In order to enhance public understanding of national and global financial issues and institutions and the various ways in which they impact on society, Stabroek Business has asked Hand-in-Hand Group CEO Keith Evelyn to contribute a series of articles on these issues.
In this issue of the Stabroek Business, we publish the third and final in that series of articles.
In the first two parts of this article we were introduced to risk and risk management. We appreciated that all our financial decisions are based on risk. We bank our money and insure our property because we don’t want to risk losing them. We learned that financial intermediaries are risk takers as well. When they invest their customers’ money they undertake the risk that it may be lost as a bad investment. These financial institutions, we understand back these risks with their shareholders’ funds. They also manage these risks through spreading risks or diversification over many different types of investments and geographical locations. They also manage their own operational risk by ensuring that their own people and business processes are in good enough order to avoid mistakes and incompetence.
We learned that systemic risks affect the whole country, like war. In finance we learned that bank and insurance company runs are systemic risk factors because they are contagious and can affect the whole economy.
Regulation of Banks and Insurance Companies
In Guyana, bank supervision is done by the Bank of Guyana also called the Central Bank. The supervision of insurance companies is done by the Office of the Commissioner of Insurance. Bank and insurance company regulators conduct regular inspections of the companies they regulate in order to assess their risks and police their operations to ensure compliance with the many regulatory laws, rules and guidelines and to ensure that they follow corporate best practices.
One main goal of regulation is to manage risk. This entails the management of risk both on the systemic level and the management of risk on the corporate risk management level. These two are inextricably linked; in fact, corporate risk management can be seen as a form of self regulation.
As we have learned, systemic risk affect us all while corporate risk affects the shareholders, creditors, depositors or policyholders of the financial institution. The regulators must chose to protect the many, sadly sometimes even at the expense of the few. What this means is that the regulator must make regulatory decisions that serve to reduce the overall level of risk in the system as a priority to any company it is regulating should the system be threatened. This cannot be overstressed and bears great significance to what is occurring in Guyana and around the world today.
Regulators must be extremely careful because they run the great risk of creating the very instability on the corporate and systemic levels that they were commissioned to prevent. If a regulators assesses that all is not well with a financial institution is oversees, they also have to evaluate whether the situation requires action that would be seen in the public eye as a vote of no confidence in the company and ultimately the system as a whole.
Signals from regulators may worsen a situation by inciting bank or insurance company runs which may then become contagious and first harm the very customers they want to protect and second harm the entire system. It is an extremely sensitive position. You may liken it to any dangerous situation in life where panic would do more harm than good to more people. I am sure that you all would agree that the first choice would be to avoid panic but you would equally agree that these are difficult choices and situations.
Worldwide, rumours are very dangerous. That’s why irresponsibly spreading a rumour about a financial institution is considered criminal in most states. In many countries, some politically motivated people would unfortunately want to see total systemic collapse; so they would be inclined to say things that would lead to contagion. A good thing to do when someone makes negative pronouncements on a financial system, rather than to panic, is to see whether that person stands to gain politically by the collapse of the financial system. This would help your own assessment of the situation. You see now, the level of political stability and maturity in a country is a systemic risk factor.
An actuary is a professional who studies and manages the financial impact of risk and uncertainty. This is called actuarial science. They consider not only the financial impact of events that are likely but the emotional impact of undesirable events. We have already seen that emotions mean a lot to systemic stability. Actuaries’ skills in business, mathematics, economics, finance, probability, banking and insurance are so rigorously examined that only the best academic minds in these disciplines become qualified actuaries. Few others can grasp even basic actuarial science.
The regulation of insurance companies requires extensive actuarial input. The management of compliance requires the absolute application of actuarial principles whereby regulators must also consider the impact of the events that may be precipitated by their own action. Guyana’s Commissioner of Insurance is a qualified actuary and would certainly understand the importance of managing the systemic and non-systemic impact of the actions of the commissioner’s office.
The Management of Compliance
Because we live in constantly changing times, regulation must be flexible. It involves developing an understanding between regulators and the entities that they regulate. It necessarily involves negotiation and adaptability. In this process the regulator must bear in mind and act according to what best reduces risk in the system and what is the best for all concerned.
