolio, had made proposal significantly below that from JRF.

34. How were the loans to FINSAC to be repaid and in what time?

Based on the proceeds realised from sale of assets, FINSAC has contributed to the repayment of some of the debt incurred through intervention in the failed institutions. However, by virtue of the rationale for its establishment, it was clear that FINSAC would never be able to repay all the loans which had been guaranteed by the Ministry of Finance.

As such, the remainder became part of the public debt, and repayment the responsibility of the Ministry of Finance.

35. Has the loans to FINSAC been repaid to date? If so, what was the status of the loans as at 2005?

Please see answer to question 34. As regards part 2 of the question such information can be made available by the Debt Manage-ment Unit of the Ministry of Finance.

36. At any time were any directions given to the Central Bank concerning interest rates?

No directions were given by the Ministry of Finance to the central bank concerning interest rates.

37. Were any directions given to the Central Bank concerning monetary policy, in particular, exchange rate, inflation and financial stability? And, if so, what were they?

No directions were given to the Central Bank. However, in terms of the development of policies related to exchange rate, inflation and financial stability, the governor and senior members of the Bank of Jamaica (BOJ) were involved in ongoing discussions with me, as minister of finance, the financial secretary and the director general of the Planning Institute of Jamaica concerning overall macro-economic policy.

Within that context, the macro-economic programme was developed for each fiscal year and for the medium term.

38. Were any directions given to the central bank to make loans available to insolvent financial institutions?

After the Administration took thedecision to establish FINSAC, the Central Bank was the only institution capable of making funds available to facilitate the intervention. However, repayment of these resources became the responsibility of the Ministry of Finance.

39. In cases where FINSAC sold properties below market value, was the delinquent borrower credited with the market value or the value at which FINSAC sold the asset?

I do not know that there were any such cases. I would add that in financial transactions of this type, the only valid ‘market value’ of an assets is that which a buyer is willing to offer.

40. Was any external advice sought as to how to deal with the financial crisis in the mid-1990’s? if so, from whom and what was the advice?

Yes. Advice was sought from the International Monetary Fund (IMF), the World Bank and the Inter-American Development Bank (IDB). The discussions took place in both Kingston and Washington and dragged on for several months.

The summary of the advice which was eventually received was that intervention would be costly and would impact for an extended period on the fiscal accounts.

Against that background the advice was to allow institutions to fail; their principals excluded from future participation in the financial sector and the depositors paid out of the proceeds of the sale of the assets which existed. In order to effect this approach, there was the recommendation to close the whole financial system for a period of two weeks to implement all the required changes.

This last recommendation reflected a total lack of appreciation of the implications of such an action and was rejected as impractical.

41. What was the prime purpose for the Financial Sector Legislation in 1997?

There were six main objectives:

1. i) to provide more effective powers for remedial action to be taken by the supervisory authorities in respect of distressed institutions;
2. ii) to reduce the capacity for institutions to lend to, or invest in, related parties;

iii) a more stringent computation of capital adequacy;

1. iv) a more precise definition of non performing rules and provide increased power for the supervisory authorities to prescribe accounting rules;
2. v) to provide the supervisory authorities with greater control over changes of ownership; and
3. vi) a stricter definition of a ‘fit and proper person’, for managers, directors and owners.
4. Was an international audit firm retained to do a forensic audit on the failed institutions? If so, what was the firm and what recommendations were made?

Two international firms were retained to do forensic audit:

1. Lindquist-Avay from Canada; and ii. Ernst and Young out of the UK.

A major recommendation made by both firms was that civil proceedings should be instituted against the principals of the failed institutions. This advice was followed with significant success. In certain instances, they advised that criminal prosecutions should proceed, but this has not met with the same success as in the civil suits.

43. The BOJ Supervisory Department made reports clearly indicating the insolvency of certain financial institutions. Why was timely action not taken by the Minister of Finance, although he had legal authority? Why were these institutions allowed to have caused a major systemic problem in the finance system?

The BOJ did make reports indicating insolvency, or expected insolvency of certain institutions. However, in virtually all instances, the level of bad loans was far greater than initial inspections. It was agreed by Cabinet, the Ministry of Finance and the BOJ that attempts would be made to work with the principals to inject capital and sell assets, in order to address the deficiencies identified. However, after many attempts, it became apparent that the principals had no genuine commitment to carry out the undertaking given and the decision was taken to do a generic intervention, through FINSAC. (My address to Parliament on July 16, 1996 provides a comprehensive report on the experience with the Century Financial Entities.)

44. The November 1996 report of the IMF, IDB and International Bank for Reconstruction and Development (IBRD) estimates the size of the insolvency of Jamaican financial institutions at 20 per cent of GDP and advised immediate action to rectify the situation.

The same report says that your administration decided that this was not “politically possible”.

Can you please explain what was meant by that statement? Do you think that the eventual cost of 40 per cent of GDP was an acceptable trade-off in this regard?

I do not recall the specific report to which reference is made. I recall discussions with the institutions and the representatives of the institutions were told that the closure of so many institutions would result in chaos.

I do not recall the use of the term “politically possible”. I do recall it being pointed out to the multilateral the potential social consequences of some of their recommendations.

As regards the trade-off of the cost of the intervention, there can be no definitive response.

Whilst the eventual cost was greater than expected, there is no way to assess the social chaos which have resulted from taking some of the actions recommended by the multilateral, for example, closure of the system for two weeks.

45. The IMF, in its letter of November 27, 1996, stated that “it has been our experience that no resolution strategy can be successful in restoring a financial system to soundness in the absence of a sound macroeconomic framework that is consistent with achieving a sustainable and low rate of inflation as well as external viability. Jamaica’s policy mix of fiscal laxity, monetary restraint, and exchange rate stability is, in our view, not consistent with achieving such macroeconomic objectives”.

Are you in agreement with this assessment? Was this advice acted upon?

I am in agreement with Part I of the assessment and actions were taken to achieve the objectives listed. These actions produced reduced inflation, an increased primary surplus, and stability in the foreign exchange market.

Within that context, I would agree that the advice was acted upon.

I do not agree with the observation in the second part of the paragraph, in particular the reference to fiscal laxity.