There are laws and rules that financial services organisations must follow, and there are penalties for non-compliance. However, in nearly every regulated environment in financial services, where there is non-compliance, it is up to the regulator to make a judgement as to what action he or she must take in the circumstances that best remedies the situation. The regulator is given this power in order to be flexible enough to manage risk.
Suppose a new regulatory law is passed, or some event occurs, which results in nearly all the financial institutions becoming non-compliant. By now you would have figured that this would be a systemic risk issue. This is what
happened when the latest Insurance Act and the last Financial Institutions Act were passed in Guyana. Most companies were not immediately compliant. The regulator would have been very unwise to shut down most of the banking or insurance system because of non-compliance. Instead, a time-table was worked out with the companies so that they would become compliant in the safest and most practicable manner. Stability in any financial system therefore entails effecting smooth transitions from one perhaps undesirable situation to the desired position. Regulators who operate like the proverbial bull in a china shop would inevitably do more harm than good.
Further, should an individual company not be in strict compliance, the regulator must consider what factors led to this non-compliance and what harm to the financial system and the customers of the business would take place should he or she act in a certain way. In the first part of this article, you learned that actuaries calculate the probability of ruin of a company. You can now understand that regulators must take into account whether the probability of ruin would be increased by their regulatory action. The company that finds itself non-compliant must also immediately work with the regulator and be as transparent as possible.
Five of the USA’s biggest banks have had serious problems with their exposure to derivative losses; exposures that outstripped their reserves. At year-end 2008, J P Morgan had estimated losses in this category of US$241 billion as against reserves of US$144 billion. Wells Fargo’s potential losses could reach US$109 billion compared to reserves of US$104 billion. Citibank’s estimate was US$140 billion as against its US$108 billion in reserves. Bank of America was exposed US$218 billion in total exposure to investment losses as against its reserves of US$122 billion, while HSBC USA had derivative losses of US$62 billion; more than triple its reserves. These banks would undoubtedly therefore all have serious compliance issues. How did the government deal with this? You now know well that these banks are candidates for and recipients of federal bailout money because their failure would lead to larger systemic failure. In October 2008, US Congress approved US$700 billion in funding to help the financial sector there, and that was only a start.
You can now appreciate the extent to which a government sees its responsibility to safeguarding the whole financial system. It is indeed commendable that the financial system of Guyana has remained so relatively stable while the largest banks and insurance companies in the developed world were daily facing collapse. This is clear testimony to the quality of financial management and regulation in this country. We are not immune, no one can escape global systemic fallout, but we certainly are insulated.
Over the three parts of this article we discussed what some of the technical financial and regulatory terms mean. We recognised that the management of non-systemic risk can be achieved through diversification of investments. We also appreciated that systemic risk affects us all and has a new global dimension. We also learned that its management must be the priority of regulators who must see smooth transitions and avoid panicky situations.
With respect to banking we recognise that even cash deposits can be risky and that a key test of a bank’s safety is the government’s commitment towards a safe system, the bank’s financial and human resources and its shareholders’ commitment. Hopefully we now recognise that bank regulation, central bank intervention, solvency tests and actuarial science are complex issues and that our financial management and regulatory regime have insulated us from the global turmoil.
Last and certainly not least, we have appreciated our individual responsibility towards ensuring a stable financial environment.
Keith Evelyn BA (Hons.), BSc, MBA, FCII, ACIB, Chartered Insurer has been CEO of the Hand-in-Hand Group of Companies for the past fifteen years. He is also a Past President of the Insurance Association of Guyana. He is chairman of the Small Business Council of Guyana, and holds directorships of the Berbice Bridge Company, E-Networks (Guyana’s leading triple-play internet service providers), and Prestige Motors (the official BMW dealer in Guyana).
He has degrees in banking, insurance and finance from Sheffield Hallam University and Manchester University in the UK. He is also an Associate of the Chartered Institute of Bankers (UK); a Fellow of the Chartered Insurance Institute (UK) and a Chartered Insurer (UK). He holds a Masters degree in Business Administration from the University of Liverpool (UK).